JP Morgan Chase 2009 Annual Report Download - page 159

JPMorgan Chase & Co./2009 Annual Report 157
use for specific products. All valuation models within the Firm are
subject to this review process. A price verification group, inde-
pendent from the risk-taking function, ensures observable market
prices and market-based parameters are used for valuation wher-
ever possible. For those products with material parameter risk for
which observable market levels do not exist, an independent
review of the assumptions made on pricing is performed. Addi-
tional review includes deconstruction of the model valuations for
certain structured instruments into their components, and
benchmarking valuations, where possible, to similar products;
validating valuation estimates through actual cash settlement;
and detailed review and explanation of recorded gains and losses,
which are analyzed daily and over time. Valuation adjustments,
which are also determined by the independent price verification
group, are based on established policies and are applied consis-
tently over time. Any changes to the valuation methodology are
reviewed by management to confirm that the changes are justi-
fied. As markets and products develop and the pricing for certain
products becomes more or less transparent, the Firm continues to
refine its valuation methodologies. During 2009, no changes
were made to the Firm’s valuation models that had, or are ex-
pected to have, a material impact on the Firm’s Consolidated
Balance Sheets or results of operations.
The methods described above to estimate fair value may produce
a fair value calculation that may not be indicative of net realizable
value or reflective of future fair values. Furthermore, while the
Firm believes its valuation methods are appropriate and consis-
tent with other market participants, the use of different method-
ologies or assumptions to determine the fair value of certain
financial instruments could result in a different estimate of fair
value at the reporting date.
Valuation Hierarchy
A three-level valuation hierarchy has been established under U.S.
GAAP for disclosure of fair value measurements. The valuation
hierarchy is based on the transparency of inputs to the valuation
of an asset or liability as of the measurement date. The three
levels are defined as follows.
• Level 1 – inputs to the valuation methodology are quoted
prices (unadjusted) for identical assets or liabilities in active
markets.
• Level 2 – inputs to the valuation methodology include quoted
prices for similar assets and liabilities in active markets, and
inputs that are observable for the asset or liability, either di-
rectly or indirectly, for substantially the full term of the finan-
cial instrument.
• Level 3 – one or more inputs to the valuation methodology are
unobservable and significant to the fair value measurement.
A financial instrument’s categorization within the valuation
hierarchy is based on the lowest level of input that is significant
to the fair value measurement.
Following is a description of the valuation methodologies used by
the Firm to measure instruments at fair value, including the
general classification of such instruments pursuant to the valua-
tion hierarchy.
Assets
Securities purchased under resale agreements (“resale
agreements”) and securities borrowed
To estimate the fair value of resale agreements and securities
borrowed transactions, cash flows are evaluated taking into
consideration any derivative features of the resale agreement and
are then discounted using the appropriate market rates for the
applicable maturity. As the inputs into the valuation are primarily
based on readily observable pricing information, such resale
agreements are classified within level 2 of the valuation hierarchy.
Loans and unfunded lending-related commitments
The majority of the Firm’s loans and lending-related commitments
are not carried at fair value on a recurring basis on the Consoli-
dated Balance Sheets, nor are they actively traded. The fair value
of such loans and lending-related commitments is included in the
additional disclosures of fair value of certain financial instruments
required by U.S. GAAP on pages 171–172 of this Note. Loans
carried at fair value on a recurring and nonrecurring basis are
included in the applicable tables that follow.
Wholesale
There is no liquid secondary market for most loans and lending-
related commitments in the Firm's wholesale portfolio. In the
limited circumstances where direct secondary market information,
including pricing of actual market transactions, broker quotations
or quoted market prices for similar instruments, is available
(principally for loans in the Firm's secondary trading portfolio),
such information is used in the determination of fair value. For
the remainder of the portfolio, fair value is estimated using a
discounted cash flow (“DCF”) model. In addition to the character-
istics of the underlying loans (including principal, customer rate
and contractual fees), key inputs to the model include interest
rates, prepayment rates, and credit spreads. The credit spread
input is derived from the cost of credit default swaps (“CDS”)
and, as a result, also incorporates the effects of secondary market
liquidity. As many of the Firm’s clients do not have bonds traded
with sufficient liquidity in the public markets to have observable
CDS spreads, the Firm principally develops benchmark credit
curves by industry and credit rating to estimate fair value. Addi-
tional adjustments to account for the difference in recovery rates
between bonds, on which the cost of credit derivatives is based,
and loans as well as loan equivalents (which represent the por-
tion of an unused commitment expected, based on the Firm's
average portfolio historical experience, to become outstanding
prior to an obligor default) are also incorporated into the valua-
tion process.
For a discussion of the valuation of mortgage loans carried at fair
value, see the "Mortgage-related exposures carried at fair value"
section of this Note on pages 169–170.
The Firm's loans carried at fair value 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.