What Are Level 2 Assets?
Level 2 assets are financial assets and liabilities that are not easily valued and lack regular market pricing. However, their fair value can be approximated using data values or market prices of comparable assets. These assets are sometimes referred to as ‘mark-to-model’ assets, as their value is often derived through models that utilize observable data as inputs.
Key Insights
- Level 2 assets include financial items that don’t have regular market pricing but can still be valued through known data points or market prices.
- These assets occupy an intermediate category, being easier to value than Level 3 assets but less straightforward than Level 1 assets.
- They are frequently held by private equity firms, insurance companies, and other financial institutions with investment arms.
Understanding the Complexity of Level 2 Assets
Publicly traded companies are mandated to establish fair values for their balance sheet assets. Investors rely on these estimates to gauge the company’s current standing and future prospects.
According to generally accepted accounting principles (GAAP), some assets must be recorded at their updated value rather than their historical cost. Companies must classify all their assets based on their valuation ease, adhering to the Financial Accounting Standards Board’s (FASB) standard 157.
Three Asset Levels by FASB 157
FASB introduces three asset levels: Level 1, Level 2, and Level 3. Each class clarifies the reliability of market value calculation for those assets:
- Level 1 Assets: Entities such as stocks and bonds have transparent, observable market prices.
- Level 2 Assets: Valued through observable, external market data.
- Level 3 Assets: Valuations rely on internal models or estimates, lacking comparable market prices.
Private equity firms, insurance companies, and similar financial institutions that have significant investment arms typically hold Level 2 assets. These assets demand valuation based on market data obtained from independent sources and may involve quoted prices for similar assets in active or inactive markets, or models involving observable inputs like default rates, interest rates, and yield curves.
Example: Interest Rate Swap as a Level 2 Asset
Interest rate swaps are typical Level 2 assets. Their values can be determined through observable underlying interest rates and market-determined risk premiums.
Recognizing Examples of Level 2 Assets in Real Life
The Blackstone Group L.P. (BX) provides insightful disclosure regarding their Level 2 assets in financial filings. The company stated:
“Fair value is determined through models or other valuation methodologies. Financial instruments in this category encompass corporate bonds and loans (including those within CLO vehicles), government and agency securities, less liquid and restricted equity securities, and certain over-the-counter derivatives where the fair value derives from observable inputs. Senior and subordinated notes issued by CLO vehicles are classified within Level 2 of the fair value hierarchy.”
Understanding Observable vs. Unobservable Inputs
Investors and analysts often grapple with distinguishing between Level 2 and Level 3 assets. This distinction is crucial as GAAP imposes additional disclosure requirements for Level 3 assets and liabilities. The key factors revolve around whether the valuation data is public and whether the value is supported by true market activities.
Ask yourself these key questions:
- Is the value based on actual market transactions?
- Is the price third-party sourced and publicly accessible?
- Is the valuation periodically distributed?
An asset falls into the Level 3 category if any answer is ’no.’
Understanding Interest Rate Swaps
Interest rate swaps involve two parties exchanging future interest payments between variable and fixed rates based on the principal value of underlying assets. Unlike those made on exchanges, these transactions typically occur over the counter.
Defining Fair Market Value
Fair market value signifies the value that a well-informed, non-pressured buyer would pay a similarly knowledgeable seller in an arm’s length transaction, as per the definitions by Cornell Law School’s Legal Information Institute.
What Is GAAP?
GAAP, jointly formulated by the Financial Accounting Standards Board (FASB) and the Governmental Accounting Standards Board (GASB), sets uniform accounting rules and standards across industries, simplifying financial data comparison and exchange.
In Conclusion
Level 2 assets represent an intermediate valuation class, relying on intrinsic factors and observable market data to establish fair value. They are predominantly held by investment firms and understanding these assets is crucial for making informed investment decisions.
Related Terms: Level 1 Assets, Level 3 Assets, Mark-to-Model Valuation, Interest Rate Swap, Risk Premium.
References
- U.S. Securities and Exchange Commission. “The Blackstone Group L.P”.
- U.S. Securities and Exchange Commission. “Significant Accounting Policies”.
- CFI Education. “Interest Rate Swap (IRS)”.
- Cornell Law School Legal Information Institute. “Fair Market Value”.
- Office of Justice Programs Territories Financial Support Center. “Generally Accepted Accounting Principles (GAAP) Guide Sheet”.
