Level 3 Assets: Meanings, Markets, and Recent Performance

Level 1
Financial assets and liabilities whose values are based on unadjusted quoted prices for identical assets or liabilities in an active market (examples include active exchange-traded equity securities, listed derivatives, most U.S. Government and agency securities, and certain other sovereign government obligations).

Level 2
Financial assets and liabilities whose values are based on quoted prices in markets that are not active or model inputs that are observable either directly or indirectly for substantially the full term of the asset or liability. Level 2 inputs include the following: a) Quoted prices for similar assets or liabilities in active markets (for example, restricted stock); b) Quoted prices for identical or similar assets or liabilities in non-active markets (examples include corporate and municipal bonds, which trade infrequently); c) Pricing models whose inputs are observable for substantially the full term of the asset or liability (examples include most over-the-counter derivatives, including interest rate and currency swaps); and d) Pricing models whose inputs are derived principally from or corroborated by observable market data through correlation or other means for substantially the full term of the asset or liability (examples include certain residential and commercial mortgage related assets, including loans, securities and derivatives).
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Level 3
Financial assets and liabilities whose values are based on prices or valuation techniques that require inputs that are both unobservable and significant to the overall fair value measurement. These inputs reflect management’s own assumptions about the assumptions a market participant would use in pricing the asset or liability (examples include certain private equity investments, certain residential and commercial mortgage related assets (including loans, securities and derivatives), and long-dated or complex derivatives including certain foreign exchange options and long dated options on gas and power).

Now let's reference rule SFAS 157. According to the Financial Accounting Standards Board:

The changes to current practice resulting from the application of this Statement relate to the definition of fair value, the methods used to measure fair value, and the expanded disclosures about fair value measurements.

Rule SFAS 157 was created as an accounting standard for valuing "hard to value assets" including securitized debt instruments. The rule became effective on November 15, 2007. Banks have been forced to come clean with their true exposure. If an investment bank wants to list an asset it is going to have to be marked to market. The rise in the popularity of level 3 assets amongst America's biggest investment banks has also given rise to the transparency of the market. "Markit" posts daily trading values for Residential Mortgage Backed Securities, Commercial Mortgage Backed Securities, Credit Default Swaps, Leveraged Loan Securities, European and Asian Securitized Credit tranches, and Corporate Default Swaps. The derivatives market and securitized debt market dwarfs the U.S. equity market. But, until recently, its transparency was only well known to institutions, hedge funds, broker dealers, and banks. Real estate has seemed to taken similar shape, as illiquid markets inherently have less transparency. Wall Street's appetite for risk, illiquidity, and easier to arbitrage instruments has undermined itself again (reference Long Term Capital). Derivative instruments have created risk contagion in lieu of efficient markets via risk transfer. This time, the Bankers have lost a big sucker to lay these hard to know instruments off on...the institutional money market investor.