Overview: nightmare on Wall st

Crisis averted. That was the view of analysts of US banks last week, as
expected writedowns of sub-prime related instruments failed to have the
catastrophic effect some had feared. But concerns about the reporting of the
instruments are unlikely to go away just yet.

What happened?

The big US banks spent last week revealing their exposure to the problems in
the US sub-prime market. The banking crisis around the world is built on fears,
among other things, that some banks may be holding more of the bad debts than
has hitherto been disclosed.

Even so, the numbers weren’t pretty. Lehman Brothers took a $700m (£347m)
hit; Morgan Stanley booked a $940m hit; and Bear Sterns took a $200m charge on
two collapsed hedge funds as well as seeing income sharply cut back.

Goldman Sachs, which recovered ground by hedging successfully, took a huge
$1.7bn hit even so. The issue going forward will be whether that is the end of
the losses or whether there will be a sting in the tail ­ in the accounting.

What’s going to happen?

It is well known that the market for the sub-prime derivatives, the US banks
have been exposed to, has collapsed. In the collapsed market, then, how are they
valuing the instruments?

Experts say it is a kind of mark-to-model type of accounting, in which as
many available market values as possible are used to create a model of what the
derivative might be worth in an active market. But the method is clearly open to
abuse; Enron made extensive use of mark-to-model, and has given it and other
similar types of accounting a bad name.

It seems inconceivable that US banks would want to do anything other than be
scrupulously careful in such a choppy market, but the incentives are clearly
there for them to minimise losses. Auditors will, in time, scrutinise the
numbers too.

Paul Sater, a financial services partner at Ernst & Young, says: ‘In
terms of auditing [these] financial instruments, we’ll be focusing on the
validity of the assumptions that went into valuing the asset. As with any
financial instrument, the key issues are: does it actually exist, how is it
valued and is that value appropriate?

‘Then we’ll assess whether the contract is enforceable ­ does the company
really own the instrument ­ and does the valuation reflect all of the terms of
the contract.’
As another senior member of the profession said, you can’t just make these
things up.

And with the stakes so high, no-one, whether auditor or banker, will want to
get things wrong.

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