RealMoney Silver - Before You Panic About Freddie, Read This

Before You Panic About Freddie, Read This
By Tom Graff
RealMoney Contributor
5/15/2008 2:54 PM EDT

Yesterday's revelation that Freddie Mac (FRE) has $157 billion in Level 3 assets has the message boards and blogs abuzz. Here is a little Q&A on what this development means to real investors.

Everyone on my message board knows that Level 3 assets are toxic waste. So Freddie Mac's entire balance sheet is suspect, right?

First of all, the concept of Level 1 2 and 3 assets stems from FAS 157, which is summarized here for those who like primary sources. The idea was to categorize the means by which assets have been valued by management. Level 3 assets are those that have been priced using "unobservable" inputs.

Aha! Unobservable means mark-to-make-believe!

Part of requiring the Level 3 disclosure was to allow investors to consider how much they want to trust asset valuations based on models, especially in a market like this. So if you want to discount the valuation of Level 3 assets, the new disclosure allows you to do so.

OK, so how much should I discount the assets? 100% or just 80%?

Unfortunately, there is some debate as to what constitutes an unobservable input. In Freddie Mac's case, it had classically valued its asset-backed securities portfolio by getting dealer quotes, and therefore it believed that suggested a Level 2 designation. However given the wide variance in dealer quotes, Freddie decided to move the assets to Level 3.

I'd think of it this way: If the model inputs being used by dealers were "observable either directly or indirectly" (Level 2), it stands to reason that the various dealers would have similar observations, and thus similar prices. Since they didn't have similar prices, you have to conclude that the model inputs are not readily observable.

Sounds like you are leaning toward 100%.

The reality of the bond world isn't that simple. The fact is that the overwhelming majority of fixed-income instruments rarely trade. Therefore, almost all bonds held on any company's balance sheet are valued by a model. For that matter, bonds that are held in your run-of-the-mill investment-grade mutual fund are similarly valued by model. One could make a case that a great many bonds are valued with "unobservable" inputs.

For example, there are 1,082 tax-exempt municipals bonds rated below investment-grade by Moody's. Of these, only 307 have traded at any time this year. Now I grant that there is some correlation among junk-rated muni spreads, but how comfortable would you feel about the valuation of some struggling nursing home deal in Wisconsin by examining the trading level of a convention center in Texas? According to the FASB, "Adjustments to Level 2 inputs that are asset specific ... might render the measurement a Level 3 measurement." Sounds like the valuation of rarely traded municipals would fall into Level 3.

But Freddie Mac is getting its quotes from dealers! And Freddie Mac is one of the five or so best accounts to have as a bond salesman. The dealer firm is obviously biased.

Granted. But what's the alternative? You are talking about positions for which there is no trading market. The best you can do is ask someone what they might pay for it, and value it that way. It's biased, but the alternative would be for Freddie Mac to create its own model. Can you imagine the outrage on the Web if that's how it valued its positions?

Besides, I'd bet that Freddie Mac thought that getting quotes from dealers was the only way to avoid Level 3 designation. Asking for a theoretical bid from a dealer could reasonably be considered an "observable input," thus allowing a Level 2 categorization. Only when it became obvious that the dealer community had no idea what to bid did Freddie move the assets to Level 3 designation.

So when the dealer quotes were too low, Freddie changed its methodology! Its Enron all over again!

Actually, Freddie Mac didn't change its methodology; it merely moved its ABS portfolio into Level 3. It always valued its positions with dealer quotes. You are better off not obsessing over the Level 3 assets themselves, but rather the fact that no one seems to know what Freddie's assets are actually worth.

So what's the point here? Any financial firm involved in fixed-income securities and related derivatives is likely to have significant Level 3 assets. Reflexively assuming that this means the firm is involved in shady securities is lazy analysis.

The hysteria over Freddie's Level 3 assets is misplaced. Thoughtful analysis as to why Freddie Mac felt compelled to move its assets into Level 3 is what's needed. It's a little spooky to consider that Freddie Mac can't get a good value on their securities, that its dealer evaluations varied so much. That's the more important point in analyzing Freddie's balance sheet.