JP Morgan Chase 2009 Annual Report Download - page 225

JPMorgan Chase & Co./2009 Annual Report 223
is consistent with methodologies and assumptions the Firm uses
when advising clients. The discount rate used for each reporting unit
represents an estimate of the cost of equity capital for that reporting
unit and is determined based on the Firm’s overall cost of equity, as
adjusted for the risk characteristics specific to each reporting unit, for
example, for higher levels of risk or uncertainty associated with the
business or management’s forecasts and assumptions. To assess the
reasonableness of the discount rates used for each reporting unit,
management compares the discount rate to the estimated cost of
equity for publicly traded institutions with similar businesses and risk
characteristics. In addition, the weighted average cost of equity
(aggregating the various reporting units) is compared with the Firms’
overall cost of equity to ensure reasonableness.
The valuations derived from the discounted cash flow models are
then compared with market-based trading and transaction multi-
ples for relevant competitors. Precise conclusions generally can not
be drawn from these comparisons due to the differences that
naturally exist between the Firm's businesses and competitor insti-
tutions. However, trading and transaction comparables are used as
general indicators to assess the general reasonableness of the
estimated fair values. Management also takes into consideration a
comparison between the aggregate fair value of the Firm’s report-
ing units and JPMorgan Chase’s market capitalization. In evaluat-
ing this comparison, management considers several factors,
including (a) a control premium that would exist in a market trans-
action, (b) factors related to the level of execution risk that would
exist at the firm-wide level that do not exist at the reporting unit
level and (c) short-term market volatility and other factors that do
not directly affect the value of individual reporting units.
While no impairment of goodwill was recognized during 2009, the
Firm’s consumer lending businesses in RFS and Card Services have
elevated risk of potential goodwill impairment due to their expo-
sure to U.S. consumer credit risk. The valuation of these businesses
are particularly dependent upon economic conditions (including
unemployment rates, and home prices) and potential legislative and
regulatory changes that affect consumer credit risk and their busi-
ness models. The assumptions used in the discounted cash flow
models for these businesses, and the values of the associated net
assets, were determined using management’s best estimates, and
the cost of equity reflected the risk and uncertainty for these busi-
nesses and was evaluated in comparison to relevant market peers.
Deterioration in these assumptions could cause the estimated fair
values of these reporting units or their associated goodwill to
decline, which may result in a material impairment charge to earn-
ings in a future period related to some portion of their associated
goodwill.
Mortgage servicing rights
Mortgage servicing rights represent the fair value of future cash
flows for performing specified mortgage servicing activities (pre-
dominantly with respect to residential mortgage) for others. MSRs
are either purchased from third parties or retained upon sale or
securitization of mortgage loans. Servicing activities include collect-
ing principal, interest, and escrow payments from borrowers; mak-
ing tax and insurance payments on behalf of borrowers; monitoring
delinquencies and executing foreclosure proceedings; and account-
ing for and remitting principal and interest payments to the inves-
tors of the mortgage-backed securities.
The Firm has one class of servicing assets. JPMorgan Chase made
this determination based on the availability of market inputs used
to measure its MSR asset at fair value and its treatment of MSRs as
one aggregate pool for risk management purposes. As permitted by
U.S. GAAP, the Firm elected to account for this one class of servic-
ing assets at fair value. The Firm estimates the fair value of MSRs
using an option-adjusted spread model (“OAS”), which projects
MSR cash flows over multiple interest rate scenarios in conjunction
with the Firm’s prepayment model and then discounts these cash
flows at risk-adjusted rates. The model considers portfolio charac-
teristics, contractually specified servicing fees, prepayment assump-
tions, delinquency rates, late charges, other ancillary revenue and
costs to service, and other economic factors. The Firm reassesses
and periodically adjusts the underlying inputs and assumptions
used in the OAS model to reflect market conditions and assump-
tions that a market participant would consider in valuing the MSR
asset. During 2009 and 2008, the Firm continued to refine its
proprietary prepayment model based on a number of market-
related factors, including a downward trend in home prices, general
tightening of credit underwriting standards and the associated
impact on refinancing activity. The Firm compares fair value esti-
mates and assumptions to observable market data where available,
and to recent market activity and actual portfolio experience.
The fair value of MSRs is sensitive to changes in interest rates,
including their effect on prepayment speeds. JPMorgan Chase uses
or has used combinations of derivatives and securities to manage
changes in the fair value of MSRs. The intent is to offset any
changes in the fair value of MSRs with changes in the fair value of
the related risk management instruments. MSRs decrease in value
when interest rates decline. Conversely, securities (such as mort-
gage-backed securities), principal-only certificates and certain
derivatives (when the Firm receives fixed-rate interest payments)
increase in value when interest rates decline.