JP Morgan Chase 2008 Annual Report Download - page 154

Notes to consolidated financial statements
152 JPMorgan Chase & Co./ 2008 Annual Report
Residential mortgages
Prime Mortgage – The Firm had exposure of $11.2 billion to prime
mortgages carried at fair value through earnings or at the lower of
cost or fair value at December 31, 2008, which consisted of $2.9 bil-
lion of securities (including $1.2 billion of forward purchase commit-
ments), largely rated “AAA”, and $8.3 billion of first-lien mortgages.
Alt-A mortgage – The Firm had exposure of $3.9 billion to Alt-A
mortgages carried at fair value through earnings or at the lower of
cost or fair value at December 31, 2008, which consisted of $787
million of securities and $3.1 billion of first-lien mortgages.
Subprime mortgage – The Firm had exposure of $941 million to sub-
prime mortgages carried at fair value through earnings or at the
lower of cost or fair value at December 31, 2008, which included
$680 million of securities and $261 million of first-lien mortgages.
Classification and Valuation
Residential mortgage loans and mortgage-backed securities are clas-
sified within level 2 or level 3 of the valuation hierarchy depending
on the level of liquidity and activity in the markets for a particular
product. Level 3 assets include residential whole loans, prime and
Alt-A residential mortgage-backed securities rated below “AAA”,
subprime residential mortgage-backed securities and single-name
CDS on ABS. Products that continue to have reliable price trans-
parency as evidenced by consistent market transactions, such as
AAA-rated prime and Alt-A securities, as well as agency securities,
continue to be classified in level 2.
For those products classified within level 2 of the valuation hierarchy,
the Firm estimates the value of such instruments using a combination
of observed transaction prices, independent pricing services and rele-
vant broker quotes. Consideration is given to the nature of the quotes
(e.g., indicative or firm) and the relationship of recently evidenced mar-
ket activity to the prices provided from independent pricing services.
When relevant market activity is not occurring or is limited, the fair
value is estimated as follows:
Residential mortgage loan s – Fair value of residential mortgage
loans is estimated by projecting the expected cash flows and dis-
counting those cash flows at a rate reflective of current market liq-
uidity. To estimate the projected cash flows (inclusive of assumptions
of prepayment, default rates and loss severity), specific consideration
is given to both borrower-specific and other market factors including,
but not limited to: the borrower’s FICO score; the type of collateral
supporting the loan; an estimate of the current value of the collateral
supporting the loan; the level of documentation for the loan; and
market-derived expectations for home price appreciation or deprecia-
tion in the respective geography of the borrower.
Residential mortgage-backed securities – Fair value of residential
mortgage-backed securities is estimated considering the value of the
collateral and the specific attributes of the securities held by the
Firm. The value of the collateral pool supporting the securities is ana-
lyzed using the same techniques and factors described above for res-
idential mortgage loans, albeit in a more aggregated manner across
the pool. For example, average FICO scores, average delinquency
rates, average loss severities and prepayment rates, among other
metrics, may be evaluated. In addition, as each securitization vehicle
distributes cash in a manner or order that is predetermined at the
inception of the vehicle, the priority in which each particular mort-
gage-backed security is allocated cash flows, and the level of credit
enhancement that is in place to support those cash flows, are key
considerations in deriving the value of residential mortgage-backed
securities. Finally, the risk premium that investors demand for securi-
tized products in today’s market is factored into the valuation. 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 appropriate-
ness of the Firm’s estimates.
Commercial mortgages
Commercial mortgages are loans to companies backed by commer-
cial real estate. Commercial mortgage-backed securities are securities
collateralized by a pool of commercial mortgages. Typically, commer-
cial mortgages have lock-out periods, where the borrower is restrict-
ed from prepaying the loan for a specified timeframe, or periods
where there are disincentives for the borrower to prepay the loan
due to prepayment penalties. These features reduce prepayment risk
for commercial mortgages relative to that of residential mortgages.
The Firm had exposure to $7.2 billion of commercial mortgage-
backed assets carried at fair value through earnings or at the lower
of cost or fair value at December 31, 2008, which consisted of $2.8
billion of securities, largely rated “AAA”, and $4.4 billion of first-lien
mortgages, largely in the U.S.
Classification and Valuation
While commercial mortgages and commercial mortgage-backed
securities are classified within level 2 or level 3 of the valuation hier-
archy, depending on the level of liquidity and activity in the markets,
the majority of these mortgages, including both loans and lower-
rated securities, are currently classified in level 3. Level 2 assets
include AAA-rated fixed-rate commercial mortgage-backed securities.
Commercial mortgage loans – Fair value of commercial mortgage
loans is estimated by projecting the expected cash flows and dis-
counting those cash flows at a rate reflective of current market liq-
uidity. To estimate the projected cash flows, consideration is given to
both borrower-specific and other market factors including, but not
limited to: the borrower’s debt-to-service coverage ratio; the type of
commercial property (e.g., retail, office, lodging, multi-family, etc.); an
estimate of the current loan-to-value ratio; and market-derived
expectations for property price appreciation or depreciation in the
respective geographic location.