Unsteadiness in the debt markets has thrown up all kinds of awkward problems, especially when it comes to valuing securitised sub-prime debt in a collapsed market.

Such is the extent of that crisis that audit experts and regulators in the US have weighed in on the issue and written a paper to give guidance on valuations in illiquid markets.

Last week, the American Institute of Certified Public Accountants, the Centre for Audit Quality, the Financial Accounting Standards Board, the Securities and Exchange Commission and the Public Company Accounting Oversight Board, met and compiled a paper warning that the correct application of the fair value standard was essential if auditors wanted to avoid violating accounting principles.

The audit gurus warned of the importance in distinguishing between an imbalance between supply and demand and a ‘forced’ or ‘distressed’ transaction, which
is referred to in the accounting standard FAS157 and directly impacts on the eventual pricing and valuation.

Any banks or traders who thought they could get away with puffed up valuations of sub-prime exposures have been cautioned.

Following the collapse of the sub-prime market, banks can no longer mark instruments to the market price. Instead, banks have to use complex formulas to generate mark-to-model valuations, which are vulnerable to error and subjectivity.