Primer on Asset Classification

Today I just want to post a note to clarify the often cited "Level 3" valuation. I would like to share with you examples of what is commonly classified as Level 3 assets (a LOT of things can qualify), and what to do to value them upon classifying them as Level 3 asset (very LITTLE).

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Figure 1. Definitions & Concepts — FAS 157
Notes on Fair Value Measurements

Fair Value Heirarchy

Inputs to Valuation Techniques

Level 1 inputs

unadjusted quoted prices in active markets for identical assets or liabilities

Level 2 inputs

• inputs other than quoted prices included within Level 1 that are observable either directly or indirectly (examples include quoted prices for similar assets; prices in markets that have few transactions)
• inputs other than quoted prices that are observable
  

Level 3 inputs

• unobservable inputs shall be used to measure fair value to the extent that observable inputs are not available, thereby allowing for situations in which there is little, if any, market activity for the asset at the measurement date
• unobservable inputs shall be developed based on the best information available, which might include the reporting entity's own data
• however the reporting entity must not ignore information about market participant assumptions that is reasonable available without undue cost and effort (THE MOST IMPORTANT INPUT IS NO-INPUT, FAS 157 SAYS)

Examples of Possible Classification of Assets:

Level 1

• Treasury and Agency debt securities
• TBA pass-throughs (in active market)

Level 2

• plain vanilla interest rate swap
• Exchange-traded derivatives swaptions
• Agency CMOs

Level 3

• Long-dated currency swap
• ABS CDOs
• Alt-A fixed A-rated MBS
  

*NOTE: There is no set standard for classification, and management has extensive discretion.

There is also frequent migration (particularly between Levels 2 and 3 assets) from one reporting period to the next, depending on market conditions - adjustments to Level 2 inputs that are asset specific that is significant to the fair value measurement in its entirety might render the measurement a Level 3 measurement.