Financial markets: is there a monster in the closet?
So the Federal Reserve has cut US interest rates, the run on deposits at Northern Rock has subsided, the stock market has recovered and the worst of the sub-prime debt crisis looks to be behind us
Yet despite these positive signs after a turbulent and distressing fortnight
in financial markets, I can’t help but feel there may still be a few nasty
sub-prime surprises lurking around the corner.
The reason for my concern is that so much of the exposure banks have to
sub-prime has been parcelled up in hideously complex derivatives and debt
instruments, which are notoriously difficult to value when markets for these
gadgets grind to a complete halt.
Instead of marking-to-market, banks now have to hire an army of actuaries,
mathematicians and goodness knows who else to pump some numbers into a formula
that churns out a valuation for debt derivatives using ‘mark-to-model’
accounting.
So far, investors have been satisfied with the valuations calculated by the
big US investment banks that have taken write-downs on these instruments.
But when debt markets eventually do thaw and the instruments start trading
again there are bound to be some mark-to-model valuations that have overvalued
the various derivatives.
This will inevitably mean more write downs and more pain for investors. I
hope I’m wrong but something tells me that despite the best efforts of auditors
and standard setters to account for these exposures accurately, their sheer
complexity combined with the unpredictably of market forces means that we are
almost certain to see some errors creeping into ‘mark-to-model’ variations that
are currently being made.
Nicholas Neveling is a reporter on Accountancy Age