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) and Wells Fargo ( WFC) 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), Citigroup ( C) and PNC Financial Services Group ( PNC).

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.

Standard & Poor's made headlines last July when it reported that Wells Fargo, Warren Buffett's top bank holding, held the highest percentage among large banks of Level 3 assets in its securities portfolio.

S&P credit analyst Stuart Plesser noted lenders such as JPMorgan, Wells Fargo, Citigroup and PNC Financial had used surging inflows of deposits to load up on securities and hard-to-value Level 3 assets as a means of supporting their earnings amid weak lending activity.

Riskier assets often carry high yields and it's not just banks that are buying them. Hedge fund and private equity investors in the market for CLO's expect gains as distressed prices and wide credit spreads dissipate in an economic recovery.

Plesser calculated banks had nearly doubled their investment portfolios to about $900 billion since 2009, and highlighted Wells Fargo as holding the highest percentage of Level 3 assets in its securities portfolio at 14.5%. Wells Fargo was followed by PNC Financial and JPMorgan, which respectively counted Level 3 assets as 13.6% and 6.8% of their overall portfolios.

After a first quarter shift of assets by JPMorgan and Wells Fargo and few similar movements by Citigroup, PNC and Bank of America, the numbers have changed.

Level of Concern Eases as Level 3 Assets Become Level 2.

Bank investors should care about the shifting characterization of assets, even if the Level 3 imprimatur on a balance sheet isn't the red flag it was during the financial crisis.

Plesser of S&P noted in his July 2012 report that the ratings agency considers the amount of Level 3 assets a bank holds in its so-called risk adjusted capital formulas, a crucial component of its credit rating methodology. "Evidence that a bank has increased the risk composition of its corporate segment and AFS/ hold-to-maturity portfolios or has taken on aggressive hedging can affect the ratings through our business and risk position assessments," Plesser wrote.

Meanwhile, the Federal Reserve recently finalized new regulations on capital and leverage that make securities holdings such as a AFS portfolios an element of bank capital ratios That move will likely result in increased volatility of regulatory ratios, according to Plesser's 2012 report.

Volatility in regulatory capital ratios could be a rude surprise for the ordinary bank shareholder, given the Fed's annual stress testing process and its authorization of dividends and share buybacks.

As the nation's largest banks attempt to win back investors in the wake of the financial crisis, differing treatment of assets between lenders could also continue to muddle the earnings of the industry.

Level 3 assets got the most press when David Einhorn of Greenlight Capital questioned whether Lehman Brothers was improperly marking and moving its assets. While Lehman is now defunct and the worst Level 3 assets such as CDO squareds, synthetic mortgage derivatives and equity tranches of structured products are no longer on bank balance sheets, investor uncertainty remains.

Some bank analysts and hedge fund investors like Bill Ackman of Pershing Square Capital Management continue to characterize the nation's largest banks as uninvestible.

Uncertainty on the values and treatment of Level 3 assets play a role, as do other crucial balance sheet measures.

Earlier in July, the Basel Committee on Bank Supervision complained of a dramatic inconsistency in how the world's largest and most interconnected lenders report their risk-weighted assets (RWAs), a crucial figure used to calculate capital ratios.

" Most of the variation in RWAs can be explained by broad differences in the composition of banks' assets, reflecting differences in risk preferences as intended under the risk-based capital framework," the committee wrote in a July 5 report. Some outliers include assets a bank would likely characterize as Level 1 or Level 2 such as sovereign bonds.

" The considerable variation observed warrants further attention," Stefan Ingves, Chairman of the Basel Committee and Governor of Sveriges Riksbank, said of the report's findings.

A Rude Second Quarter Earnings Surprise?

Issues such as Level 3 assets will play an important role in second quarter earnings. It is unclear whether JPMorgan and Wells Fargo's asset shift will prove sustainable. Meanwhile, competitors such as PNC and Citigroup could follow suit.

A late quarter surge in interest rates, meanwhile, may hit AFS securities portfolios across the banking industry, after lenders such as JPMorgan and Wells Fargo saw among the greatest earnings benefit in recent years from gains on their Level 3 holdings. In the third quarter, securities portfolio losses could even undermine capital ratios among the nation's largest banks.

Fitch Ratings said in a July 8 report that banks are set to report declines in the values of their AFS securities holdings. "Bank securities portfolios will still be in an aggregate gain position at June 30, 2013; however, as rates inch up higher, these gains will likely ultimately revert to losses," Julie Solar, a senior financial institutions director, wrote.

Banks subject to the Fed's recently authorized Basel III accounting treatments will see gains from AFS securities become a much smaller contribution to regulatory capital ratios, Solar noted. If interest rates continue to rise in the third quarter, portfolio losses could even become a drag to capital ratios.

For now, Level 3 assets and balance sheet boogeymen such as CLOs and structured products are likely to remain a marginal issue for the U.S. banking industry.

Federal Reserve Governor Jeremy C. Stein, a well-positioned sponsor of bank safety, said in late June the central bank's bond buying hasn't been undermined by overly aggressive risk taking among large and "too big to fail" banks.

"Although asset purchases also bring with them various costs and risks--and I have been particularly concerned about risks relating to financial stability--thus far I would judge that they have passed the cost-benefit test," Stein said on June 28. The governor's recent communications indicate he would make public statements if he perceived systemically risky balance sheet activity.

On Wednesday, however, Fed Chairman Ben Bernanke indicated a recent change in communications about asset purchases may have helped to unwind some highly leveraged credit market bets, in a beneficial development for the financial system.

Even if prominent Fed officials aren't ready to make negative judgments on bank balance sheets or a compulsion to chase yield at historic interest rate lows, investors should, at the very least, understand clear changes that are occurring on the balance sheets such as a shifting of Level 3 assets.

While JPMorgan and Wells Fargo may not be putting their investors at imminent risk and have a clear accounting rationale for reclassifying their CLO assets, their first quarter disclosures do deserve scrutiny and analysis.

Wells Fargo declined to comment beyond its public disclosures, while JPMorgan couldn't immediately be reached for comment via e-mail. Plesser of S&P said in an e-mail the agency hadn't published an updated analysis of banks' Level 3 assets in the wake of first quarter earnings.

-- Written by Antoine Gara in New York

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