JP Morgan Chase 2009 Annual Report Download - page 140

Management’s discussion and analysis
JPMorgan Chase & Co./2009 Annual Report
138
If such loans had not been within the scope of the accounting guid-
ance for purchased credit-impaired loans, they would have been
recorded at the present values of amounts to be received determined
at appropriate current interest rates, less an allowance for loan losses
(i.e., the Washington Mutual allowance for loan losses would have
been carried over at the acquisition date).
The Firm estimated the fair value of its purchased credit-impaired
loans at the acquisition date by discounting the cash flows ex-
pected to be collected at a market-observable discount rate, when
available, adjusted for factors that a market participant would
consider in determining fair value. The initial estimate of cash flows
to be collected was derived from assumptions such as default rates,
loss severities and the amount and timing of prepayments.
The accounting guidance for these loans provides that the excess of
the cash flows initially expected to be collected over the fair value
of the loans at the acquisition date (i.e., the accretable yield)
should be accreted into interest income at a level rate of return
over the term of the loan, provided that the timing and amount of
future cash flows is reasonably estimable. The initial estimate of
cash flows expected to be collected must be updated each subse-
quent reporting period based on updated assumptions regarding
default rates, loss severities, the amounts and timing of prepay-
ments and other factors that are reflective of current market condi-
tions. Probable decreases in expected loan principal cash flows
after acquisition trigger the recognition of impairment, through the
provision and allowance for loan losses, which is then measured
based on the present value of the expected principal loss, plus any
related foregone interest cash flows discounted at the pool’s effec-
tive interest rate. Probable and significant increases in expected
principal cash flows would first reverse any related allowance for
loan losses; any remaining increases must be recognized prospec-
tively as interest income over the remaining lives of the loans. The
impacts of (i) prepayments, (ii) changes in variable interest rates
and (iii) other changes in timing of expected cash flows are recog-
nized prospectively as adjustments to interest income. As described
above, the process of estimating cash flows expected to be col-
lected has a significant impact on the initial recorded amount of the
purchased credit-impaired loans and on subsequent recognition of
impairment losses and/or interest income. Estimating these cash
flows requires a significant level of management judgment. In
addition, certain of the underlying assumptions are highly subjec-
tive. As of December 31, 2009, a 1% decrease in expected future
principal cash payments for the entire portfolio of purchased credit-
impaired loans would result in the recognition of an allowance for
loan losses for these loans of approximately $800 million.
Finally, the accounting guidance states that investors may aggre-
gate loans into pools that have common risk characteristics and
thereby use a composite interest rate and estimate of cash flows
expected to be collected for the pools. The Firm has aggregated
substantially all of the purchased credit-impaired loans identified in
the Washington Mutual transaction (i.e., the residential real estate
loans) into pools with common risk characteristics. The pools then
become the unit of accounting and are considered one loan for
purposes of accounting for these loans at and subsequent to acqui-
sition. Once a pool is assembled, the integrity of the pool must be
maintained. Significant judgment is required in evaluating whether
individual loans have common risk characteristics for purposes of
establishing pools of loans.
Goodwill impairment
Under U.S. GAAP, goodwill must be allocated to reporting units
and tested for impairment at least annually. The Firm’s process and
methodology used to conduct goodwill impairment testing is de-
scribed in Note 17 on pages 222–225 of this Annual Report.
Management applies significant judgment when estimating the fair
value of its reporting units. Imprecision in estimating (a) the future
earnings potential of the Firm’s reporting units and (b) the relevant
cost of equity or terminal value growth rates can affect the esti-
mated fair value of the reporting units. The fair values of a signifi-
cant majority of the Firm’s reporting units exceeded their carrying
values by substantial amounts (fair value as a percent of carrying
value ranged from 140% to 500%) and thus, did not indicate a
significant risk of goodwill impairment based on current projections
and valuations.
However, the goodwill associated with the Firm’s consumer lending
businesses in RFS and CS have elevated risk due to their exposure
to U.S. consumer credit risk. The valuation of these businesses and
their assets are particularly dependent upon economic conditions
(including unemployment rates and home prices) that affect con-
sumer credit risk and behavior, as well as potential legislative and
regulatory changes that could affect the Firm’s consumer lending
businesses. The assumptions used in the valuation of these busi-
nesses include portfolio outstanding balances, net interest margin,
operating expense and forecasted credit losses and were made
using management’s best projections. The cost of equity used in
the discounted cash flow model reflected the estimated risk and
uncertainty for these businesses and was evaluated in comparison
with relevant market peers. The fair value of the credit card lending
business within CS exceeded its carrying value by approximately
8%. The fair value of a consumer lending business within RFS did
not exceed its carrying value; however, implied fair value of the
goodwill allocated to this consumer lending business within RFS
significantly exceeded its carrying value.
The Firm did not recognize goodwill impairment as of December
31, 2009, based on management's best estimates. However,
prolonged weakness or deterioration in economic market condi-
tions, or additional regulatory or legislative changes, may result in
declines in projected business performance beyond management's
expectations. This could cause the estimated fair values of the
Firm's reporting units or their associated goodwill to decline, which
may result in a material impairment charge to earnings in a future
period related to some portion of their associated goodwill.