Monday, 12 November 2007

Ever heard of FAS 157?

No, I hadn't heard of it either until I read this article in the Times. It is a new accounting standard that requires banks operating in the US to classify their assets into three categories:

  • Level-one assets, which are easy to value or trade, have to have quoted prices in active markets such as US government bonds or gold bullion;
  • Level two assets, which are not as fully marketable as level one, but still sufficiently tradeable to have a definite value;
  • Level-three assets usually artificial financial instruments, which do not have quoted prices in active markets.
This new accounting standard kicks in on Thursday and guess what we find; all the major banks are holding mountains of level three assets. Unmarketable, and difficult to value. In some banks, the mountain of level three assets are so large that it is greater than bank capital (the difference between the banks assets and liabilities and as such the cushion against insolvency).

The times quoted the following numbers for the holdings of level-three assets;

  • Lehman has $22 billion;
  • Bear Stearns $20 billion;
  • JP Morgan Chase $60 billion.
  • Goldman Sachs. has $72 billion of level-three assets, out of total assets of $900 billion.
These four banks alone are holding $170 billion of assets that can not be properly valued. What are these so-called level thee assets? A fair proportion might be sub prime related toxic debt.

Here is a question no banker wants to hear; if a large proportion of a banks balance sheet can not be properly valued, then what is the value of the bank? The answer must be "eerrr, we don't know". I hesitate to examine the implications of that kind of answer, but the name Northern Rock does come to mind a little more quickly than I would like.

Six months ago, it would have been hard to imagine that investment banks could be in such poor shape. Yet it all goes back to one source; property. This news might be coming out of the US at the moment, but take no comfort from that. It is just that their housing market is about 18 months further down the road of financial ruin. We here in the UK have just taken our first tentative steps down that path.

Once the housing market starts to crash here, it is a fair bet that we will begin to hear quite a bit about the deteriorating asset quality of UK banks. Lest we forget, the first run on a major bank happened in the UK and not over in the States. Our housing market is more overvalued, with more deeply indebted consumers and more reckless banks. The buy-to-let speculative wheeze is British to the core.

When the brown stuff hits the fan, things will be worse here.

1 comment:

Anonymous said...

What we are finding out in the USA is that everytime a new city joins the party the infection spreads quicker. Its amazing how fast these markets crumble right before your eyes. I think the UK will catch up to us very quickly.