JP Morgan Chase 2014 Annual Report Download - page 164

Management’s discussion and analysis
162 JPMorgan Chase & Co./2014 Annual Report
housing prices), FICO scores, borrower behavior and other
risk factors. While all of these factors are important
determinants of overall allowance levels, changes in the
various factors may not occur at the same time or at the
same rate, or changes may be directionally inconsistent
such that improvement in one factor may offset
deterioration in the other. In addition, changes in these
factors would not necessarily be consistent across all
geographies or product types. Finally, it is difficult to
predict the extent to which changes in these factors would
ultimately affect the frequency of losses, the severity of
losses or both.
PCI loans
In connection with the Washington Mutual transaction,
JPMorgan Chase acquired certain PCI loans, which are
accounted for as described in Note 14. The allowance for
loan losses for the PCI portfolio is based on quarterly
estimates of the amount of principal and interest cash flows
expected to be collected over the estimated remaining lives
of the loans.
These cash flow projections are based on estimates
regarding default rates (including redefault rates on
modified loans), loss severities, the amounts and timing of
prepayments and other factors that are reflective of current
and expected future market conditions. These estimates are
dependent on assumptions regarding the level of future
home price declines, and the duration of current overall
economic conditions, among other factors. These estimates
and assumptions require significant management judgment
and certain assumptions are highly subjective.
Formula-based component - Wholesale loans and lending-
related commitments
The Firm’s methodology for determining the allowance for
loan losses and the allowance for lending-related
commitments requires the early identification of credits
that are deteriorating. The formula-based component of the
allowance calculation for wholesale loans and lending-
related components is the product of an estimated PD and
estimated LGD. These factors are determined based on the
credit quality and specific attributes of the Firm’s loans and
lending-related commitments to each obligor.
The Firm uses a risk rating system to determine the credit
quality of its wholesale loans and lending-related
commitments. In assessing the risk rating of a particular
loan or lending-related commitment, among the factors
considered are the obligor’s debt capacity and financial
flexibility, the level of the obligor’s earnings, the amount
and sources for repayment, the level and nature of
contingencies, management strength, and the industry and
geography in which the obligor operates. These factors are
based on an evaluation of historical and current information
and involve subjective assessment and interpretation.
Emphasizing one factor over another or considering
additional factors could affect the risk rating assigned by
the Firm to that loan.
PD estimates are based on observable external through-
the-cycle data, using credit rating agency default statistics.
A LGD estimate is assigned to each loan or lending-related
commitment. The estimate represents the amount of
economic loss if the obligor were to default. The type of
obligor, quality of collateral, and the seniority of the Firm’s
loans in the obligor’s capital structure affect LGD. LGD
estimates are based on the Firm’s history of actual credit
losses over more than one credit cycle. Changes to the time
period used for PD and LGD estimates (for example, point-
in-time loss versus longer views of the credit cycle) could
also affect the allowance for credit losses.
The Firm applies judgment in estimating PD and LGD used
in calculating the allowances. Wherever possible, the Firm
uses independent, verifiable data or the Firm’s own
historical loss experience in its models for estimating the
allowances, but differences in loan characteristics between
the Firm’s specific loan portfolio and those reflected in
external and Firm-specific historical data could affect loss
estimates. Estimates of PD and LGD are subject to periodic
refinement based on any changes to underlying external
and Firm-specific historical data. The use of different inputs
would change the amount of the allowance for credit losses
determined appropriate by the Firm.
Management also applies its judgment to adjust the
modeled loss estimates, taking into consideration model
imprecision, external factors and economic events that have
occurred but are not yet reflected in the loss factors.
Historical experience of both LGD and PD are considered
when estimating these adjustments. Factors related to
concentrated and deteriorating industries also are
incorporated where relevant. These estimates are based on
management’s view of uncertainties that relate to current
macroeconomic and political conditions, quality of
underwriting standards and other relevant internal and
external factors affecting the credit quality of the current
portfolio.
Allowance for credit losses sensitivity
As noted above, the Firm’s allowance for credit losses is
sensitive to numerous factors, depending on the portfolio.
Changes in economic conditions or in the Firm’s
assumptions could affect its estimate of probable credit
losses inherent in the portfolio at the balance sheet date.
For example, changes in the inputs below would have the
following effects on the Firm’s modeled loss estimates as of
December 31, 2014, without consideration of any
offsetting or correlated effects of other inputs in the Firm’s
allowance for loan losses:
• For PCI loans, a combined 5% decline in housing prices
and a 1% increase in unemployment from current levels
could imply an increase to modeled credit loss estimates
of approximately $1.2 billion.
• For the residential real estate portfolio, excluding PCI
loans, a combined 5% decline in housing prices and a
1% increase in unemployment from current levels could