Before You Panic About Freddie, Read This

Yesterday's revelation that Freddie Mac (FRE - commentary - Cramer's Take) 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.

---

At the time of publication, Graff had no positions in stocks mentioned, although positions may change at any time.

Tom Graff is a Managing Director of Cavanaugh Capital Management, a registered investment advisor in Baltimore Maryland. The opinions expressed here are Graff's own and in no way are the statements of Cavanaugh Capital Management, and may or may not reflect the strategies being pursued for clients of Cavanaugh Capital Management. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Graff appreciates your feedback; click here to send him an email.