The dreaded level 3 assets

By now you may have heard the term level 3 assets. These are assets that financial institutions conveniently are able to value using their own assumptions rather than mark to market as there are supposedly "no observable inputs." Although personally I find the ABX indices fairly easily observable.

The Financial Accounting Standards Board's new rule 157 will put pressure on companies to put more realistic values on such assets. Whilst the new rule is effective from November 15th we probably wont get a feel for its effect until companies report 4th quarter earnings in January although some of the brokers will report in December and we could get some pre-earnings announcements before the year is out.

Royal Bank of Scotland today released a report that estimates up to $100 billion of writedowns could come as a result of the new accounting rules. From Bloomberg:

Banks Face $100 Billion of Writedowns on Level 3 Rule

U.S. banks and brokers face as much as $100 billion of writedowns because of Level 3 accounting rules, in addition to the losses caused by the subprime credit slump, according to Royal Bank of Scotland Group Plc.

The Financial Accounting Standards Board's rule 157 will make it harder for companies to avoid putting market prices on securities considered hardest to value, known as Level 3 assets, Royal Bank's chief credit strategist Bob Janjuah in London wrote in a note today. The new rule is effective Nov. 15.

"This credit crisis, when all is out, will see $250 billion to $500 billion of losses," Janjuah said. "The heat is on and it is inevitable that more players will have to revalue at least a decent portion" of assets they currently value using "mark- to-make believe."

Does anyone really think 4Q07 earnings are going to be in the double digits? Interestingly the golden boy of brokers Goldman Sachs has the most exposure to level 3 assets as a percentage of it equity.