NY Times' Peter Eavis Part II: Dark nooks in JP Morgan's fortress balance sheet

In a NY Times Dealbook article, Peter Eavis explores the issue of how are assets that don't trade very much valued on a bank balance sheet.

Regular readers will recall that your humble blogger has been calling for ultra transparency to be applied in this area.  For example, I have been calling for observable event based reporting for all structured finance securities (an example being a subprime mortgage backed security).

With observable event based reporting market participants always know the current status of the underlying collateral (reporting takes place on the business day after an event like a payment, delinquency, default or modification takes place with the underlying collateral).  This is the data that is necessary if an investor is going to be able to independently assess the security and know what they own.

When there is ultra transparency, market participants can independently assess value.  As a result, even if a security does not trade very often, price can still be determined by the market and not by internal bank models.

Banks get to play a fun game every quarter that could be called Guess the Value of Your Assets!

With ultra transparency, the market will also estimate the value of the bank's assets.  The result of the market's estimate reveals whether the bank is conservative or aggressive in its valuations.

JPMorgan Chase plays it more than its peers. 

The bank’s claim that it has a “fortress balance sheet” took a knock after its high-rolling traders racked up more than $2 billion of losses on some derivatives bets. It will be telling to see how the losses – and the trades themselves – show up in crucial areas of JPMorgan’s balance sheet for the second quarter. 

One place to focus on will be disclosures for the bank’s “Level 3” assets. That’s the accounting designation given to assets that don’t trade much. Banks set the value of these assets – which can be bonds, loans, stocks or derivatives — mostly according to their own models. 

Level 3 assets became a problem during the financial crisis. When markets dried up, banks no longer had reliable prices for many assets. This prompted fears that bank balance sheets were getting weighed down with hard-to-sell positions of questionable value. 

Please re-read the highlighted text as opacity plays into the fears about banks in two ways.

First, there were the opaque, hard to value assets.

Second, there were the opaque, bank balance sheets that prevented market participants from knowing what was on them.

Both of these areas require ultra transparency so that market participants can independently assess and value them.

At the end of 2008, Citigroup had $146 billion of Level 3 assets. That was equivalent to 455 percent of Citigroup’s tangible common equity, a conservative measure of a bank’s capital. At the same time, Bank of America was at 121 percent, and JPMorgan was at 164 percent.

Things have changed. In the first quarter, Citigroup’s Level 3 assets were 39 percent of its tangible common equity, and Bank of America’s were equivalent to 33 percent. But JPMorgan has remained somewhat elevated. Its $109.2 billion of Level 3 assets were 84 percent of its tangible common equity in the first quarter. ...

Right now, the vast majority of the bank’s $252 billion of credit derivatives are classified as Level 2, which may still involve some guesswork by banks. But the bet is so big that it’s reportedly skewing the indicated market prices of such credit derivatives. 

Does JPMorgan rely heavily on those prices? Or will valuing the trade place more emphasis on what it thinks prices should be? 

I wonder if JP Morgan includes the $75 billion of European residential mortgage-backed securities in Level 2 or Level 3 assets.  After all, according to the International Financing Review, JP Morgan trades these assets between its CIO and an affiliate.