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.