JP Morgan Chase 2006 Annual Report Download - page 86

MANAGEMENT’S DISCUSSION AND ANALYSIS
JPMorgan Chase & Co.
84 JPMorgan Chase & Co. / 2006 Annual Report
factors such as liquidity and concentration concerns and, for the derivatives
portfolio, counterparty credit risk (For a discussion of CVA, see Derivative con-
tracts on pages 69–72 of this Annual Report). For example, there is often lim-
ited market data to rely on when estimating the fair value of a large or aged
position. Similarly, judgment must be applied in estimating prices for less
readily observable external parameters. Finally, other factors such as model
assumptions, market dislocations and unexpected correlations can affect esti-
mates of fair value. Imprecision in estimating these factors can impact the
amount of revenue or loss recorded for a particular position.
Trading and available-for-sale portfolios
The majority of the Firm’s securities held for trading and investment
purposes (“long” positions) and securities that the Firm has sold to other
parties but does not own (“short” positions) are valued based upon quoted
market prices. However, certain securities are traded less actively and, therefore,
are not always able to be valued based upon quoted market prices. The
determination of their fair value requires management judgment, as this
determination may require benchmarking to similar instruments or analyzing
default and recovery rates. Examples include certain collateralized mortgage
and debt obligations and high-yield debt securities.
As few derivative contracts are listed on an exchange, the majority of the
Firm’s derivative positions are valued using internally developed models that
use as their basis readily observable market parameters – that is, parameters
that are actively quoted and can be validated to external sources, including
industry-pricing services. Certain derivatives, however, are valued based upon
models with significant unobservable market parameters – that is, parameters
that must be estimated and are, therefore, subject to management judgment
to substantiate the model valuation. These instruments are normally either
traded less actively or trade activity is one way. Examples include long-dated
interest rate or currency swaps, where swap rates may be unobservable for
longer maturities, and certain credit products, where correlation and recovery
rates are unobservable. Due to the lack of observable market data, the Firm
defers the initial trading profit for these financial instruments. The deferred profit
is recognized in Principal transactions revenue on a systematic basis (typically
straight-line amortization over the life of the instruments) when observable mar-
ket data becomes available. Management’s judgment includes recording fair
value adjustments (i.e., reductions) to model valuations to account for param-
eter uncertainty when valuing complex or less actively traded derivative trans-
actions. The following table summarizes the Firm’s trading and available-for-
sale portfolios by valuation methodology at December 31, 2006:
Trading assets Trading liabilities
Securities Securities AFS
December 31, 2006 purchased(a) Derivatives(b) sold(a) Derivatives(b) securities
Fair value based upon:
Quoted market prices 83% 3% 97% 3% 97%
Internal models with significant
observable market parameters 13 96 3 95 3
Internal models with significant
unobservable market parameters 41—2—
Total 100% 100% 100% 100% 100%
(a) Reflected as debt and equity instruments on the Firm’s Consolidated balance sheets.
(b) Based upon gross mark-to-market valuations of the Firm’s derivatives portfolio prior to netting positions pursuant to FIN 39, as cross-product netting is not relevant to an analysis based upon valua-
tion methodologies.
To ensure that the valuations are appropriate, the Firm has various controls in
place. These include: an independent review and approval of valuation models;
detailed review and explanation for profit and loss analyzed daily and over
time; decomposing the model valuations for certain structured derivative
instruments into their components and benchmarking valuations, where possible,
to similar products; and validating valuation estimates through actual cash
settlement. As markets and products develop and the pricing for certain
derivative products becomes more transparent, the Firm continues to refine its
valuation methodologies.
For further discussion of market risk management, including the model review
process, see Market risk management on pages 77–80 of this Annual Report.
For further details regarding the Firm’s valuation methodologies, see Note 31
on pages 135–137 of this Annual Report.
Loans held-for-sale
The fair value of loans in the held-for-sale portfolio generally is based upon
observable market prices of similar instruments, including bonds, credit
derivatives and loans with similar characteristics. If market prices are not
available, fair value is based upon the estimated cash flows adjusted for credit
risk that is discounted using an interest rate appropriate for the maturity of
the applicable loans.
Commodities inventory
The majority of commodities inventory includes bullion and base metals
where fair value is determined by reference to prices in highly active and
liquid markets. The fair value of other commodities inventory is determined
primarily using prices and data derived from the markets on which the underly-
ing commodities are traded. Market prices used may be adjusted for liquidity.
Private equity investments
Valuation of private investments held primarily by the Private Equity business
within Corporate requires significant management judgment due to the
absence of quoted market prices, inherent lack of liquidity and the long-term
nature of such assets. Private equity investments are valued initially based
upon cost. The carrying values of private equity investments are adjusted from
cost to reflect both positive and negative changes evidenced by financing
events with third-party capital providers. In addition, these investments are
subject to ongoing impairment reviews by Private Equity’s senior investment
professionals. A variety of factors are reviewed and monitored to assess
impairment including, but not limited to, operating performance and future
expectations of the particular portfolio investment, industry valuations of com-
parable public companies, changes in market outlook and the third-party
financing environment over time.