Gold News

Level 3 Assets

Buying assets with borrowed money is a dangerous game...

WE DIDN'T NEED to go far in the headlines this morning to find the issue of capital – what it is, what it does – at stake yet again, writes Dan Denning for The Daily Reckoning.

   "The US Securities and Exchange Commission will require investment banks to disclose their capital and liquidity levels after the agency was criticized for regulatory failings in the wake of the Bear Stearns collapse," reports Jesse Westbrook at Bloomberg.

The SEC will require Wall Street firms to report on their capital and liquidity levels in "terms the market can readily understand and digest." Oh right! So now we will know who has an excess of dodgy assets over real capital.

But of course, we already knew quite a bit about that.

A new accounting rule last November required banks to report their assets in three categories, ranging from the easiest to sell and value (Level 1) to the very hardest to sell and value (Level 3).

We also know that all five major US investment banks – Goldman Sachs, Merrill Lynch, Bear Stearns, Morgan Stanley, and Lehman Bros. – have Level 3 assets that are at least double the capital listed on their balance sheets.

Write-downs in Level Three assets – meaning a cut in their recorded value – directly affect a bank's capital. It might not seem like such a big deal at first. After all, at Merrill Lynch, Level 3 assets represent just 8% of the firm's total assets. The trouble is that in the first quarter of this year, Merrill saw its Level 3 assets grow to $82.4 billion...up by more than two-thirds in just three months.

It's not just Merrill, either. Goldman Sachs reported that its Level Three assets grew by 39% in the first quarter to over $78 billion. Those investments still represent just 8.1% of the firm's total assets. But again, they exceed by a large margin the firm's capital base.

The same is true of Lehman Brothers. And let us not mention that total liabilities for these firms are many, many times greater than stockholder's equity. And in an unrelated development, shares for all five investment banks have slipped. National US securities firms have lost 6% of their value so far this week.

Seriously, with so many assets parked up on Level their ability to attract new capital infusions from foreign investors now suspect – and with conditions in the American consumer economy so dire – what utterly oblivious investor would consider financial shares "good value"?

When your assets are really liabilities waiting to be born, your capital hangs by a slender thread.

Here in Australia we can see a fair share of balance sheet problems too, both at the household and corporate level. We read in today's Age, via professor Steve Keen, that "At the bottom of the 1990s recession...Australia's debt was about 78% of GDP. It is now 165%. That's more than doubled over the past 15 years."

In 1892, he says, debt peaked at 104% of GDP and in 1931 it peaked at 77%. Put another way, Australians are way more indebted than ever before, with the housing boom to thank for it.

But buying assets with borrowed money is a dangerous game.

Best-selling author of The Bull Hunter (Wiley & Sons) and formerly analyzing equities and publishing investment ideas from Baltimore, Paris, London and then Melbourne, Dan Denning is now co-author of The Bill Bonner Letter from Bonner & Partners.

See our full archive of Dan Denning articles

Please Note: All articles published here are to inform your thinking, not lead it. Only you can decide the best place for your money, and any decision you make will put your money at risk. Information or data included here may have already been overtaken by events – and must be verified elsewhere – should you choose to act on it. Please review our Terms & Conditions for accessing Gold News.

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