Levels of asset classification for fair valuations

FAS 157 divide Banks/PE's/Hedge Funds assets into three “levels”, according to the freedom with with which they can be bought or sold.

Level 1 assets have quoted prices in active markets such as US government bonds or gold bullion, thus valued at mark-to-market.

Level 2 asset - these assets are not as fully marketable as level one, but still sufficiently tradeable to have a definite value. Known as mark-to-model, these are estimates based on observable inputs. generally banks have their own valuation models (e.g. price multiple model & further complex ones)

Level 3 assets – usually artificial financial instruments – are the problem. They do not have quoted prices in active markets. They have to be valued by reference to the bank’s own models. Level 3 consists of unobservable inputs, its what market participants would use to price the asset or liability (including risk), using the best information available.

Another problem arises when the investment is a greenfield project (no revenues generated), and no market comparible exists as hardly greenfield projects may get listed on bowsers. There we have to rely on company's projection - however good or bad - a model is hard be build around this!!

According to industry analysts, the holdings of level 3 assets are substantial. Lehman has $22 billion; Bear Stearns $20 billion; JP Morgan Chase $60 billion, Goldman Sachs $72 billion. Even these figures may be understated, since the banks have themselves decided whether assets belong to level three or the more acceptable level two. Thus any jolt to economy may cause huge write-off trigger for Investment Banks/PE's and Hedge Funds.