Wishing away toxic assets

June 10, 2009

It wasn’t too long ago that there were worries on Wall Street, and presumably in Washington, about the rising tide of so-called Level 3 assets on bank balance sheets. That’s all those hard-to-trade and impossible-to-value securities that many like to call “toxic assets,” but that U.S. Treasury officials euphemistically refer to as “legacy assets”.

These days, however, Washington policymakers seem to have forgotten all about those concerns. How else can you explain the Treasury’s decision to allow 10 banks to repay $68 billion in TARP funds, even though the trash heap of ailing real estate-related securities and other troubled assets at many of these institutions has only grown since last summer.

That’s right. The percentage of assets that can’t be traded or valued on the open market is up at 6 of the 10 banks repaying money to the Treasury. And at some banks, the increase in the percentage of Level 3 assets from last summer is substantial, according to an analysis conducted by the Los Angeles-based research firm Audit Integrity.

Bank of New York Mellon most recently described 7 percent of its assets as Level 3, compared with just 1 percent last August. The surge in the percentage of assets classified as Level 3 was even greater at U.S. Bancorp and State Street.
Only JPMorgan Chase and Capital One reported a decline in the percent of financial assets they characterize as difficult to value with independent, or outside prices.

Now there are a number of factors that could be contributing to the rise in the percentage of Level 3 assets at institutions like State Street and US Bancorp – none particularly good.

One is that as balance sheets shrink, banks are having an easier time finding buyers for more of their liquid assets, meaning the percentage of untradeable, illiquid assets is getting proportionally bigger.

Or, as Audit Integrity’s Jim Kaplan suspects, some financial institutions may be reclassifying some assets as Level 3, simply to avoid valuing them at depressed market prices and incurring additional write-downs.

Either way, this is bad news because for as long as a bank’s balance sheet is jammed-up with toxic or untradeable assets, it will be reluctant to get back into any serious lending to consumers or small businesses. Banks will be reluctant to expand their balance sheets as long as they still have a mountain of assets they can’t unload or properly value.

Shares of financial stocks may continue to rally on the knowledge that the U.S. government will no longer let a big institution fail the way it let Lehman Brothers crash and burn in September.

And banks will no doubt continue to make money on deposits as long as the Federal Reserve keeps interest rates low. But none of that will do much to deal with the banks’ continuing Level 3 asset problem.

In letting big banks return TARP money, the Obama administration is all but insuring that its much-hyped plan to help the banks rid themselves of toxic securities is all but dead. The Treasury is essentially relinquishing whatever power it had to compel financial firms to participate in the balance sheet cleansing program known as the Public-Private Investment Program.

But the problem of toxic assets weighing down their balance sheets hasn’t gone away. All that’s changed is that Washington has stopped talking about it.

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