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JPMorgan, Wells Fargo Shuffle Riskiest $38 Billion Amid Bond Boom

Updated from 11:50 a.m. ET to include Fed Chairman Ben Bernanke's comments on third page.

NEW YORK ( TheStreet) -- JPMorgan (JPM - Get Report) and Wells Fargo (WFC - Get Report) took $37.9 billion of their riskiest assets in from the shadows in the first quarter as a rise in trading activity convinced them the assets were easier to value.

Given a sharp second quarter reversal in the bond market, it bears watching in upcoming earnings whether a couple of the nation's largest financial institutions made the right call.

In particular, investors should watch for movement among asset classifications in banks' available for sale (AFS) securities portfolios. Although JPMorgan and Wells Fargo have been the most active in changing their characterization of AFS assets, other large commercial banks could follow suit, including Bank of America (BAC - Get Report), Citigroup (C - Get Report) and PNC Financial Services Group (PNC - Get Report).

Currently, banks hold hundreds of billions of dollars of AFS assets that they mark to fair value each quarter. While the bulk of those portfolios consist of relatively safe government bonds and mortgage bundles backed by housing agencies such as Fannie Mae (FNMA), banks hold billions in riskier assets, including opaque structured credit products, collateralized loan obligations (CLOs) and asset backed securities (ABS).

To ensure investors have some confidence that banks are marking their books appropriately every quarter, assets are characterized by the transparency of their pricing. Treasury bonds and government guaranteed mortgages trade frequently and with publicly available pricing. They are either characterized as Level 1 or Level 2 assets on balance sheets across the banking industry.

Securities that trade in shadowy and less liquid over-the-counter markets, including CLOs, are generally characterized as Level 3 assets, given less clear price information.

That is, they were characterized as Level 3 assets before the first quarter of 2013.

First-quarter financial statements showed JPMorgan and Wells Fargo shifted $37.9 billion in hard-to-value debt securities from Level 3 to Level 2. JPMorgan said on page 99 of its quarterly earnings filing with the Securities and Exchange Commission it had transferred $27.3 billion in high-rated CLO assets from Level 3 to Level 2 "based on increased liquidity and price transparency" of those assets.

In a footnote on page 123 of Wells Fargo's quarterly filing, the nation's largest mortgage lender said it had reclassified $10.6 billion in Level 3 AFS CLO assets to Level 2 "as a result of increased observable market data in the valuation of such instruments." The bank added that the shift of CLO assets had been done at the discretion of a broker.

During the first quarter, JPMorgan reduced its Level 3 AFS assets by 94% to about $2 billion. Wells Fargo reduced its Level 3 AFS assets by about 40% to about $17 billion in the first quarter and it attributes a remaining position to "limited market activity."

Both banks spend multiple pages detailing the process they use to mark their Level 3 assets, including unobservable inputs such as default rates, loss severity, price, yield and credit spreads. While Wells Fargo holds a minimal amount of Level 3 trading assets, JPMorgan continues to report $44.6 billion in such assets within its trading account, mostly loans and derivatives.

The decline in long-term interest rates to historic lows in the first quarter may have caused illiquid CLO assets to trade with more frequency as yield-starved investors entered the market. Richard X. Bove, a banking analyst at Rafferty Capital Markets, meanwhile, says a push to move derivative and OTC trading to clearinghouses may have added price transparency. For his part, Bove is unconcerned.

"Investors just don't look at this anymore," Bove says of Level 3 AFS portfolios given banks' improving balance sheets. "Most of the stuff that you couldn't value has been written off," he adds.

As recently as a year-ago, Level 3 assets proved a point of controversy for JPMorgan, Bank of America and Citigroup, and even relatively staid lenders like Wells Fargo, U.S. Bancorp (USB) and PNC.
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