Merrill is getting very good at the number one game on Wall Street, ‘Hide the Mortgages’. When worthless mortgage paper is presenting a problem to your financial sitaution, move them to your Level 3 books, mark them at par or better and put out a press release saying ‘we don’t need to raise anymore capital’. Merrill’s top competitors in this game are Goldman, Lehman, Citi, Chase, Morgan, Bear etc. The usual suspects…the ones (other than Citi) that posted ‘really great earnings’ last quarter.

Merrill says it’s most difficult to value Level 3 ’assets’ jumped big-time in Q1. It’s ratio of Level 3 to total assets rose to 8 percent from 5 percent. Good de-leveraging job guys! But, what about your $770 BILLION in Level 2 ‘assts’ John? Maybe they are not all ’illiquid’ as are the Level 3 assets, but are they really worth par? Level 3 is where most have stuck the subprime, home equity, alt-a etc paper.

So, this is what being “80% done with the credit crisis” looks like. Untradable, marked-to-myth assets surge, as banks neatly get their books in order putting all their toxins on their Level 3 books, awaiting the day the Fed comes in and saves everyone? But until that day comes and even as the Fed, Treasury and the banks themselves preach ‘deleveraging’, the banks are levering up.

Level 3 ‘assets’ among the many of the nations largest US banks (listed below - thanks Ninja & TF) add up to nearly $500 BILLION! That is more than the Fed has left! “. If you look over to column 5, you see the level 3 assets as a percentage of equity (column 6). For example, Morgan Stanley (MS) has Level 3 assets (column 4) that total 235% (column 5) of equity (column 6)…oops. Columns, 2, 3, and 4 are total Level 1, 2 and 3 assets respectively.

But wait a minute. What the heck are those Level 2 assets?’ Finding a bid for those in this market is likely as to close to impossible as a Level 3 ‘asset’ bid. BUT THOSE ASSETS ADD UP TO NEARLY $5.5 TRILLION! That makes the Fed’s $400 Billion or so they have left look miniscule.

This makes the news released simultaneously regarding Merrill being investigated by various Gov’t agencies for their part in the Auction-Rate Securities nightmare look trivial.

Last night in Singapore, John Thain said he ”sees no need for more capital as the subprime crisis nears an end, but expects U.S. banks with large exposure to consumers to be the next problem area”. Two comments on this…he said the same thing about a month ago while in Japan and subsequently raised capital two weeks later saying ‘I meant only through issuing common stock’. As if, taking on more debt to raise capital doesn’t count for anything. Second, he actually may not need to raise capital this time because of the news above. The toxic items on the books that would require a capital backstop were moved to Level 3 and marked to myth, instantly taking care of the need to additional capital.

Wouldn’t it be great if Merrill and other brokers let you mark your portfolio to what you believed the assets to be worth on those dreaded days on which you receive a margin call?

All joking aside, this is an absolute disaster in the making. The Fed does not have enough reserves to take care of many of the nations largest banks, who as you can see, are OVER their ears on Level 2 and Level 3 ‘assets’, of which much has not been able to be priced for months. Much of it never will.

Level 1, 2, and 3 assets are ways of classifying a company’s assets based on the degree of certainty around the assets’ underlying value. Level one assets can be valued with certainty because they are liquid and have clear market prices. At the other end of the spectrum, Level 3 assets are illiquid and estimating their value requires inputs that are unobservable and reflect management assumptions.

Level 1

Financial assets and liabilities whose values are based on unadjusted quoted prices for identical assets or liabilities in an active market (examples include active exchange-traded equity securities, listed derivatives, most U.S. Government and agency securities, and certain other sovereign government obligations).

Level 2

Financial assets and liabilities whose values are based on quoted prices in markets that are not active or model inputs that are observable either directly or indirectly for substantially the full term of the asset or liability. Level 2 inputs include the following: a) Quoted prices for similar assets or liabilities in active markets (for example, restricted stock); b) Quoted prices for identical or similar assets or liabilities in non-active markets (examples include corporate and municipal bonds, which trade infrequently); c) Pricing models whose inputs are observable for substantially the full term of the asset or liability (examples include most over-the-counter derivatives, including interest rate and currency swaps); and d) Pricing models whose inputs are derived principally from or corroborated by observable market data through correlation or other means for substantially the full term of the asset or liability (examples include certain residential and commercial mortgage related assets, including loans, securities and derivatives).

Level 3

Financial assets and liabilities whose values are based on prices or valuation techniques that require inputs that are both unobservable and significant to the overall fair value measurement. These inputs reflect management’s own assumptions about the assumptions a market participant would use in pricing the asset or liability (examples include certain private equity investments, certain residential and commercial mortgage related assets (including loans, securities and derivatives), and long-dated or complex derivatives including certain foreign exchange options and long dated options on gas and power).