What are Level 3 Assets
Level 3 assets are assets whose fair value cannot be determined by using observable inputs or measures, such as market prices or models. Level 3 assets are typically very illiquid, and fair values can only be calculated using estimates or risk-adjusted value ranges.
BREAKING DOWN Level 3 Assets
Generally Accepted Accounting Principles (GAAP) require companies to record certain assets at their current value, not historical cost. Investors rely on the fair value estimates that a company records in its accounting statements in order to analyze the firm's current condition and future prospects.
In 2006, the U.S. Financial Accounting Standards Board (FASB) verified how companies were required to mark their assets to market through the accounting standard known as FASB 157 (No. 157, Fair Value Measurements). Now named Topic 820, FASB 157 introduced a classification system which aims to bring clarity to the balance sheet assets of corporations. The categories for asset valuation were given the codes Level 1, Level 2 and Level 3. In effect, Level 1 assets are those valued according to readily observable market prices. These assets can be marked to market and include Treasury Bills, marketable securities, foreign currencies, gold bullion, etc. Level 2 assets and liabilities have their values based on quoted prices in inactive markets, or linked to models which have observable inputs (interest rates, default rates, yield curves, etc.). An interest rate swap is an example of a Level 2 asset.
Level 3 is the least marked to market of the categories, with asset values based on models and unobservable inputs. These assets and liabilities are not actively traded, and their values can only be estimated using a combination of complex market prices, mathematical models and subjective assumptions. Examples of Level 3 assets are mortgage-backed securities (MBS), private equity shares, complex derivatives, foreign stocks, distressed debt, etc. The stated value of Level 3 assets for accounting purposes is subject to interpretation, therefore, a margin of safety needs to be factored in to account for any errors in using Level 3 inputs to value an asset. The process of estimating the value of Level 3 assets is known as mark to management.
Topic 820, introduced in 2009, requires firms not just to state the value of their Level 3 assets, but also to outline how using multiple valuation techniques might have affected those values. The accounting standard requires a reconciliation of beginning and ending balances for Level 3 assets, with particular attention paid to changes in value of existing assets as well as details on transfers of new assets into or out of Level 3 status. In addition to Level 1 and Level 2 assets (both of which have more accurate fair values), Level 3 assets must be reported on by all publicly traded companies.
Even though they are hard to value, Level 3 assets are held at large investment shops and commercial banks by the billions. These assets received heavy scrutiny during the credit crunch of 2007, as many Level 3 assets consist of mortgage-backed securities, which suffered massive defaults and write-downs in value. The firms that owned them were often not adjusting asset values downward even though credit markets for asset-backed securities had dried up, and all signs pointed to a decrease in fair value.