Loan Fair Value’s Ability in Predicting Loan Losses during the Recent Credit Crisis

Statement of Financial Accounting Standards No. 107 (codified in ASC 825-10), Disclosures about Fair Value of Financial Instruments, mandates the disclosure of fair values for financial instruments with the objective of providing investors with more relevant information about firms’ future cash flows. However, the results show that fair value measurements of loans did not explain any variation in future loan losses during the earlier sample period of 1999-2007. It was because credit risk information embedded in fair value estimates was obscured by extraneous factors such as changes in market interest rates. In addition, it is difficult for investors to reliably separate market interest rate effects and credit risk effects from loan fair value disclosures. In contrast, during the credit crisis extraneous factors other than credit risk information were naturally controlled and thus, fair value measurements provided incremental information about future loan losses. Overall, our results suggest that requiring additional disclosure of assumptions and inputs used in estimating fair values is likely to improve the usefulness of fair value information of loans.