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Goldman sparks rally in financials but FASB Rule 157 is an overhang

Financial stocks rallied today. The Select Sector Financial SPDR (XLF) was up 4.69%. The KBW Bank ETF (KBE) was up 4.63%

What was behind the gains today? WalMart reported good earnings and provided decent forward guidance but I don't think that did much for the banks. Apple selling iPhones in China? Not likely. Many analysts attributed the rally to comments by Goldman Sachs (GS) CEO Lloyd Blankfein saying that Goldman doesn't expect to take any significant write downs and has a "pretty good grip" on asset valuations. Furthermore, it is said that Goldman has short positions in subprime mortgages.

All that is well and good; however, there is a good possibility that Blankfein is being a little too sanguine on the situation. Last week there were several blogs that wrote about FASB Rule 157.

The general thrust if Rule 157 is that assets and liabilities should be valued at market prices and take risk into account. It will make it harder for companies to avoid putting market prices on securities considered hardest to value, known as Level 3 assets.

The fair value hierarchy --

In the fair value hierarchy, Level 1 is simple mark-to-market, whereby an asset's value is based on an actual price. Level 2, known as mark-to-model and used when there aren't any quoted prices available, is an estimate based on observable inputs.

Level 3 consists of unobservable inputs, such as those that reflect the reporting entity's own assumptions about what market participants would use to price the asset or liability (including risk), developed using the best information available without undue cost and effort, according to FASB.

Impacts on Goldman --

In a recent report, Bob Janjuah, Royal Bank of Scotland's chief credit strategist, noted that according to Bloomberg, Goldman Sachs has a Level 3 to Equity ratio of 185%. This is based on an estimated Equity base of $39B and Level 3 assets of $72B. Compare these numbers to Merrill Lynch (MER). Merrill's Equity base is $42B, Level 3 assets are $16B and Level 3 to Equity ratio is 38%. Of the six big investment banks listed by Janjuan, the only company with a worse Level 3 to Equity ratio than Goldman is Morgan Stanley.

So is today's bank rally premature?

FASB 157 is effective for fiscal years that begin after November 15, 2007. This means, for the most part, we won't see the real hits to bank assets until after first quarter of 2008. Banks can party on for a few more months but I suspect there are some CEO's praying the credit market comes back to life and SIVs, CDOs and MBSs regain some value by the time FASB 157 begins to have an impact . Otherwise, they may well have to take another round of write downs that would put further downward pressure on the credit markets, wreak havoc on balance sheets and possibly put some other CEOs out of a job. Better hope for the best, Lloyd.

Disclosure: author has no positions in any stocks mentioned in this article

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