Fair Value Classification Case

Case 1-Hierarchy

• Key issues:– Active vs inactive markets

• We cannot simply use quoted prices in inactive markets. Quoted prices may require significant adjustments to reflect market inactivity.

• Further, a change in valuation techniques may be necessary (e.g. it may require use of a combination of several techniques, such as market and present value approaches)

– Which valuation techniques are used – If any valuation technique uses unobservable inputs, level

III classification is triggered automatically.

What defines an inactive market?

• Few recent transactions• Price quotes are not based on current information• Price quotes vary substantially either over time or among market makers• Indexes that were previously highly correlated with the fair values of the

asset or a liability, but no longer are correlated.• Increases in implied liquidity premium• Significant increases in bid-ask spreads/high spread level• Decline or absence of market for new issuances• Little information is released publiclyImportant: inactive market means that many (not just some) of these

factors are present

Lack of orderly transactions• Even if the market is inactive, it does not mean transactions

are not orderly (i.e. distressed or forced). When transactions are not orderly, use of past transaction prices is not appropriate to value an asset.

• What makes a transaction not orderly: – No history of usual or customary transactions due to lack of prior

market exposure– Marketing an asset or a liability to a single market participants– The seller is near bankruptcy or receivership– The seller is required to sell to meet regulatory or legal requirements– A transaction is an outlier vs. other transactions

Classification: CDO• Answer: Level III. – Markets are inactive (both for the security held and for

similar securities).– Uses income based approach to value the security. The

inputs used are: • (1) Implied rate of return of 15% for the CDO on the basis of last

date of the market for the CDO (observable)• (2) Credit spread of 2% based on FFC estimates (unobservable)• (3) Liquidity spread of 3%, also estimated by FFC (unobservable)• (4) Non-binding broker quotes based on proprietary models

(unobservable). Because (2) and (3) had a material impact on valuation, it

automatically triggers level III classification.

Mortgage backed securities

• Classification: Level II• Why: – Valuation technique based on inputs that do not require

significant adjustment. Inputs include quoted prices in active markets for similar MBSs with insignificant adjustments for differences between the MBS held by FFC and similar securities

– FFC concluded that …prices for transactions were current and therefore did not reduce their relevance to their fair value measurement… observed transactions were orderly… and any adjustments were insignificant

Auction-rate security (ARS)

• Classification: level III• Why: – Inactive markets due to repeated auction failure.

Hence, we cannot use Level I classification, as prices cannot be trusted

– Inputs to DCF model used to value: • Estimate of future coupon rates, prepayment speed

assumptions, and credit risk assumptions. These are unobservable inputs, automatically triggering level III valuation

Equity security of non-public company

• Classification: Level III. • Why: – Cannot be level I since there are no quotable prices. That

is, market is inactive for this security.– Most competitors are either privately held, segments of

other public firms, or have thinly traded shares. Bottom line: no good observable market inputs.

– Inputs: • Significant entity-specific adjustments to observable market

transactions (risk adjustments for illiquidity, business model, etc.). These adjustments are based on FFC’s own judgments, and therefore represents unobservable inputs (triggering level III classification).

Interest rate swap

• Classification: level II• Why: – Interest rate swaps are customized contracts with

individual terms. Hence, no quoted prices are available for them. Hence, not level I.

– Inputs:• LIBOR yield curve (observable)• Active OTC market exists for similar swaps (observable).

Gasoline swap

• Classification: Level III. • Why– Not level I since no price quotes exist for this particular

contract. – Inputs:

• Independently quoted unleaded gasoline forward price curve for one of the three years remaining under swap (observable)

• For last two years of the swap, FFC uses a forward curve obtained from a third party pricing service… which constructs the forward curve using proprietary model that incorporated projected global supply and demand (unobservable)

• FFC calculates credit valuation adjustment (CVA) for credit worthiness of counter-party (unobservable)