Morgan Stanley’s Hard-to-Value Assets Increased on E*Trade Deal

(Bloomberg) -- The amount of the hardest-to-value assets held by Morgan Stanley and Citigroup Inc. continued to rise in the last six months of 2020.

The two New York-based lenders both reported double-digit increases in their so-called Level 3 assets, opaque securities such as high-risk loans and some derivatives that caused havoc during the financial crisis, according to a Bloomberg analysis of company filings.

The surge at the duo sets them apart from most other global investment banks, which saw the level of such transactions decline in the second half of the year as the market chaos triggered by the coronavirus eased off. U.S. firms will give investors a sense of whether the first quarter brought further improvement in market conditions as they report results this week.

While most banks saw their holdings of such assets drop slightly in the second half of 2020, the levels were still up sharply from the end of 2019. That's provided a note of caution in what was otherwise a banner year for trading desks at the biggest firms.

The second-half jump at Morgan Stanley is linked to loans and lending commitments and almost $3 billion of available-for-sale ‘investment securities' tied to the completion of its purchase of discount brokerage E*Trade Financial Corp. in October, according to filings. Citigroup added billions of dollars of loans and complex derivatives linked to stocks in the second half of the year.

Spokespeople for the two firms declined to comment.

The year-on-year increase -- banks say they are now sitting on Level 3 assets worth some $233 billion compared with about $200 billion twelve months ago -- reflects the complicated transactions banks made during the first months of 2020 as investors rushed to make bets or protect themselves from market gyrations. Lenders also had to re-classify existing assets as Level 3 as the coronavirus froze markets and made already-complex deals even harder to value.

Regulators and investors alike apply particular scrutiny to Level 3 assets because there is little market data available for the securities owing to their esoteric nature, which makes them difficult to value. So banks decide themselves how much they're worth based on internal risk models and historical trends. During the financial crisis, lenders' valuations proved unrealistic and they lost billions of dollars.

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The securities contrast with banks' so-called Level 1 assets, which have transparent, readily available prices, such as stocks. Level 2 assets, which include many derivatives, are harder to value, but there's some external data available for pricing.

German lender Deutsche Bank AG still holds about 24 billion euros ($28 billion) of Level 3 assets, more than any of its rivals, even though it was one of the few to reduce its holdings during the year. Goldman Sachs Group Inc., the second-biggest holder, has more than $25 billion of hard-to-value investments.

Despite the increases at Citigroup and Morgan Stanley, Level 3 assets are less of a concern for U.S. banks because they're a smaller portion of their overall businesses. For European banks, however, the hardest-to-value assets loom large over their balance sheets. They're equivalent to more than 50% of Tier 1 Common Equity, a key measure of financial strength, at Frankfurt-based Deutsche Bank, for example, but only 6% at Charlotte, North Carolina-based Bank of America Corp.

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