Rising Level 3 assets threaten bank profits

Dealers are relying on in-house models to value large amounts of complex structured products

The most fundamental role of a dealer is to put a price on things. Their utility as financial intermediaries is tied to their ability to buy and sell assets at fair value. To make money, they must know the bid and the ask, and capture the spread between them.

The coronavirus crisis has thrown a bucketload of grit into banks’ price-producing engines. A series of unprecedented events made pricing all but impossible: European companies held up pre-announced dividends en masse, fixed-income indexes delayed periodic rebalancings and front-month oil futures turned negative.

These incidents, and the many like them, have played havoc with banks’ valuation processes. As a result, billions of dollars’ worth of complex assets cannot currently be priced using observable inputs and have instead been classified as Level 3 – meaning the banks set their prices using their own models and unobservable inputs.

Since there is no real market for them, the “true” market price of a Level 3 asset is slippery and mysterious. A bank loaded with Level 3 assets could run into trouble if its portfolio is worth a lot less than its model says it is. Back in 2008, a discrepancy in how Lehman Brothers accounted for its Level 3 assets was one of the red flags that hedge fund manager David Einhorn cited in his infamous speech at the Ira W. Sohn Investment Research Conference – a speech which catalysed market concerns that the firm was fundamentally unsound.

In the here and now, UBS has $8.1 billion of Level 3 assets and $14.3 billion of Level 3 liabilities. Unfavourable changes to the model inputs that set these prices could cost it $780 million. Elsewhere, BNP Paribas said 12% of its equity derivatives exposures were marked-to-model as of end-June. Writedowns to these incurred by model input changes could hit €230 million.

As of Q1, around €231 billion of top EU banks’ assets were at the mercy of their Level 3 valuation models. If markets degrade over the coming months, big writedowns may be on the cards.

Dealers that put more of their expected profits into valuation reserves in recent months may benefit in future quarters as these are steadily released into the income statement. But if markets get squirrelly, losses may eat them up instead

Murky market forecasts have also led some banks to defer the amount of day-one profits they expect to reap from the sale of structured products and complex derivatives. UBS put aside $121 million of anticipated profits for instruments sold in the second quarter of 2020, compared with just $58 million the year-ago quarter. Societe Generale deferred €475 million over the first half of this year for new issuances, up from €346 million a year ago.

To a degree, a higher volume of sold products would lead to an increase in so-called deferred margins. But updates to the methodologies used to estimate deferred margin, in response to the Covid crisis, are likely contributors, too.

Dealers that put more of their expected profits into valuation reserves in recent months may benefit in future quarters as these are steadily released into the income statement. But if markets get squirrely, losses may eat them up instead.

On the flip side, firms that held back a smaller amount of expected profits may look good in the here and now, but could see future losses tear through their flimsier valuation reserves.

Deferred pain or delayed gratification – which will it be? Much depends on the future course of the pandemic-stricken economy. But the profitability (or otherwise) of those with bulging structured products inventories may depend on the prudence of dealers’ valuation models.