The Level 3 Assets Scam

I'm a shareholder of Citigroup (300 shares). I've been following the problems they've been. I read that Citigroup has $134.84 billion in "Level 3 Assets". When I checked a few days ago, Citigroup's market capitalization is $178 billion. Citigroup's book value is less than $128 billion.

Level 3 assets are loans and assets that are illiquid. A bank would have a very hard time selling a loan like this to someone else. A bank would probably take a huge loss if forced to sell a Level 3 loan.

During the bust phase of the business cycle, it is harder to repay loans due to a shortage of money. During each bust phase, the weakest debtors are forced into bankruptcy. It is a statistical necessity, built into the monetary system, that there will be a certain number of bankruptcies during each economic bust.

However, large banks cannot be allowed to go bankrupt. First, if large banks start being forced into bankruptcy, the whole economic system collapses. Second, the Federal Reserve is owned and controlled by banks. Why would the red market agents at the Federal Reserve allow the people who control it to be injured?

During the bust phase of the economic cycle, banks wind up owning a lot of loans of shaky quality. The loans are worth less, because the default risk has increased due to the economic bust. However, the banks are not required to immediately write down the loans to their current value. If banks were really forced to write down their loans to their true current value, they would also be bankrupted during the economic bust.

In the above statistic, Citigroup has $134.84 billion in Level 3 loans. Citigroup is not directly loaning out its own capital. Citigroup is borrowing from the Federal Reserve (or from depositors) and loaning that money out. Citigroup is using a leverage ratio of 10x, 20x, or 100x on these loans. If Citigroup were forced to mark down the value of these loans by 10%, it would immediately lose $13 billion. After the writedown, Citigroup might no longer be within the required leverage ratio; Citigroup might suffer a margin call. Citigroup would be forced to sell off some loans, driving down the price even more. Citigroup would be unable to find other large banks to buy the loans during an economic bust, because the other banks would be having the same problem.

Fortunately, there is no secondary market for Level 3 loans. A bank can carry its Level 3 loans at whatever value it chooses, as long as it isn't totally unreasonable. For example, maybe the bank will write down the loans by 5% when a more accurate assessment would lead to a writedown of 15%.

It wouldn't pay for a large bank to borrow and buy stock, even though the expected return would be high. With a stock position, you are required to mark it to market every day. If you maxed out your leverage by borrowing to buy stock, you would be margin called out of your position during the economic bust.

The important point is that banks don't have to write down their assets immediately. Large banks aren't subject to the same accounting rules as everyone else. During the economic bust, a small business using leverage is forced into bankruptcy. A large bank using leverage isn't required to mark down its assets, and can hold onto its assets until the next boom phase.

How do banks benefit from the delay in being forced to write down their assets? The answer is that the Federal Reserve will eventually lower interest rates. This makes all outstanding loans worth more. For example, if interest rates drop 1%, the value of a 10 year bond or loan increases by 10%. The formula is, approximately, change in value of the loan equals change in interest rates times the duration of the loan. Decreasing interest rates mean outstanding loans are worth more. Increasing interest rates mean outstanding loans are worth less.

This means that the bank's faulty accounting winds up being correct, retrospectively. The bank doesn't have to mark its loans down during the bust phase. The Federal Reserve lowers interest rates, which means that the shaky loans wind up being worth more after all. The price of the loan decreases due to the higher default risk, but the price of the loan increases due to the Federal Reserve interest rate cut. Eventually, the economy is in boom phase again. The debtor will now be able to repay his loan, possibly refinancing at a lower interest rate. If the debtor was forced into bankruptcy, the foreclosure process typically takes a year or two. By the end of the foreclosure process, when the bank tries to sell the confiscated asset, the economy is in boom phase again.

Also, the interest rate cut causes inflation. The inflation means that debtors have an easier time repaying their debts. Large banks don't mind inflation, because they can borrow at a negative real interest rate of 4.5%. Banks profit from the interest rate spread times their leverage ratio. Large banks don't mind inflation. Large banks want the inflation/deflation cycles to occur at a predictable rate.

The monetary system is completely biased in favor of banks. The Federal Reserve's interest rate policy, combined with nebulous accounting, means that banks are guaranteed to make a profit.

Paradoxically, banks and hedge funds are BETTER OFF if they invest in illiquid assets, such as Level 3 assets. This means they don't have to write down their positions during the economic bust, and they can hang on until the next boom phase and then liquidate their positions. In this post, I mention Citigroup as an example. You could substitute any large bank or leveraged buyout hedge fund and reach the same conclusion. The rules of the economic system, combined with accounting rules, encourage such dishonest behavior by banks.