Level 2 assets are more difficult to value, but they can be valued based on some observable data. For example, an interest rate swap might be a Level 2 asset since underlying interest rates and risk premiums are generally easy to establish from available data, even if it's not public data.
Level 3 assets are very difficult to value and are often guesstimated. They aren't regularly traded, and when they are bought or sold, it's hardly a transparent process. Many Level 3 assets are fairly unique, making them hard to even value compared to one another. Mortgage-backed securities are considered a Level 3 asset.
How are Level 3 assets valued?
Level 3 assets are considered the scariest, most risky assets because of how they're valued. Since there aren't straightforward inputs into the value of a Level 3 asset, such as interest rates or bond yields, the value of a Level 3 asset is often a wild guess. Professionals try to use mathematical and economic models to come to a fair assessment of the value of these assets, but with very little to go on. Since these assets aren't actively traded in any significant way, it can be extremely difficult to know if these model valuations are accurate at all.
The only true test of what a Level 3 asset is worth is trying to sell it. However, it can take a long time to find a buyer, which also complicates pricing since the value of anything can change over a long period and require frequent adjustment of prices.