Level 1, Level 2, Level 3

I will spare you my sentiment regarding the end of the great experiment we call capitalism and democracy. I will have to just hope the next Raja has many sons.

Instead I would like to convey my recent enlightenment on Level 1, Level 2, and Level 3 assets. This stems from my ignorance of Level 3 asset classification and how assets can move between classes. For my example I will use both high finance examples and garage sale examples.

Level 1 assets are the easiest to understand. They are assets to which there is a known quoted price. A finance example would be a share of a stock like Microsoft. A garage sale example would be an ordinary gold coin. The true value of the asset is generally accepted.

Level 2 assets are a little more difficult to understand. These are assets that trade in active markets or are based on models. A finance example would be inactively traded municipal bonds. A garage sale example would be a used car. The true value of the asset could have a moderate range, but you can’t have a 1994 Chevy on your balance sheet for $15,000.

Level 3 assets are even more vague. Valuation require inputs that are both unobservable and significant. A finance example would be a private equity investment. A garage sale example would be a restored antique desk that was once owned by a famous politician. In the finance example it is difficult to know what is going on under the covers. In the garage sale example, does the desk really have historic significance?

But when would reclassification of an asset become necessary? If an investment firm claims that they are moving assets from one class to another (typically downgrading, not upgrading), then the asset is less frequently traded or the model to determine its value requires inputs that are no longer available. With the finance example companies had to downgrade bonds backed by residential mortgages. As the value of the mortgages could no longer be determined, who knows what the bonds are worth?

Our garage sale example is much easier to follow. Say one has a set of glasses from Target with a paid in cash receipt. This is pretty easy to value as there is a market (Target) where the glasses are actively traded. After using the glasses for 6 months and losing the receipt, the glasses now fall into a Level 3 category. What about the car that we had pegged as a Level 2 asset? Say the legislative environment changes and you can only drive gasoline powered vehicles Monday –Friday. As a result everybody starts buying electric cars. Yes your vehicle goes down in value, but by how much? The Level 3 assets are what the government intends to buy with tax dollars.

The only saving grace would be if (and this is a big if) an auction were set up by which not only the US government, but foreign sovereign wealth funds, private equity and anybody else who wants to play gets to bid on the assets to create at least a temporary true market value.