Wednesday, January 30, 2008

Morgan Stanley and the $7 Billion Unknowable

(WSJ DealBook) If you thought the fog surrounding the value of debt securities was starting to lift, think again.

For a reality check, we would direct you to a brief but illuminating nugget that appeared in Morgan Stanley’s year-end financial results, which it filed Tuesday with regulators. Deep in the 10-K, the securities firm disclosed that during its fourth quarter, it “reclassified” about $7 billion in assets to what is known in accounting circles as “Level 3″ status. Level 3 assets are things on a balance sheet whose value on a given day is more or less a big, fat question mark — or, to put it more scientifically, whose valuation is “based on inputs that are unknowable.”

The fourth-quarter reclassification doesn’t necessarily mean that these assets are worth less today than they were yesterday. Morgan Stanley hasn’t taken a charge because of the accounting change.

But it does mean that Morgan Stanley felt a lot less confident than it did just three months earlier about how to put a price tag on those assets. That, in turn, could imply that the debt markets are becoming more opaque instead of less — which might reasonably raise questions about the accuracy of the recent spate of multibillion-dollar write-downs at Morgan Stanley and other Wall Street firms.

In its filing, Morgan Stanley put most of the blame for the latest reclassification on “continued market and liquidity deterioration in the mortgage markets.”

Morgan Stanley said its new Level 3 assets included commercial whole loans — which is potentially disturbing in itself, because these assets are outside the residential-mortgage market when the subprime troubles began — as well as residuals from the securitization of residential mortgages.

On the bright side, the total value of Morgan Stanley’s Level 3 assets actually declined in the period between Aug. 31 and Nov. 30, regulatory filings show. For example, its debt-related Level 3 assets were $37 billion at the end of November, down from $43.3 billion at the end of August. Part of the decline is likely because of write-downs or asset sales.

Make no mistake: Level 3 isn’t simply a code word for “worthless.” Morgan Stanley and other firms generally classify private-equity investments as Level 3, for example, because they aren’t traded on any market. Those investments are can be worth quite a bit when they are eventually sold.

Still, investors and analysts can be forgiven for wondering, as David Weidner of MarketWatch does in this column, if Level 3 isn’t just a pit stop on the road to a write-down.

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