As sub-prime casualties begin to mount, John Bruce considers whether accountants and auditors could find themselves the target of litigation. With individual banks reporting losses from sub-prime at numbers as great as $11bn, any professional involved at any stage in the sub-prime process, including the accountants and auditors, must be concerned.

What’s happened? Up to six million people in the USAhave borrowed 100% of the value of their homes. Sounds common enough. However, these are people who may have difficulty servicing their borrowing - the sub-prime borrowers. They have been charged higher interest rates to reflect the higher risk of default. Uncommonly for the US, the rates are variable and not fixed. The US housing market has now fallen and interest rates have increased. Result: many sub-prime borrowers have not kept up with repayments and the sale of their houses has been insufficient to repay the money borrowed.

Surely a US problem for a few low quality US lenders? Not so. The sub-prime lenders have rolled the sub-prime mortgages into bonds called Mortgage- Backed Securities (MBS) which they have then sold into the secondary market. The subprime lenders then used the money received to lend more money to more sub-prime borrowers, who bought more houses, which pushed up property prices and the spiral begins. The MBSs are bought by investment institutions from the sub-prime lenders but these institutions are deal makers these days rather than risk takers and so want to sell the securities on as quickly as possible. Since credit rating agencies, not surprisingly, give the bonds a low credit score, the securities have therefore been sliced and diced into different Collateralized Debt Obligations (CDOs) to improve the credit rating. The higher rated/investment grade CDOs are relatively easily sold on. But what about the riskier CDOs, or the ‘toxic waste’? Much of it is sold to hedge funds, which funds are possibly created and owned by the selling investment institution itself. When the housing market is rising, the investments appear to be making huge profits. These toxic waste CDOs are priced up more quickly than the underlying house prices because they contain all the price volatility. Success leads to leveraging to enable the hedge fund to purchase more and more of these star investments. Then the housing market collapses and these CDOs drop in value as quickly as they rose. The hedge funds can be left owing lenders billions.

That is a brief description of the simpler derivatives created from the MBSs. These risks have also been passed on via more complex instruments such as credit default swaps or synthetic CDOs. By these products, the investment institution effectively passes the risk of default to another institution. The institution taking the risk receives a steady ‘premium’ income stream and while the market is on the rise, they pay out no money. This is obviously attractive to fund managers who have been investing in what they might have considered a safe investment. These are products which have been assessed by the credit rating agencies.

All those products have been further repackaged and then sold on to, and through, the world’s investment institutions. As a result, when the sub-prime market began to crater in the US, every major financial institution started looking to check their exposure. That led to the recent credit crunch and the subsequent intervention by the world’s central banks. It was the credit crunch which caused Northern Rock its recent woes.

Nobody knows the true values at stake, but it could easily be hundreds of billions of dollars. The value of the US sub-prime market is estimated at $150 trillion (although the financial markets must be hoping that only a fraction of that figure is exposed to risk of default).

And the claims?

The first claims to have arisen out of sub-prime have been classactions brought against the original sub-prime lenders. Claims are also predicted against the investment managers of the hedge funds and structured investment vehicles (the SIVs) which have had such a keen appetite for the MBSs. Most recently, Merrill Lynch has faced a class-action arising out of its investment in sub-prime related CDOs. The rating agencies also seem likely litigation targets. We are not yet aware of any claims having been made or intimated against the auditors or accountants. However, it seems likely that if the losses keeping increasing, then the auditors and accountants will face claims along with the investment banks, perhaps as secondary targets by way of claims for contribution.

So what might the claims against the auditors, and accountants look like? It’s helpful to break down sub-prime into three tiers. The first tier is the original lending of money by the sub-prime lender to the sub-prime borrower. The second tier is the creation of the MBS which uses the sub-prime loans as the asset backing that security. The third tier is the trading in those MBSs.

Clearly, wherever an auditor has given an unqualified opinion on the value of a particular asset or company, which opinion has since been shown to be inaccurate, there is the possibility of a claim. Unfortunately for auditors, they could be vulnerable from work they have carried out at each of these tiers. As we say above, the sub-prime lenders are already facing class actions premised on the overstating of the value of subprime books of business by those sub-prime lenders. Might auditors be complicit in the over valuations?

What about the role of the accountants in calculating the likely flow of income coming through to the holders of the asset backed securities when the securities are created? Again, over-valuations seem likely. Finally, we see the biggest potential for liability to be against the auditors who before the subprime crisis hit, were involved in the valuation of the hedge funds and SIVs that have had such a keen appetite for the MBSs. Many of those valuations seem certain to have been massively overstated.

Auditors’ current role today in valuing such MBSs is particularly difficult now that the market for such instruments has collapsed. Banks would prefer not mark-tomarket as a result of the near complete illiquidity in the market with auditors being forced instead to construct complicated models in order to conduct markto- model valuations. But it may be the controversial nature of such mark-to-model valuations that has caused the US Financial Accounting Standards Board to issue FASB regulation 157 compelling banks to value assets at market prices rather than against controversial models. Whether or not the approach is adopted on this side of the Atlantic, the current financial crisis is likely to test the auditor’s judgement, in turn increasing the risk of liability exposure.

It is worth emphasising that this is somewhat of a doomsday prophesy: of course defences for auditors and accountants will exist and any limitation of liability provisions in retainers will provide some comfort. But unfortunately, whatever the defences available and however innocent the auditors and accountants may be, the size of the losses being reported means that it seems inevitable that the accountants and auditors will be targets along with all other professionals involved.