Bankers sweat over sub-prime accounting

Banks across the world were fretting over the accounting for complex derivatives this week, as US banks sought to draw a line under the crisis of confidence in the markets.

As UK regulators struggled to deal with a run on the bank at Northern Rock in the UK, US banks were reporting third-quarter numbers including new estimates of the value
of complex sub-prime mortgage related instruments.

The market for such instruments has collapsed, meaning banks can no longer ‘mark-to-market’ and will have to construct complicated models in order to report under mark-to-model valuations. But such models are controversial, after being abused by Enron.

A senior member of the profession warned banks: ‘The market is what it is, and people who try and build their wishes and dreams into valuation models will find that that is not consistent with the accounting rules.’

A Big Four partner told Accountancy Age that the crisis compared with the dotcom crash and the Russian default of 1998. Paul Sater, financial services partner at Ernst & Young, said: ‘We’ve experienced similar market conditions before: the 1994 bond crash, Mexico in 1995, Asia in 1997, Russia and Long Term Capital Management in 1998, the internet bubble - all these were huge challenges too. In times like this the audit of valuations requires significant application of auditors’ judgment. There is no silver bullet.’

Lehman Brothers took a $700m (£350m) writedown on its share of the complex instruments on Tuesday, with Morgan Stanley due to report yesterday and Goldman Sachs and Bear Stearns today.

Fears over possible losses from the complex derivatives instruments have crippled banking systems across the world, as banks grow concerned about lending to each other. The US third-quarter numbers are crucial in assessing how bad the issues are.
Although the world stock markets began falling in July, Sater suggested that banks had already been working on the accounting models for the previous two quarters, after initial concerns over sub-prime problems crystallised in February.