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Level 3 assets at large American investment banks may have “bottomed out”, according to a new report by Moody’s. The stores of these illiquid, difficult-to-value assets often housed many of the most toxic securities that battered banks’ balance sheets during the credit crunch. Any decline in Level 3 assets is considered positive for banks’ credit profiles, Moody’s claims. (For previous coverage of Level 3 assets, click here.)

Somewhat ominously, the ratings agency adds that further falls in Level 3 inventories are unlikely. Although risky and illiquid, these securities feature “attractive yields and wide bid-offer spreads.” Under pressure to boost shareholder returns, it will be difficult for bankers to shun them completely.

An excellent new paper from Andrew Haldane of the Bank of England provides a breezy summary of the debate over fair-value accounting. In an account that spans 15th-century Italy to the present day—with the likes of Shakespeare, Goethe and Mussolini making unexpected appearances along the way—Mr Haldane neatly portrays the arguments for and against marking assets to market, both past and present. (Other aspects of the paper are addressed in this post at Alphaville.)

The strength of banks’ current opposition to fair-value measurement is made clear by comparing the profits reported by British banks between 1999 and 2008 with what they would have reported if required to mark banking books to market in addition to trading books. Between 2001 and 2006, greater use of fair-value accounting would have added £100bn in profits. However, in 2008 the hypothetical loss to banks would have been some £300bn more than reported. “Had shareholders not already torn it out, this rollercoaster ride in profits would have been hair-raising,” Mr Haldane writes.

In a fair-minded conclusion—so to speak—he notes that “now would be an unfortunate time to starve balance sheets of the sunlight provided by fair values.” But on the other hand, “too much sunlight can scorch.”

In a “noteworthy sign of returning liquidity to capital markets,” a report from Moody’s highlights a drop in Level 3 assets (L3) at the biggest American investment banks in 2009.

These assets cannot be valued easily because they are generally illiquid. Many of the credit boom’s newfangled financial instruments—subprime-linked securities, collateralised debt obligations and the like—were classified as L3 and marked to internal models when reporting their values on balance sheets. Subsequent write-downs of these assets called into question the judgment and competence of bank executives.

In general, creditors now prefer banks to hold less L3, with outright disposals preferable to transfers into the Level 2 or 1 categories. As a percentage of tangible common equity, cash L3 at five lenders with large investment-banking operations fell sharply in 2009; “good news for creditors,” according to Moody’s. (L3 derivative positions were excluded from the analysis due to inconsistent disclosure practices.)

Despite the decline as a share of equity, the absolute value of L3 at Bank of America and JPMorgan remained relatively flat in 2009. Bank of America reported the largest increase in value of L3 (US$9.4bn) in the sample, while JPMorgan was the only bank to disclose a net transfer into the L3 category. Morgan Stanley reported the largest absolute decline in L3, trimming its balance by some 38% during the year, largely through disposals.

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