From guidence on the use of broker quotes when determining fair value for fixed income products from inactive markets… by K&L Gates…
~~~~ ” ….The example presented in the FSP will be familiar to firms dealing with the present crisis. An entity invested in a BBB-rated tranche of a collateralized debt obligation at the beginning of 2008, the underlying collateral for which is unguaranteed, nonconforming residential mortgage loans.
Until the end of June, there were quoted prices in active markets for identical securities or quoted prices in active markets for similar securities. Accordingly, the investor was able to determine the fair value of the securities using a “market approach valuation” technique. Since the beginning of July, however, the market for the securities has become increasingly inactive.
Factors cited as evidencing that the market is “inactive” include:
(i) a significant widening of the bid-ask spread in the brokered markets in which the securities and similar securities trade, and then a significant decrease in the volume of trades of the securities and similar securities relative to historical levels; and
(ii) that there are few observable transactions, the prices for transactions that have occurred are not current, and the observable prices for those transactions vary substantially either over time or among market makers.
Consequently, under the FSP, the investor would be reasonable if it were to value the securities using “significant unobservable inputs,” including management’s internal assumptions about future cash flows, appropriately risk-adjusted discount rates, and indicative quotes from brokers or independent pricing services based on proprietary pricing models.
In this example, significant adjustments to market data are required to determine fair value at the measurement date. The FSP emphasizes that an entity is required to reconcile the beginning and ending balances, including separately presenting changes that occurred during the period, that are attributable to the change in the valuation technique applied…. ” ~~~~
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