April 9 (Bloomberg) -- Goldman Sachs Group Inc., the most profitable securities firm, reported an increase in hard-to- value assets during the first quarter, exceeding those at Morgan Stanley and Lehman Brothers Holdings Inc.

Goldman's so-called Level 3 assets surged 39 percent to $96.4 billion at the end of February from $69.2 billion in November, according to a filing with the U.S. Securities and Exchange Commission today. The ratio of Level 3 to total assets rose to 8.1 percent from 6.2 percent.

Investors are wary of banks and brokerages with difficult- to-sell securities on their books as $232 billion of writedowns and credit losses from the collapse of the subprime mortgage market have crippled earnings. More assets have become difficult to value in the last three months as investors shunned a wider array of credit, reducing trading.

``People are concerned about Level 3 because of possible writedowns, though it isn't necessarily all losing value,'' said Erin Archer, senior equity research analyst at Thrivent Financial for Lutherans, which holds shares of the three firms in the $73 billion under management. ``We aren't out of the woods yet when it comes to writedowns and profitability of the brokers.''

Goldman fell $4.76, or 2.7 percent, to $174.14 at 4 p.m. in New York Stock Exchange composite trading. The shares had gained 8 percent this month through yesterday. Morgan Stanley declined $1.25 today, or 2.6 percent, to $46.10. Lehman dropped $3.13, or 7.2 percent, to $40.54.

Relative Risk

Goldman Chief Financial Officer David Viniar said last month the Level 3-to-assets ratio had risen to about 8 percent mostly because some assets classified as Level 2, including commercial real estate loans, dropped to Level 3. The biggest increase in the hard-to-value category was a 59 percent jump in derivative contracts, according to today's filing. Mortgage and other asset-backed loans and securities increased 56 percent in the quarter.

``Just because an asset is defined as Level 3 doesn't mean we're uncomfortable with the value of the asset,'' said Lucas van Praag, a spokesman for Goldman Sachs. ``It also doesn't provide any insight into the relative risk of the underlying asset.''

Under accounting rules, Level 1 assets are those for which market prices are readily available. Level 2 holdings are valued based on ``observable inputs,'' or prices of similar assets traded in the market. Assets are placed into the Level 3 category when there are hardly any observable inputs, and the firm has to rely on in-house models to calculate potential gains or losses.

FAS 157

The largest investment banks adopted a Financial Accounting Standards Board rule, known as FAS 157, a year earlier than mandated by the board, and have been publishing the breakdown of their asset valuations. The rule, which went into effect last November, requires all public companies to make similar disclosures this year, starting with their first-quarter reports.

The new standard doesn't change the way firms value their assets. It only creates clear-cut categories and is intended to increase transparency about valuations.

Morgan Stanley's Level 3 assets rose 6.1 percent to $78.2 billion last quarter, the firm said today in an SEC filing. Lehman, which also filed a report with the agency today, said its Level 3 holdings rose 1.3 percent to $42.5 billion. All three firms are based in New York.

Lehman's Ratio

The harder-to-value securities made up 7.2 percent of Morgan Stanley's total assets at the end of February, up from 7 percent three months earlier. Lehman's ratio declined to 5.4 percent from 6.1 percent as total assets grew faster. Lehman CFO Erin Callan said last month the ratio would be around 5 percent.

``The uncertainty of Level 3 asset valuation is already priced in the stocks of brokerage firms,'' said Steve Roukis, managing director at Matrix Asset Advisors Inc. which oversees $1.8 billion of assets in New York. ``We expect more writedowns in coming quarters, but they're not going to be huge numbers like the past quarters.''

Goldman faces a maximum potential loss of $22.4 billion from assets held off the firm's balance sheet in so-called variable interest entities, down from $25.9 billion in the previous quarter, according to today's filing. The holdings aren't included among assets classified as Level 1-Level 3. Morgan Stanley said its maximum potential loss from VIEs fell to $11.6 billion from $16 billion. Lehman's dropped to $8 billion from $9.1 billion.

Bear Stearns

Almost one third of the assets held by Goldman's off- balance-sheet entities were mortgage-linked collateralized debt obligations. The market for those instruments has frozen since July.

In the fourth quarter of last year, Bear Stearns Cos. had 7.1 percent of its assets classified as Level 3, the most among the four firms. Bear Stearns didn't publish first-quarter results this year after agreeing to be sold to JPMorgan Chase & Co. last month, following a bank run on the securities firm that depleted its cash reserves.

Stripping out stakes owned by others, Goldman's ``exposure'' to Level 3 assets was $82.3 billion, or 6.9 percent of the firm's total assets. That amounts to a 50 percent increase from the previous quarter. Goldman is the only one of the three banks that reports such an adjusted Level 3 figure.

The following table compares the Level 3 assets on the balance sheets of the three U.S. securities firms that filed their quarterly reports with the regulators today.

Firm           Level 3        Level 3 Assets as   Change in
Value
               Assets         a Percentage of     From Previous
               (in billions)  Total Assets        Quarter

Goldman
Sachs          $96.39         8.1%                 39%
  excluding
  some assets  $82.32         6.9%                 50%

Morgan
Stanley        $78.16         7.2%                 6.1%

Lehman
Brothers       $42.51         5.4%                 1.3%

To contact the reporter on this story: Yalman Onaran in New York at yonaran@bloomberg.net.

Last Updated: April 9, 2008 16:06 EDT