The Kryptonite Still On Wall Street's Books

Being that I've been around the block now doing business journalism for two decades, I've seen my share of nonsense and impenetrable stupidity.

There are very few experts I admire, respect and listen to.

One of them is the economist Ed Yardeni, who I think is brilliant. Yardeni has a crack staff of economists, a really sharp squad, taking a hard look at the numbers for investors -- including Debbie Johnson, chief economist; Joe Abbott, chief quantitative strategist; and Mali Quintana, senior economist. They do their homework in this shop, and what they put out is a must-read.

Yardeni and his team recently released a report that sought to shed new light on the now almost hackneyed comparisons between the US housing and credit crisis and Japan's financial crisis during the 1990s.

It's been an interesting but now well-ventilated comparison. The thrust of it is, Japan was too slow to write down its problem loans in the ‘90s -- mostly because its banks had heavily invested huge sums in each other, so they were basically propping each other up.

Japanese banks also submerged these problems out of sight, and responded too slowly to get rid of these problem loans, causing the country to lose an entire decade of growth, what's called its zombie decade.

Lost in the comparison between the US and Japan here are other parallels between the two economic disasters.

For instance, the fact that the reason US Congress abolished Glass-Steagall, which had kept the iron-clad walls up between traditional deposit-taking banking and investment banking, among other financial products, was largely due to heated competition from Japan back in the late ‘80s, the very products that got them in trouble.

Lost, too, is the fact that back then, Japanese banks had notoriously low capital cushions against their book of businesses. Ironic, yes, given the thin sliver of a wedge in the form of capital cushions you'll find at many beleaguered US institutions, against highly levered business models.

Anyway, Yardeni and his team point out that US financial institutions aren't hiding their losses. "That's obviously true, given that the S&P 500 financial companies have reported huge write-offs over the past four quarters," he points out, with some $503 billion (and climbing) in losses and writedowns.

But Yardeni warns that "actually, this is only obviously true if we continue to ignore the losses that remain hidden in the so-called 'Level 3' assets of financial institutions."

As Yardeni explains, under new US accounting rules that took effect only last year, publicly traded US companies must value their assets at market prices and include them in certain buckets in their financials. Yes, understanding accounting can make you feel like you are bicycling through quicksand, but it's important -- it's what drives valuations and the stock market.

The rules set up three buckets to hold problem assets. The Level 1 bucket holds the assets that can more easily be sold in the markets. Those assets not easily sold and valued based on partial market data by using valuation models get stuck in the Level 2 bucket. If there is no market available, the assets are Level 3, and may be valued based on the best guesses of management. Meaning, these assets are poison, Kryptonite, so they are valued based upon what's called marked-to-myth or mark-to-make-believe accounting.

Yardeni and his squad plowed through the quarterlies of the S&P 500 Financials to find out more about these assets. What they found should send a chill down your spine:

* Among the eight large commercial and investment banks that have been reporting this information since Q3-2007, over the past four quarters, Level 3 totaled $461 billion (Q3-2007), $485 billion (Q4-2007), $600 billion (Q1-2008) and $612 billion (Q2-2008).

* Level 2 totaled $4.3 trillion (Q3-2007), $4.5 trillion (Q4-2007), $6 trillion (Q1-2008) and $5.5 trillion (Q2-2008). "These numbers suggest that there may be plenty more kitchen sinks that will weigh on earnings for the large banks during the second half of this year," Yardeni warns.

* What about Level 1 for the big 8 banks? "Unbelievably, these are tiny compared to Level 2 and aren't that much bigger than Level 3," Yardeni says. Level 1 totaled $1.1 trillion (Q3-2007), $1.1 trillion (Q4-2007), $1 trillion (Q1-2008) and $956 billion (Q2-2008).

There's more, Yardeni notes. I can't deliver this information any better than Yardeni did, this is straight from his report -- again, his information, and the analysis collected and delivered by his team, is as vital as oxygen to investors.

"Writing in the 8/15 issue of The Washington Independent, Charles Morris observes: "During the first half of the year, they [Freddie Mac] moved $154 bn of securities backed by high-risk mortgages from Level 2 to Level 3. A reasonable guess is that they're carrying them at 80 cents on the dollar, or thereabouts.

Morris adds: "But these are the same class of instrument that Merrill Lynch recently cleared off its books for 22 cents on the dollar. At a minimum, Freddie may be sitting on another $30-$50 bn in losses. Freddie ended the half with only $13 bn in equity supporting $879 bn in assets."

Morris writes: "If a beam of sunlight hits those Level 3 assets, the walking corpse instantly shrivels into ashes. Almost laughably, Freddie plans to solve its problems by raising another $5.5 bn in capital--or will as soon as its investment bankers tell them the time is 'propitious.'"

Yardeni then quotes from the Aug. 11 Wall Street Journal, which reported that Lehman Brothers had only $32.4 billion of Level 3 assets, far behind Goldman's $58.8 billion and Morgan Stanley's $57.1 billion.

But the WSJ notes that Lehman's Level 3 assets constitute 23% of all of its financial instruments -- the same percentage as much-larger Morgan Stanley and far higher than Goldman Sachs, for which Level 3 assets account for only 18% of its total financial instruments.

And Yardeni says: "Compare those Level 3 assets as a percentage of tangible common equity, which is a metric that measures how much equity is available to stockholders.

Lehman's Level 3 assets are 146% of its tangible common equity -- less than Goldman, where it is 162%, but far more than Merrill Lynch, whose recent fire sale of collateralized debt obligations (CDOs) to Lone Star Capital, a Dallas vulture fund, at 22 cents on the dollar (more like 6 cents because Merrill loaned Lone Star 75% of the deal) dropped its percentage down to just 48%.

Morgan Stanley's Level 3 assets as a percentage of tangible common equity is pretty high, 136%, which shows that there is a lot more blood to be let in terms of getting risky assets off the books and into the market."

Yardeni points out that the Aug. 15 WSJ notes: "In the second quarter, Wells Fargo's holdings of level-three mortgages increased substantially, but the bank's write-down on those mortgages looked small.

Level-three mortgages jumped $3.3 billion to $5.28 billion, but in the quarter Wells Fargo booked only a $43 million net loss on them. Wells Fargo declined to give more detail. One reason for the seemingly small markdown may be that the mortgages are to prime borrowers and the bank may believe they will experience a low level of defaults.

But past-due prime mortgages rose for many banks in the second period. While Wells Fargo doesn't break out a prime-mortgage delinquency rate, its past-due residential mortgages were equivalent to 2.19% of the total in the second quarter, up from 1.91% in the first."

Yardeni says this is also important: "Wells Fargo's second-quarter filing said that level-three assets included collateralized debt obligations, securities that have caused huge losses for several banks.

The bank didn't give the size of its CDO holdings or any changes in their value. It didn't even mention CDOs in its first-quarter level-three data. Other banks' disclosures of CDOs regularly contain such information."