Goldman Sachs Level 3 Assets Jump, Exceeding Rivals

Goldman's share of Level 3 assets surged 39 percent to $96.4 billion at the end of February from $69.2 billion in November, according to a filing with the U.S. Securities and Exchange Commission today. The ratio of Level 3 to total assets rose to 8.1 percent from 6.2 percent.

While many subprime-related stakes that lost almost 100 percent of their value since July were categorized in Level 3, other holdings such as private-equity stakes, real estate and rarely traded corporate debt are also included because market prices for them aren't available. More assets have become difficult to value in the last three months as investors shunned a wider array of credit, reducing trading.

Goldman Chief Financial Officer David Viniar said last month the Level 3-to-assets ratio had risen to about 8 percent mostly because some assets classified as Level 2, including commercial real estate loans, dropped to Level 3. The biggest increase in the hard-to-value category was a 59 percent jump in derivative contracts, according to today's filing. Mortgage and other asset-backed loans and securities increased 56 percent in the quarter.

Under accounting rules, Level 1 assets are those for which market prices are readily available. Level 2 holdings are valued based on ``observable inputs,'' or prices of similar assets traded in the market. Assets fall into the Level 3 category when there are hardly any observable inputs, and the firm has to rely on in-house models to calculate potential gains or losses.

Morgan Stanley's & Lehman's Ratio

Morgan Stanley's Level 3 assets rose 6.1 percent to $78.2 billion last quarter, the firm said today in an SEC filing. Lehman, which also filed a report with the agency today, said its Level 3 holdings rose 1.3 percent to $42.5 billion. All three firms are based in New York.

The U.S. Recession

We are experiencing the worst US housing recession since the Great Depression and this housing recession is nowhere near bottoming out. Housing starts have fallen 50% but new home sales have fallen more than 60% thus creating a glut of new –and existing homes- that is pushing home prices sharply down, already 10% so far and another 10% in 2008. With home prices down 10% $2 trillion of home wealth is already wiped out and 6 million households have negative equity and may walk away from their homes; with home prices falling by year end 20% $4 trillion of housing wealth will be destroyed and 16 million households will be in negative wealth territory. And by 2010 the cumulative fall in home prices will be close to 30% with $6 trillion of home equity destroyed and 21 million households being underwater (40% of the 51 million having a mortgage). Potential credit losses from households walking away from their homes (“jingle mail”) could be $1 trillion or more, thus wiping out most of the capital of the US financial system.

The US is experiencing its most severe financial crisis since the Great Depression. This is not just a subprime meltdown. Losses are spreading to near prime and prime mortgages; they are spreading to commercial real estate mortgages. They will spread to unsecured consumer credit in a recession (credit cards, auto loans, student loans). The losses are now increasing in the leveraged loans that financed reckless and excessively debt-burdened LBOs; they are spreading to muni bonds as default rates among municipalities will rise in a housing-led recession; they are spreading to industrial and commercial loans. And they will soon spread to corporate bonds – and thus to the CDS market – as default rates – close to 0% in 2006-2007 will spike above 10% during a recession. I estimate that financial losses outside residential mortgages (and related RMBS and CDOs) will be at least $700 billion (an estimate close to a similar one presented by Goldman Sachs). Thus, total financial losses – including possibly a $1 trillion in mortgages and related securitized products - could be as high as $1.7 trillion.

Rosner on the Prospects for the Credit Market

We have been talking about this for six months, but there seems to be a refusal on the part of many observers to accept that the losses reported to date have been primary trading book write downs vs. actual charge offs of loan losses. Citigroup (NYSE:C), for example, did just 120bp in aggregate charge offs in 2007.

There is a lack of appreciation or maybe a lack of understanding between these two issues, mark to market losses and actual credit losses, and we need to distinguish between these two issues. I continue to believe that we are going to see further downward pressure on home prices -- regardless of what the Congress believes or intends or manipulates. Unless we actually nationalize the housing industry, there is not much we can do to avoid the downward correction in home values.

Case for L Shaped Recession

Credit hedge funds are now the weakest link in the chain, Morris says. Their equity stands at some $750 billion and is so massively leveraged that "most funds could not survive even a 1 percent to 2 percent payoff demand on their default swap guarantees," he writes.

Morris sketches a scenario in which hedge fund counterparty defaults would ripple through default swap markets, triggering writedowns of insured portfolios, demands for collateral, and a rush to grab cash from defaulting guarantors. The credit system would suffer "an utter thrombosis," he says, making the subprime crisis "look like a walk in the park."

What he fears is that the U.S. will instead follow the Japanese precedent, seeking to "downplay and to conceal. Continuing on that course will be a path to disaster."

What's not debatable is what will happen if $1 trillion is written off. And that is the other "D" word: "deflation". A $1 trillion debt writeoff can hardly mean anything else. Furthermore, a $1 trillion writeoff will affect a whopping $10 trillion in future lending.

If the Fed and Congress drag this out, which at this point seems likely, we will see a severe "L" or "WW" shaped recession playing out over several (or more) years.

Central Banks Are Dangerous

As Herb Stein told us, what cannot go on forever won't. "When the music stops, in terms of liquidity, things will be complicated." Remember that? The music may have stopped already for Citibank, but it's still playing for the USA. The record is just beginning to skip.

The Trillion Dollar Meltdown

Either way we are only at the beginning of a process of realizing, acknowledging, writing down and accounting for the full variety of financial and real losses that the worst financial crisis since the Great Depression and the most serious recession in decades will entail. So the recent partial recovery of equity markets after the Bear Stearns is delusional; conditions in credit markets and money markets remain extremely strained and the onslaught of weak macro and financial news has not reached its peak yet. So the worst for the real economy and financial markets is ahead of us, not behind us.

Lehman raises $4 bln of capital to hush critics

Lehman Brothers Holdings Inc (LEH.N: Quote, Profile, Research) raised $4 billion of capital on Tuesday by selling convertible preferred stock in a deal designed to stop questions about the Wall Street investment bank's stability.

Shares of Lehman rose over 16 percent, as the offering met with strong demand, after rumors of looming write-downs left some investors worried that Lehman could face a drain on its cash resources similar to the run on the bank that triggered the collapse of Bear Stearns Cos Inc.

Investors are jittery about investment banks, and particularly Lehman, after Bear's demise and more than $200 billion of write-downs industrywide tied to subprime mortgages and other debt.

Some investors question whether Lehman has written down enough of its $73.4 billion of mortgage and real estate assets, but Lehman has said its valuation measures are fair.

Lehman has also said it suspects short sellers have spread false rumors about the company to profit from share declines. The company said last month that it has nearly $100 billion of assets at its holding company that could be easily sold or borrowed against.