Wall Street playing with more funny money

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NEW YORK (Fortune) -- Banks' exposure to illiquid, hard-to-value assets jumped sharply higher in the third quarter, a development that deepens concerns about the transparency and strength of bank balance sheets.

Recently, banks have been required to show in financial statements which of their assets and liabilities rarely trade and are therefore valued according to in-house estimates. These so-called level three assets ballooned at banks in the third quarter as markets for many mortgage-related assets seized up, with Merrill Lynch posting the highest increase - a nearly 70% jump - in its level three assets from the second to the third quarter, according to a Fortune survey.

It might sound like an increase in assets is a positive thing for a bank. But no financial institution wants to record a big increase in illiquid assets, because pricing and selling them is difficult and, if the credit crunch persists, many of them could be a source of large losses in coming quarters.

Investors have long been skeptical about the values that the banks themselves place on their level three assets, and that mistrust deepened after both Merrill and Citigroup (Charts, Fortune 500) recently revealed huge mortgage-related losses that were much bigger than outsiders had expected.

Changes in the values of all assets and liabilities typically create a gain or loss in a bank's income statement. At banks, assets classified as level three have been hurt to differing degrees by the credit crunch. Least hit, so far at least, are private equity stakes and real estate holdings, but the level three bucket also includes leveraged buy-out loans, as well as seriously problematic assets like subprime mortgages and collateralized debt obligations (CDOs), which are securities that pool together asset-backed bonds.

Investor frustration about the lack of transparency in banks' balance sheets have contributed to the recent slump in bank stocks, which are down 12% since the end of Sept., according to the KBW Banks Index. And even if credit markets stabilize for some assets, and lead some banks to record non-cash, unrealized gains on level three assets, those profits won't be considered anywhere near as dependable as earnings from more liquid assets. Indeed, many level three assets were deemed to be reliable earners until very recently; in the first half of this year, level three assets were a big driver behind earnings at several banks, as Fortune first reported in September.

So, how much did level three assets increase in the third quarter? Merrill's 69% jump took level three assets up to $27 billion. A big part of that increase was due to a shift of $6 billion in subprime mortgage-related assets to level three from level two, the classification for assets that are theoretically more liquid than level three assets but still don't get valued according to prices in active markets. (Only level one assets are valued on a bank balance sheet according to quoted prices in liquid markets.)

Merrill (Charts, Fortune 500) says it moved assets to level three from level two because they became less liquid. At $27 billion, Merrill's level three assets are equivalent to 70% of Merrill's equity (which is the net worth of a bank after liabilities are subtracted from assets).

Of course, no bank's level three assets are going to be marked down to zero, so the comparison with equity doesn't mean these assets could potentially wipe away all or most of a bank's net worth. However, since future losses are most likely to come from level three asset markdowns, a comparison with equity makes sense, because the losses will immediately cause a hit to equity - and banks need strong equity to grow and maintain high credit ratings.

To get a better grip on how level three assets might affect a bank, it makes sense to look at what exactly makes up level three assets, though this can be hard because of banks' limited disclosure. In the case of Merrill, for example, we know that a sizable share of level three assets are distressed mortgages and CDOs, which are likely to be subject to further losses in the fourth quarter.

Goldman Sachs' level three assets leapt by a third in the third quarter to $72 billion, which is equivalent to 184% of equity. That looks high. However, Goldman spokesman Lucas van Praag responds that roughly half the increase was due to leveraged loans. These loans are nowhere near as toxic as subprime mortgages and CDOs. Van Praag adds: "It's worth noting that, since the end of the quarter, the leveraged loan market has eased somewhat and pricing inputs are more readily available."

With its nearly $90 billion of level three assets equivalent to 255% of equity, Morgan Stanley looks particularly exposed to illiquid assets. In response, a Morgan Stanley spokesman notes that much of the level three total isn't in distressed mortgage assets, but assets like private equity and real estate. In announcing $3.7 billion of losses on subprime in the two months ended Oct. 31, Morgan Stanley disclosed a remaining net subprime mortgage exposure at Oct. 31 of $6 billion. The subprime assets that give that exposure are all in level three, the bank says.

But focusing only on level three assets would be a mistake, because banks could also be holding assets at disputable values in their level two buckets. For example, some of the CDOs that Merrill marked down in its third quarter were shifted from level two to level three. To be sure, in the second quarter, those CDOs may have been correctly classified as level two, but the movement of assets between levels at Merrill shows that these regulatory classifications are frustratingly fluid. Since banks typically don't disclose gains and losses from level two assets, this part of their balance sheet is likely to remain opaque.

Much hope has been placed on banks' auditors making sure that assets are properly valued, especially those marked according to internal guesstimates. In October, the Center for Audit Quality, which represents the auditors, warned brokerage managers and company directors that they had no choice but to abide by a recently introduced accounting rule for valuing illiquid assets.

But even a well-resourced auditor can't be expected to properly scrutinize the huge amount of level two and three assets sitting on banks' balance sheets. For the seven banks Fortune surveyed, level three assets totaled over $430 billion, equivalent to 110% of the banks' combined equity. That number will likely increase in the fourth quarter, making bank balance sheets even harder to read. Yes, that's right: Wall Street's black hole is getting bigger.