November 6, 2007

Haven’t heard of Level Three Accounting?  By the time you do (or at least by the time you read about it in the newspaper and/or hear about it on the TV) the Financial sector of the economy and of the stock market will be going through the ringers (even more than it is now).

I am not going to get into the details of accounting because that will just bore most people.  So I apologize ahead of time to those that, like me, love the details.  But trust me there will be a lot of commentary from other news sources on this subject in months to come.

There are three pools of assets (Level 1, Level 2 and Level 3) that preparers of financial statements must classify.  The most liquid and easily identifiable assets (as far as prices and valuations are concerned) are Level 1 holdings.  These could include common stocks (IBM, GE), mutual funds, ETFs, etc.  Level 2 holdings are less frequently traded securities (like restricted stock) which may be valued by using either recently executed prices or even prices of similar, more liquid investments.

Level 3 holdings include CDOs, subprime mortgages, and other often-unpriceable holdings that require assumptions, guesses, and too-often hopes of what a price might be.     

So when you hear about a major investment bank being unsure about what future write downs may be, they are really saying that they are not sure how to value the holdings in the Level 3 asset pool.  And unless they go ahead and sell a portion of the assets in question (which gives us a real-time market value) they likely will have to assume, guess, and/or hope that that what they “calculate” at the end of the quarter will be accurate.

So how concerned am I with the hidden time bombs buried in Level 3 accounting pools?  Let’s try to make some comparisons. Admittedly, comparisons are difficult because we do not know what the Level 3 write down losses will ultimately be.  Currently most estimates start at about $100 billion, but there has also been quarter-trillion dollar figures bandied about. 

To put things in perspective, in 1998 the infamous hedge fund Long Term Capital Management imploded.  The losses were not $100 billion, but closer to $3 billion (less than what Citigroup has already written off).  And the result was about a 20% haircut on the stock market.

A better comparison might be the savings and loan crisis of the 1980s.  Over 1,000 savings and loan institutions failed and losses totaled $150 billion (that amount has not been adjusted for inflation).  It is hardly arguable that this was not a huge contributor of the 1990-1991 recession (an oil price spike and Fed inflation fighting also contributed).

On the other end of the spectrum is the three-quarter of a trillion dollars worth of losses that Japan lost its 1990s banking crisis.  That led to a decade of economic and market turmoil.

Using empirical evidence to extrapolate possibilities, this situation may be most like the 1980s savings and loan crisis.  The result?  A recession.  And what is a recession good for?  Usually about a 20% loss in the stock market.