JP Morgan Chase 2005 Annual Report Download - page 117

JPMorgan Chase & Co. /2005 Annual Report 115
The Firm evaluates other-than-temporary impairment by reviewing changes
in mortgage and other market interest rates over historical periods and then
determines an interest rate scenario to estimate the amounts of the MSRs’
gross carrying value and the related valuation allowance that could be
expected to be recovered in the foreseeable future. Any gross carrying value
and related valuation allowance amounts that are not expected to be recovered
in the foreseeable future, based upon the interest rate scenario, are considered
to be other-than-temporary.
The carrying value of MSRs is sensitive to changes in interest rates, including
their effect on prepayment speeds. JPMorgan Chase uses a combination of
derivatives, AFS securities and trading instruments to manage changes in the
fair value of MSRs. The intent is to offset any changes in the fair value of MSRs
with changes in the fair value of the related risk management instrument.
MSRs decrease in value when interest rates decline. Conversely, securities
(such as mortgage-backed securities), principal-only certificates and derivatives
(when the Firm receives fixed-rate interest payments) decrease in value when
interest rates increase. The Firm offsets the interest rate risk of its MSRs by
designating certain derivatives (e.g., a combination of swaps, swaptions and
floors that produces an interest rate profile opposite to the designated risk of
the hedged MSRs) as fair value hedges of specified MSRs under SFAS 133.
SFAS 133 hedge accounting allows the carrying value of the hedged MSRs to
be adjusted through earnings in the same period that the change in value of
the hedging derivatives is recognized through earnings. Both of these valuation
adjustments are recorded in Mortgage fees and related income.
When applying SFAS 133, the loans underlying the MSRs being hedged are
stratified into specific SFAS 133 asset groupings that possess similar interest
rate and prepayment risk exposures. The documented hedge period for the
Firm is daily. Daily adjustments are performed to incorporate new or terminated
derivative contracts and to modify the amount of the corresponding similar
asset grouping that is being hedged. The Firm has designated changes in the
benchmark interest rate (LIBOR) as the hedged risk. In designating the bench-
mark interest rate, the Firm considers the impact that the change in the
benchmark rate has on the prepayment speed estimates in determining the
fair value of the MSRs. The Firm performs both prospective and retrospective
hedge-effectiveness evaluations, using a regression analysis, to determine
whether the hedge relationship is expected to be highly effective. Hedge
effectiveness is assessed by comparing the change in value of the MSRs as a
result of changes in benchmark interest rates to the change in the value of
the designated derivatives. For a further discussion on derivative instruments
and hedging activities, see Note 26 on page 123 of this Annual Report.
Securities (both AFS and Trading) also are used to manage the risk exposure
of MSRs. Because these securities do not qualify as hedges under SFAS 133,
they are accounted for under SFAS 115. Realized and unrealized gains and
losses on trading securities are recognized in earnings in Mortgage fees and
related income; interest income on the AFS securities is recognized in earnings
in Net interest income; and unrealized gains and losses on AFS securities are
reported in Other comprehensive income. Finally, certain nonhedge derivatives,
which have not been designated by management in SFAS 133 hedge relation-
ships, are used to manage the economic risk exposure of MSRs and are
recorded in Mortgage fees and related income.
Certain AFS securities purchased by the Firm to manage structural interest
rate risk were designated in 2005 as risk management instruments of MSRs.
At December 31, 2005 and 2004, the unrealized loss on AFS securities used
to manage the risk exposure of MSRs was $174 million and $3 million,
respectively.
The following table summarizes MSR activity and related amortization for the
dates indicated. It also includes the key assumptions and the sensitivity of the
fair value of MSRs at December 31, 2005, to immediate 10% and 20%
adverse changes in each of those assumptions.
Year ended December 31, (in millions)(a) 2005 2004 2003
Balance at January 1 $ 6,111 $ 6,159 $ 4,864
Additions 1,897 1,757 3,201
Bank One merger NA 90 NA
Sales —(3) —
Other-than-temporary impairment (1) (149) (283)
Amortization (1,295) (1,297) (1,397)
SFAS 133 hedge valuation adjustments 90 (446) (226)
Balance at December 31 6,802 6,111 6,159
Less: valuation allowance 350 1,031 1,378
Balance at December 31, after
valuation allowance $ 6,452 $ 5,080 $ 4,781
Estimated fair value at December 31 $ 6,668 $ 5,124 $ 4,781
Weighted-average prepayment
speed assumption (CPR) 17.56% 17.29% 17.67%
Weighted-average discount rate 9.68% 7.93% 7.31%
(a) 2004 results include six months of the combined Firm’s results and six months of heritage
JPMorgan Chase results. 2003 reflects the results of heritage JPMorgan Chase only.
CPR: Constant prepayment rate
2005
Weighted-average prepayment speed assumption (CPR) 17.56%
Impact on fair value with 10% adverse change $ (340)
Impact on fair value with 20% adverse change (654)
Weighted-average discount rate 9.68%
Impact on fair value with 10% adverse change $ (231)
Impact on fair value with 20% adverse change (446)
CPR: Constant prepayment rate.
The sensitivity analysis in the preceding table is hypothetical and should be
used with caution. As the figures indicate, changes in fair value based upon a
10% and 20% variation in assumptions generally cannot be easily extrapolated
because the relationship of the change in the assumptions to the change in
fair value may not be linear. Also, in this table, the effect that a change in a
particular assumption may have on the fair value is calculated without changing
any other assumption. In reality, changes in one factor may result in changes
in another, which might magnify or counteract the sensitivities.
The valuation allowance represents the extent to which the carrying value
of MSRs exceeds its estimated fair value for its applicable SFAS 140 strata.
Changes in the valuation allowance are the result of the recognition of
impairment or the recovery of previously recognized impairment charges due to
changes in market conditions during the period. The changes in the valuation
allowance for MSRs were as follows:
Year ended December 31, (in millions)(a) 2005 2004 2003
Balance at January 1 $ 1,031 $ 1,378 $ 1,634
Other-than-temporary impairment (1) (149) (283)
SFAS 140 impairment (recovery) adjustment (680) (198) 27
Balance at December 31 $ 350 $ 1,031 $ 1,378
(a) 2004 results include six months of the combined Firm’s results and six months of heritage
JPMorgan Chase results, while 2003 results include heritage JPMorgan Chase only.