Figured the first place to start the search was in the messages that relay chat and see if the HTML conversion takes place there. Now mind you I've already poked and prodded Facebook Chat's message relay server before. Its a MochiWeb server, which you can see in the HTTP headers for chat packets. For more background specifics on the setup that is Facebook chat, see Facebook's engineering blog.
Server: MochiWeb/1.0 (I'm not even supposed to be here today.)Anyhow, by reading the HTTP packet flow, I can get the "raw" information that the webpage uses to talk to the server. These I believe are in JSON although don't quote me on that, suffice to say I can at least read enough of the raw information they contain to see the message I just received. And sure enough these contain the text just as they would have been typed, that is, asterisks instead of HTML bold tags and underscores instead of HTML underline tags.
So, then this tells me that the replacement of "Facebook Chat style markup" takes place in the user's web browser. Problem is, there's a bunch of JavaScript files attached to any Facebook page. Fortunately for me though with Firefox with the FireBug extension the process of analyzing a web page's code is fairly streamlined.
Going straight to the code generated for a chat window, I noticed that the "pic_padding" class is on each message's node (which happen to be paragraph elements). So I searched for this class in the JavaScript given that is was the best lead I had. Fortunately this lead turned out results.
if(pendingMsgID||errorMarkup){
var pendingElementID=pendingMsgID?' id="pending_'+this.id+'_'+pendingMsgID+'"':'';markup+=''+
299(errorMarkup?errorMarkup:'')+' 
