What Is a Level 2 Asset?
Let me explain what a Level 2 asset is. These are financial assets and liabilities that aren't easy to value directly because they don't have regular market pricing. Instead, you determine their value based on other data or market prices. We sometimes call them 'mark-to-model' assets since you can approximate them using simple models and extrapolation methods that rely on known, observable prices as parameters. This sets them apart from Level 1 assets, which are liquid and straightforward to value using actual market prices.
Key Takeaways
Here's what you need to know about Level 2 assets. They are financial assets and liabilities without regular market pricing, but you can determine their fair value using other data values or market prices. They represent the middle classification in terms of how reliably you can calculate their fair market value. Typically, private equity firms, insurance companies, and other financial institutions with investment arms hold these assets.
Understanding Level 2 Assets
Publicly traded companies have to establish fair values for the assets on their books, and investors like you rely on these estimates to assess the firm's current state and future potential. Under generally accepted accounting principles (GAAP), certain assets must be recorded at their current value, not historical cost. These companies also classify all assets based on valuation ease, following the Financial Accounting Standards Board (FASB) 157 standard.
The FASB introduced three asset levels to clarify corporate balance sheets. Level 2 assets sit in the middle, based on the reliability of calculating their fair market value. Level 1 assets, such as stocks and bonds, are the easiest to value. Level 3 assets, on the other hand, rely solely on internal models or estimates and lack observable market prices.
You must value Level 2 assets using market data from external, independent sources. This data can include quoted prices for similar assets and liabilities in active markets, prices for identical or similar items in inactive markets, or models with observable inputs like default rates, interest rates, and yield curves. Take an interest rate swap as an example—its value comes from observed underlying interest rates and market-determined risk premiums.
Fast Fact
Just so you know, Level 2 assets are commonly held by private equity firms, insurance companies, and other financial institutions that have investment arms.
Example of a Level 2 Asset
Consider Blackstone Inc., which details its Level 2 assets in its 10-K and 10-Q filings for shareholders. In those documents, they state that fair value is determined through models or other valuation methodologies. This category generally includes corporate bonds and loans, including those held within CLO vehicles, government and agency securities, less liquid and restricted equity securities, and certain over-the-counter derivatives where the fair value is based on observable inputs. Senior and subordinated notes issued by CLO vehicles are classified within Level II of the fair value hierarchy.
Observable vs. Unobservable Inputs
Investors and analysts often find it challenging to distinguish between Level 2 and Level 3 assets, but it's crucial because GAAP requires extra disclosures for Level 3 items. The classification depends on the valuation inputs and whether the market data is publicly available. Ask yourself these questions: Is the value supported by real market transactions? Is the price obtained from outside the organization and readily available to the public? Is the valuation distributed at regular intervals? If the answer to any is no, the input is unobservable, making it a Level 3 asset.
What Is an Interest Rate Swap?
An interest rate swap happens when two parties exchange interest payments due at a future time. These swaps are usually over-the-counter, not on exchanges, and they're based on the principal value of the underlying assets. They often involve loans with floating and fixed rates.
What Is Fair Market Value?
According to the Cornell Law School Legal Information Institute, fair market value is the value of property as determined by the marketplace or objective purchasers, rather than by a subjective individual. It's what an informed and unpressured buyer would pay to an informed, unpressured seller in an arm's length transaction.
What Is GAAP?
GAAP, or generally accepted accounting principles, was created and issued jointly by the Financial Accounting Standards Board (FASB) and the Governmental Accounting Standards Board (GASB). It establishes accounting rules and standards that apply across industries, making financial information easier to compare and exchange.
The Bottom Line
The fair value of Level 2 assets draws from related but not immediately apparent factors and prices. These values are midway between assets that match their market prices exactly and those based on educated guesses. Investment firms and institutions primarily hold them, and understanding these assets is essential if you're considering certain types of investments.
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