What Are Level 3 Assets?

What Are Level 3 Assets?

Let me explain Level 3 assets to you directly: these are financial assets and liabilities that stand out for their illiquidity and the real difficulty in putting a value on them. Unlike Level 1 and Level 2 assets, which have some market data to lean on, Level 3 assets don't have reliable market pricing, so companies like mine have to use estimates and models that involve assumptions and subjective judgments.

You'll see examples such as mortgage-backed securities, complex derivatives, and private equity shares. I want you to understand why these matter—they play a big role in financial markets and came under intense scrutiny during crises like the 2007 credit crunch.

Deep Dive Into Level 3 Assets

Publicly traded companies must establish fair values for the assets on their books, and under GAAP, some need to be recorded at current value rather than historical cost. You, as an investor, rely on these fair value estimates to gauge a firm's health and future prospects.

Back in 2006, the FASB introduced FASB 157, which outlined how companies should mark assets to market. It's now known as Topic 820, and it created a classification system to clarify balance sheet assets for corporations.

Asset Valuation Levels Explained

FASB 157 divides assets into Level 1, Level 2, and Level 3 based on how easy they are to value. Level 1 is the simplest.

Level 1

Level 1 assets get their values from readily observable market prices. You can mark them to market easily, and they include things like Treasury bills, marketable securities, foreign currencies, and gold bullion.

Level 2

These assets and liabilities lack regular market pricing, but you can assign them a fair value using quoted prices from inactive markets or models with observable inputs like interest rates, default rates, and yield curves. An interest rate swap serves as a good example of a Level 2 asset.

Level 3

Level 3 is the category least tied to market marking, with values derived from models and unobservable inputs. We use assumptions from market participants to price the asset or liability, since there's no readily available market data. These assets aren't actively traded, so their values come from combining complex market prices, mathematical models, and subjective assumptions.

Examples you should know include mortgage-backed securities (MBS), private equity shares, complex derivatives, foreign stocks, and distressed debt. The valuation process here is called mark to model.

These assets faced heavy criticism during the 2007 credit crunch, when MBS saw massive defaults and value write-downs. Firms holding them often delayed adjusting values downward, even as credit markets for asset-backed securities dried up and fair values clearly dropped.

How Level 3 Assets Are Recorded

Past mistakes in valuing Level 3 assets prompted stricter rules. In 2009, Topic 820 required firms to state asset values and explain how techniques might impact them.

By 2011, FASB tightened this further, demanding a reconciliation of beginning and ending balances for Level 3 assets, focusing on value changes in existing assets and details on transfers in or out of Level 3 status.

Companies must disclose clearly how they value Level 3 assets, including quantitative info about unobservable inputs used. They also added sensitivity analysis to help you understand the risk of incorrect valuations.

In August 2018, FASB updated Topic 820 with Accounting Standards Update 2018-13, effective for fiscal years starting after December 15, 2019. This modified some rules, asking companies to disclose the range and weighted average of significant unobservable inputs and how they're calculated. Narrative descriptions now focus on measurement uncertainty at the reporting date, not future sensitivities.

This approach aims to increase transparency and comparability, though companies still have leeway in deciding what information is relevant to disclose.

Navigating Challenges With Level 3 Assets

Since Level 3 assets are notoriously hard to value, don't take their stated worth at face value as an investor. Valuations involve interpretation, so factor in a margin of safety to cover any errors in the inputs used.

These assets often make up a small part of a company's balance sheet but are more common in sectors like large investment firms and banks.

How Many Levels of Company Assets Are There?

Companies classify assets into levels 1, 2, or 3 based on valuation ease. Level 3 is the most illiquid and hardest to value.

What Are Level 1 and Level 2 Assets?

Level 1 assets have readily observable, transparent prices, giving them a reliable fair market value. Level 2 assets are tougher to value but can be approximated with simple models and extrapolation using known, observable prices as parameters.

What Are Examples of Level 3 Assets?

Examples include complex derivatives, distressed debt, foreign stocks, mortgage-backed securities (MBS), and private equity shares.

Final Thoughts on Level 3 Assets

Level 3 assets are the most illiquid and hardest to value among financial assets and liabilities, mainly because they trade infrequently and lack observable market prices. Companies place them under FASB's Topic 820 framework, which underscores the difficulties in using unobservable inputs and complex models.

You need to remember that these valuations are open to interpretation and might require a margin of safety. Accurate, transparent disclosures are essential for understanding and managing the risks tied to these assets.