Merrill’s Level III Assets Jump by 68%

Merrill Lynch (NYSE: MER) reported today that their Level III assets - those that are the hardest to value - jumped to $68.9 billion from $41.4 billion reported at the end of 2007. An increase of this magnitude signals that the end of the financial crisis may not be as near as many have thought.

Level III assets, by definition, cannot be valued based on the market because there is no market to peg them to. Instead, Level III assets are valued based on the asset owners’ own judgment. In other words, Level III assets are not marked-to-market, they’re marked-to-whatever the company feels like marking them to. This term has been dubbed “mark-to-myth” because in the end, it’s simply a guess. We can derive, however, that Merrill will mark these assets higher than their actual value, because there is incentive to do so. Strong disincentives exist for marking them lower than their actual value, including credit downgrades, shareholder anger, and stock price punishment. Just look at what happened to Bear Stearns when trust in them was lost.

Merrill is now marking more of their assets Level III, from the Level II, or even Level I, asset pools. If Merrill feels the need to do this, there must be a good reason. The only reason I can think of is that they don’t like the actual market values that must be used on Level I and Level II assets, and would rather just make up the value of their assets.

If the credit markets return to normal, this might be a solid play to regain investor confidence. If the markets don’t return to normal in the next few quarters, Merrill shareholders will be in for a big surprise when their Level III books are accurately valued.

This is not just a Merrill problem, this is an investment bank problem. Goldman Sachs, Morgan Stanley, and Lehman Brothers all face similar issues. In fact, Merrill is one of the strongest with regards to Level III assets compared to their tangible equity capital of $78 billion, coming in at around 90%. The others are all above 200%.

But this does leave one pondering if Merill will continue to move assets to its Level III portfolio at such a rapid pace. At the beginning of today, their Level III assets comprised of 53% and with today’s announcement it’s up to 90%. A few more of these and it’ll be well over the 200% mark that seems to be the norm in the industry.

I’ve said it before, I’ll say it again: Be very careful in the financial services industry. We do not know the extent to which these companies are exposed to toxic debt.

Freund Investing Managing Member Ryan Freund holds no position in any of the companies mentioned in this article. Freund Investing has a solid Disclosure Policy.