Auditing season in full swing

This week continues auditing season, as leading banks and other financial institutions publish their first audited accounts since the sub-prime crisis erupted. 

Timing is everything -- auditors have become more vigilant since the crisis, which could lead to higher levels of writedowns than preliminary results suggested.

American International Group (AIG) was the first such institution to disclose greater losses based on new asset valuations.  On February 11, AIG announced revised losses on its credit-default swap portfolio, from just over $1 billion to nearly $4.9 billion, which saw its shares drop almost 12% to a five-year low.  The revision was prompted by PricewaterhouseCoopers's audit, which concluded there was "material weakness" in the way AIG valued its exposure to collateralised debt obligations tied to sub-prime mortgages.  AIG's latest estimates come from a change in accounting methodology: relying on 'mark-to-market' prices, effectively pricing off cash bonds, rather than financial models that have grown increasingly suspect.

Expectations are of far more to come -- up to 400 billion dollars in sub-prime losses across the system, according to German Finance Minister Peer Steinbrueck.  The sub-prime crisis has spotlighted key weaknesses in global financial market regulation, particularly a lack of transparency in the extent of exposure to illiquid derivative instruments, such as AIG's credit-default swaps. As investor risk-aversion grows, pressure is mounting on financial institutions -- and their auditors -- to measure sub-prime exposure more fully.

While strengthened accounting standards and auditors' roles may lead to improved disclosure of pricing and quoting, they are likely also to generate further significant writedowns and market losses.  This greater disclosure of losses increases the likelihood of severe aggregate capital deficiency -- which in turn could lead to credit tightening, and even a ‘credit crunch’ of the like seen last autumn, increasing banks’ reluctance to lend to one another.