JP Morgan Chase 2008 Annual Report Download - page 145

JPMorgan Chase & Co./ 2008 Annual Report 143
For certain loans that are expected to be securitized, such as commer-
cial and residential mortgages, fair value is estimated based upon
observable pricing of asset-backed securities (“ABS”) with similar col-
lateral and incorporates adjustments (i.e., reductions) to these prices
to account for securitization uncertainties including portfolio composi-
tion, market conditions and liquidity to arrive at the whole loan price.
When data from recent market transactions is available it is incorpo-
rated as appropriate. If particular loans are not expected to be securi-
tized they are marked for individual sale taking into consideration
potential liquidation proceeds and property repossession/liquidation
information, as appropriate. For further discussion of the valuation of
mortgage loans carried at fair value, see the “Mortgage-related expo-
sures carried at fair value” section of this Note on pages 151–153.
The Firm’s loans carried at fair value and reported in trading assets
are largely classified within level 3 due to the lack of observable pric-
ing. Loans carried at fair value and reported in loans including lever-
aged lending funded loans, high-yield bridge financing and purchased
nonperforming loans held in the Investment Bank (“IB”) are classified
within level 2 or 3 of the valuation hierarchy depending on the level
of liquidity and activity in the markets for a particular product.
Consumer
Fair values for consumer installment loans (including automobile
financings and consumer real estate not expected to be securitized),
for which market rates for comparable loans are readily available, are
based upon discounted cash flows adjusted for prepayment assump-
tions. The discount rates used for consumer installment loans are
based on current market rates for new originations of comparable
loans. Fair value for credit card receivables is based upon discounted
expected cash flows. The discount rates used for credit card receiv-
ables incorporate only the effects of interest rate changes, since the
expected cash flows already reflect an adjustment for credit risk.
Consumer installment loans and credit card receivables that are not
carried on the balance sheet at fair value are not classified within
the fair value hierarchy. For further discussion of the valuation of
mortgage loans carried at fair value, see the “Mortgage-related
exposures carried at fair value” section of this Note.
Securities
Where quoted prices for identical securities are available in an active
market, securities are classified in level 1 of the valuation hierarchy.
Level 1 securities include highly liquid government bonds, mortgage
products for which there are quoted prices in active markets (such as
U.S. government agency or U.S. government-sponsored enterprise pass-
through mortgage-backed securities) and exchange-traded equities.
If quoted market prices are not available for the specific security, the
Firm may estimate the value of such instruments using a combina-
tion of observed transaction prices, independent pricing services and
relevant broker quotes. Consideration is given to the nature of the
quotes (e.g., indicative or firm) and the relationship of recently evi-
denced market activity to the prices provided from independent pric-
ing services. The Firm may also use pricing models or discounted
cash flows. In cases where there is limited activity or less transparen-
cy around inputs to the valuation, securities are classified within level
3 of the valuation hierarchy.
For certain collateralized mortgage and debt obligations, asset-backed
securities and high-yield debt securities the determination of fair value
may require benchmarking to similar instruments or analyzing default
and recovery rates. For “cash” collateralized debt obligations
(“CDOs”), external price information is not available. Therefore, cash
CDOs are valued using market-standard models, such as Intex, to
model the specific collateral composition and cash flow structure of
each deal; key inputs to the model are market spread data for each
credit rating, collateral type and other relevant contractual features.
Asset-backed securities are valued based on external prices or market
spread data, using current market assumptions on prepayments and
defaults. For those asset-backed securities where the external price
data is not observable or the limited available data is opaque, the col-
lateral performance is monitored and the value of the security is
assessed. To benchmark its valuations, the Firm looks to transactions
for similar instruments and utilizes independent pricing provided by
third-party vendors, broker quotes and relevant market indices such as
the ABX index, as applicable. While none of those sources are solely
indicative of fair value, they serve as directional indicators for the
appropriateness of the Firm’s estimates.The majority of collateralized
mortgage and debt obligations, high-yield debt securities and asset-
backed securities are currently classified in level 3 of the valuation
hierarchy. For further discussion of the valuation of mortgage securi-
ties carried at fair value see the “Mortgage-related exposures carried
at fair value” section of this Note on pages 151–153.
Commodities
Commodities inventory is carried at the lower of cost or fair value.
The fair value for commodities inventory is determined primarily
using pricing and data derived from the markets on which the under-
lying commodities are traded. Market prices may be adjusted for liq-
uidity. The Firm also has positions in commodity-based derivatives
that can be traded on an exchange or over-the-counter. The pricing
inputs to these derivatives include forward curves of underlying com-
modities, basis curves, volatilities, correlations, and occasionally other
model parameters. The valuation of these derivatives is based upon
calibrating to market transactions, as well as to independent pricing
information from sources such as brokers and dealer consensus pric-
ing services. Where inputs are unobservable, they are benchmarked
to observable market data based upon historic and implied correla-
tions, then adjusted for uncertainty where appropriate. The majority
of commodities inventory and commodities-based derivatives are
classified within level 2 of the valuation hierarchy.
Derivatives
Exchange-traded derivatives valued using quoted prices are classified
within level 1 of the valuation hierarchy. However, few classes of
derivative contracts are listed on an exchange; thus, 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. Depending on
the types and contractual terms of derivatives, fair value can be mod-
eled using a series of techniques, such as the Black-Scholes option
pricing model, simulation models or a combination of various mod-