Further writedowns expected for US banks

As US investment banks Morgan Stanley, Lehman Brothers, Goldman Sachs and Bear Stearns reported Q3 numbers last week, revealing combined write-downs in excess of $3bn (£1.5bn) from sub-prime exposures, markets responded positively in the hope that the worst of the fallout was now over.

But fund managers believe that, because the valuation of debt securities in an illiquid market is so complex, future writedowns remain a real possibility.

‘I think we all realise that more write-downs are coming. The sub-prime market has not been around for very long, so valuations are difficult. The banks have tried to be honest, but we just don’t know which tranches of sub-prime still have to come in and which bits will be bad,’ said Ralph Cole, a fund manager at Ferguson Wellman Capital Management.

Reaching accurate valuations for debt instruments has become so tricky because the market for such securities has crashed and 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.

‘The banks created these products, so there is nobody better placed to come up with a valuation, but it’s a fluid situation and the banks’ crystal balls are as cloudy as anybody else’s,’ said Douglas Ciocca, a fund manager at Renaissance Financial.

Uncertainty over valuations is likely to put increasing pressure on auditors, who will have to check through the assumptions used by banks in their models and verify that the complex models have generated accurate values.