The Trouble with Credit Market Alarmism

Nice comment from Rick Bookstaber on how amateur-hour behavior in marking to market leads to unnecessary credit market alarmism:

I have seen a number of sources extrapolate the E-Trade transaction, asking what would happen if all the Level 3 positions of banks and investment banks were to be remarked based on this transaction. This seems to be a variation on the game that started a month or so ago of assessing the prospects of a bank staying in business based on the ratio of Level 3 assets to capital. I think this is an exercise that is alarmist. Level 3 positions are not all sub-prime or even all CDO. There may be Level 3 positions that are good as gold, but simply do not have comparables or models that can provide adequate marking. And it is no surprise that these institutions are highly leveraged – they typically might have a balance sheet that is twenty times their capital. So with that sort of leverage, and with the sorts of businesses they are in (remember, they tend to make markets in things that you can’t just run out and buy on an exchange), it is not surprising to me that they will have Level 3 assets that are greater than their capital. But again, “Level 3” does not mean “worthless”.

A few people singing over-loud praises of today’s Federal bailout might give this a second read.


  1. I disagree with this comment. The very fact that you are speculating whether an asset has value or not, because the company has no basis to value it other than it own model, shows a complete lack of transparency. If I were an I-bank and I had a level 3 asset that had a discernable transparent value, not a speculative ‘mark to model’ value, than that asset should be moved to level 1. The point is there is no transparency, and thus saying that level 3 assets are not worthless is just speculation. The sad part is all of this level 3 stuff is in compliance with GAAP, so everyone can happily say that the financial statements are not materially misstated.

  2. Im not sure I agree with the prior comment. Some level 3 assets are high quality investments with real value, but are simply not traded on any market. Examples would include investments in private equity and venture funds, mezzanine debt etc. These assets may not be impaired at all, they are just not the type of investments that one marks to market each day. Level 3 is a label that indicates the character of the assets, not their quality or value which can only be ascertained by evaluating each individual position.

  3. Thomas Pindelski says:

    There seems to be a general belief that ‘prime’ and ‘good quality’ are synonymous.
    That is not correct.
    ‘Prime’ is not the same as high quality.
    The typical 5/1 ARM which is called ‘prime’ would require IO for 5 years, then resets to a conventional 30 yr. P&I loan. The system classifies these as prime loans, meaning they are simply priced off prime after the reset, but that has nothing to do with their credit quality.
    Now 5% on $1mm IO is $50,000 per year. A 7% conventional P&I loan is $79,836/year in payments. Most of the 5/1 programs (the most popular) start to reset in 2008.
    So your payments just went up 60%. Few can afford that. So many of the ‘prime’ 5/1 ARMs are bad. ‘Sub-prime’ is not the only category in trouble.
    If the underlying point is that Level 3 assets are not worthless, then obviously that is right. The broader question is whether Level 3 is materially understated owing to the absence of these so called prime loans.

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