The Answer to Who's Next on Wall Street

Beating analysts expectations--expectations that companies routinely jawbone down--has shares in Lehman Bros. (LEH) and Goldman Sachs (GS) trading higher today, despite the fact their first-quarter profits fell more than 50% versus a year ago.

Brush aside the pixie dust. Don't join the hallelujah chorus just yet, much as I'd personally like to, given that I am a long-term bull--I like to quote a buddy of mine who jokes that his epitaph on his tombstone is going to read "I'm in it for the long term."

There is a little-known, little-understood but crucially important time-bomb of a profit figure that is swamping the net worth of Wall Street firms with red ink and putting their book values per share, one of the most important valuation measures for banks and brokerages, in intensive care.

It's a relatively new number investment houses now must disclose beginning this past Jan. 1, according to new accounting rules. It's a number Wall Street has been desperately submarining out of sight in their profit reports, hoping you'll zip right by it.

It's an issue we've been talking about on our morning show, Money for Breakfast, for months now, as the result helps answer the question on everyone's lips: Who is next?

This earnings result has helped blow out the economic circuits at places like Citigroup and Merrill Lynch, it's helped create a record $195b in writedowns at western banks. Its being held partly to blame for the meltdown at Bear Stearns, and it's a big reason why the Federal Reserve threw Bear a $30b lifeline.

It is also partly why CEOs have been frog marched out the door, it has helped torch tens of billions of dollars out of investor portfolios and it has caused many market watchers to start applying Novocaine to their nerve endings. It's the reason why Wall Street has sheepishly gone hat in hand to sovereign wealth funds in the Middle East and Asia.

It's such a touchy number that Goldman didn't disclose an updated figure for it in its recent profit release or on its earnings call today, waiting to do so weeks from now when it has to file its latest quarterly with the Securities & Exchange Commission. Lehman also didn't print the figure in its earnings release, but disclosed the number on its earnings conference call this morning.

But with the help of Fox's crack statistician and researcher, Jonathan Fallon, we got the figures for you. It's important to hold onto these numbers, known as level 3 assets, in coming days, even if you don't own shares in these companies, because the financials are causing chaos in the markets.

Note: Latest figures available. Source: Company filings; Lehman's numbers were reported in the company's conference call

The figures represent the value of the risky, illiquid mortgage- and credit-backed securities that companies can't get price tags on because the markets for them are frozen solid, as traders have bolted in panic from all corners of the credit market. They are the zombie securities that are typically backed by the sub prime and other credit deals now defaulting left and right, dead loan walking.

Companies must deduct the changes in the value of these Frankenstein securities from their profits, causing steam pipes to burst. These securities, which are going belly up right and left, are already submerging shareholder capital (a company's assets minus it's liabilities, similar to your own net worth).

Now this isn't to say that all of these assets will drop into a ditch. No one knows, it depends on the credit markets. All could be worthless--all could have value. Some analysts now say to figure out what future hits to earnings could be at each firm, multiply the level 3 assets by 15% to 20% to get a rough idea, those percentages equivalent to what the best guesses are about how much mortgage- and other credit-backed assets have further to drop (if you're really bearish, raise those percentages). The resulting writedowns get carved out of both company profits and book value.

Level 3 assets provide one of the truest gauges of the speculative bender Wall Street was on during the housing bubble. And it proves we are still in the third inning of this crisis.

The level 3 bucket can hold other items, to be sure. For instance, Morgan Stanley and other firms generally classify private-equity investments as level 3, because private equity deals, being private, aren't traded on any market.

But for the most part, level 3 assets are a no-man's land, as they tend to be securities no one wants, which is why the firms tend to bury information about these holdings in footnotes using typeface that are the font size of pharmaceutical disclosures.

Because no one wants them, there is no market for them. And because there is no market for them, these holdings are priced based on top management's best guess of what they think they are worth, using their own idiosyncratic, internal models, a "mark to market" valuation approach that has been jokingly redubbed "mark to  myth" or "mark to make-believe," (see prior blogs "What's Really Rocking the Stock Market," and "The Bear Trap"). Level 3 assets are also the subject of a growing controversy in Washington, DC as the Securities & Exchange Commission mulls a plan to relax the accounting rules used to book them.

Lehman Bros. says its level 3 assets have lately dropped by $3b to $38.7b, after having more than doubled to $42b in the last six months of last year. Lehman in its most recent quarterly report took just a $1.8b "mark to market" haircut against earnings due to the market downturn in these holdings.

But $38.7b is still a big number, outstripping Lehman's $24.8b in shareholder equity, or what's generally understood as net worth. The number was of such concern that it was partly why Lehman has hastened in recent days to point out that it has not just a $2b credit line--a sign of the good faith and confidence its lenders have in its operations--but also that it has a "robust liquidity pool" of $34b plus other "unencumbered" assets of $64b to plug this black hole.

The numbers are pretty frightening--they show the financials still have a long way to go. For instance, Wall Streeters are now talking about just how vulnerable Merrill Lynch really is. The numbers show that Merrill has $41.4b in level 3 assets, far above its $31.9b in shareholder equity.

Check out the havoc level 3 assets have wreaked in the third quarter. These assets caused Morgan Stanley (MS) and Lehman Bros. to report earnings declines, and they helped create an $8.4b writedown at Merrill Lynch ($24.5b to date), triggering the largest losses in Merrill's history.

Goldman Sachs has been better than its compatriots at disclosing its level 3 assets, being first out of the box to do so last summer, a full two quarters before new accounting rules forcing such disclosures began January 1. "We are in the asset valuation business, and we don't think it's possible to manage risk effectively if you don't know the value of your assets and liabilities," says a Goldman spokesman.

Goldman's level 3 assets actually helped juice its earnings in its third quarter. It booked a 79% increase in third-quarter profit, the biggest on Wall Street at the time, even after it took a $1.48b loss from problematic high-yielding loan assets.

Goldman reaped a third quarter net gain of $2.94b from level 3 derivatives, $2.62b of which came from what are called "unrealized" or paper gains made from these derivatives trades that can't yet be cashed out yet--likely because no one wants to give cash for this, shall we say, mysterious paper, according to excellent analysis by Fortune Magazine. 

Again, Goldman is not telling investors yet what its level 3 assets are right now. Investors have to wait a month or so for those numbers, to see how much of its profit figures came from such paper gains.

What we do know is that Goldman held a bigger slug of hard-to-value assets as a percentage of total assets at the end of the third quarter than Citigroup (C), which, besides Bear Stearns, was among the hardest by the subprime meltdown.

Goldman's level 3 assets accounted for 6.9% of the New York-based firm's $1.05t total at the end of the third quarter 2007. Citigroup recorded 5.7% of its assets as level 3 on Sept. 30th.

However, Goldman's exposure becomes more serious on closer look. For the full fiscal 2007 year ending November, Goldman had $69.2b in gross level 3 assets, with over half coming from the iced-over private equity and real estate investment market, which has left firms including Goldman stuck with loans.

Although the $69.2b is down from the $72b Goldman reported in the quarter ending in August, it is still 45% higher than the $47.6 b the company reported in February, and was 26% more than Goldman's shareholder capital of $42.9b.

And the level 3 number can show how the credit crisis has clearly gone viral, which we've known for some months now. For instance, buried in  Morgan Stanley's year-end financial results, you'll see that the level 3 pot grew by about $7b due to problems with commercial loans--now of growing concern, too, as it's largely been the residential housing sector that has caused lots of hair-tearing around the country.