According to Standard & Poor's (a unit of McGraw Hill (NYSE:MHP)), so-called level 3 assets -- which are the least transparent in terms of their value -- on the balance sheets of U.S. financial institutions rose by 15.5% to $610 billion during the third quarter. If you own (or want to invest in) bank stocks, you need to understand the underpinnings of that trend.

With little or no new issuance of these brainteaser securities (the market's still struggling to digest what's already out there), there are a few different explanations of a rise in level 3 assets -- two of which aren't particularly cheerful for bank stock investors. Before getting into possible "negative" rationales for the increase, there is one obvious, positive explanation:

  • An increase in the value of the assets! Morgan Stanley (NYSE:MS) cited this to justify a 9% increase in level 3 assets in the fourth quarter, despite efforts "to systematically sell our level three legacy assets whenever opportunities arise."

Fair enough, but here are two alternative explanations that are less favorable:

  • Despite numerous writedowns, warnings, and subsequent assurances from bankers, there is still room to tighten up assumptions regarding the risk of mortgage-related assets. As bankers apply more conservative (or more realistic) assumptions in valuing assets, they may have been forced to recognize that some of the valuations are less transparent than previously assumed. They would then need to reclassify corresponding assets, including some from level 2 to level 3.
  • By definition, there are no readily available prices for level 3 assets. In fact, there aren't even market prices for the inputs that might be used to value them. No trading equals no market prices. Thus, if liquidity dries up in certain asset markets, it could force bankers to reclassify certain securities as level 3 assets. This scenario would imply that there are still logjams in various areas of the capital markets.

The latter two could contribute to volatility in bank earnings in the coming quarters as it appears that there could still be considerable uncertainty surrounding the valuation of these assets. The following table demonstrates that level 3 assets remain significant compared to banks' net worth:

Company

Level 3 Assets
(U.S. $ billions)

Level 3 Assets as a
% of Shareholder Equity

Morgan Stanley**

$85.5*

168%

Merrill Lynch (being acquired by Bank of America (NYSE:BAC))

$55.3

144%

Citigroup (NYSE:C)

$157.6

125%

Goldman Sachs (NYSE:GS)**

$66.0

103%

JPMorgan Chase (NYSE:JPM)

$140.8

96%

Wachovia (being acquired by Wells Fargo (NYSE:WFC))

$25.2

50%

Sources: Company SEC Filings and press releases.
*Approximate value.
** Fiscal fourth-quarter values.

If you are thinking about investing in bank stocks in 2009, that's not necessarily a bad reflex -- distressed sectors usually present opportunity. However, you need to be armed with an understanding of the sector and nerves of steel; bank stocks will continue to be volatile as the market witnesses the evolution of bank balance sheets.

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Alex Dumortier, CFA, has a beneficial interest in Wells Fargo, but not in any of the other companies mentioned in this article. JPMorgan Chase and Bank of America are Motley Fool Income Investor picks. The McGraw-Hill Companies is an Inside Value recommendation. Try any of our Foolish newsletters today, free for 30 days. The Motley Fool has a disclosure policy.