That's not fair Mummy

Or perhaps it is. I've just got around to looking at FASB Statement 157 on Fair Value from the tail end of last year. It is remarkably sensible. The definition of fair value is more or less the same as before

The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.

Note though that the definition is based on an exit price (for an asset, the price at which it would be sold) so the intention is clearly to mark at bid/offer rather than mid or acquisition price. This presumably means everyone will show a loss when the buy assets (since they will buy at the offer, mark at the bid), although there is some mealy mouthed language that the standard "does not preclude" the use of mid-market prices or other "conventions as a practical expedient".

The innovative part of 157 is the hierarchy of valuation principles:

Level 1. Valuation using quoted market prices for identical assets or liabilities in active markets.

This is the traditional idea of fair value: I have 2000 shares of IBM, and I mark them at the market price.

Level 2 — Valuation using observable market-based inputs, other than Level 1 quoted prices (or unobservable inputs that are corroborated by market data)

This is what firms mostly do in OTC derivatives: we see traded implied vols for some plain vanilla options (or perhaps simpler exotics in some markets) and we use those implieds (together with rates, dividend rate estimates, underlying prices and so on) as inputs to a valuation model to mark the entire book. Here we are saying 'this 1478 strike 70 week OTC call on the SPX I own is worth $50,000 because brokers are quoting a 1450 strike 78 week call at $57,400 and Black Scholes calibrated to that known price give me $50K for my asset'.

Level 3 — Unobservable inputs (that are not corroborated by observable market data)

This is where we mark a mountain range option to (spread to) a historical correlation, for instance, or a private equity position based on projected cash cashflows.

Firms are required to use the lowest level possible, so the most market based marking must be used. Best of all, firms are required to disclose the split between the levels, and to discuss the basis of unrealised level 3 gains and losses. This should be a really useful disclosure for the readers of the financial statements issued by large financial institutions.

Now, consider Jos Ackermann's recent call for banks to reveal their losses in the current subprime/ credit crisis. He's right of course: banks should have an idea of what their exposure is, and they have a duty to reveal that to their investors. But at the moment a lot of securities and derivatives that would have been valued at level 1 last year would currently have to be valued at level 3 - there isn't a market for many credit products right now. This shows the importance of FASB's hierarchy: knowing that a bank has definitely lost $1B is very different from knowing that on the basis of non-market based estimates a bank thinks it might have lost $1B.

Update. Bloomberg backs me up here:

Dealers stopped providing prices on subprime bonds when trading dried up during July and August [...] the firms are reluctant to give low quotes that suggest clients have lost money and are even more hesitant to give high estimates that they would then have to honor as market-makers by purchasing the securities.

``The dealers are finding themselves away from their desks a whole lot more, [...] No one is willing to put out a quote.''

It was liquid, now it's not, and you should be disclosing that fact.