JP Morgan Chase 2003 Annual Report Download - page 110

Notes to consolidated financial statements
J.P. M organ Chase & Co.
108 J.P. Morgan Chase & Co./ 2003 Annual Report
of evaluating and measuring impairment of M SRs, the Firm
stratifies its portfolio on the basis of the predominant risk char-
acteristics: loan type and interest rate. Any indicated impairment
is recognized as a reduction in revenue through a valuation
allow ance to the extent that the carrying value of an individual
stratum exceeds its estimated fair value.
The Firm evaluates other-than-temporary impairment by review -
ing changes in mortgage and other market interest rates over
historical periods and then determines an interest rate scenario
to estimate the amounts of the M SRs’ gross carrying value and
the related valuation allow ance that could be expected to be
recovered in the foreseeable future. Any gross carrying value
and related valuation allow ance amount that are not expected
to be recovered in the foreseeable future, based upon the inter-
est rate scenario, are considered to be other-than-temporary.
The carrying value of M SRs is sensitive to changes in interest
rates, including their effect on prepayment speeds. The Firm
offsets this interest rate risk by designating certain derivatives
(e.g., a combination of swaps, swaptions and floors that pro-
duces an interest rate profile opposite to the designated risk of
the hedged M SRs) as fair value hedges of specified M SRs under
SFAS 133. SFAS 133 hedge accounting allow s the carrying value
of the hedged M SRs to be adjusted through earnings in the
same period that the change in value of the hedging derivatives
is recognized through earnings. Both of these valuation adjust-
ments are recorded in M ortgage fees and related income.
When applying SFAS 133, the loans underlying the M SRs being
hedged are stratified into specific SFAS 133 similar-asset group-
ings that possess similar interest rate and prepayment risk expo-
sures. The documented hedge period for the Firm is daily. Daily
adjustments are performed to incorporate new or terminated
derivative contracts and to modify the amount of the correspon-
ding similar asset grouping that is being hedged. The Firm has
designated changes in the benchmark interest rate (LIBOR) as
the hedged risk. In designating the benchmark interest rate, the
Firm considers the impact that the change in the benchmark
rate has on the prepayment speed estimates in determining the
fair value of the M SRs. The Firm performs both prospective and
retrospective hedge effectiveness evaluations, using a regression
analysis, to determine whether the hedge relationship is expected
to be highly effective. Hedge effectiveness is assessed by
comparing the change in the value of the M SRs as a result of
changes in benchmark interest rates to the change in the value
of the designated derivatives. For a further discussion on deriva-
tive instruments and hedging activities, see Note 28 on pages
116-117 of this Annual Report.
AFS securities are also used to manage the risk exposure of
M SRs. These instruments are accounted for as stand-alone
instruments, because AFS securities do not qualify as hedges
under SFAS 133. Accordingly, the securities are accounted for as
AFS securities under SFAS 115, with realized gains and losses
recognized in earnings in Securities gains (losses); interest
income on the AFS securities is recognized in earnings in Net
interest income. Unrealized gains and losses on AFS securities
are reported in Other comprehensive income. In addition, cer-
tain nonhedge derivatives, w hich have not been designated by
management in SFAS 133 hedge relationships, are used to man-
age the economic risk exposure of M SRs and are recorded in
M ortgage fees and related income.
The follow ing table summarizes M SR activity and related amorti-
zation for the dates indicated. It also includes the key assumptions
and the sensitivity of the fair value of M SRs at December 31,
2003, to immediate 10% and 20% adverse changes in each of
those assumptions:
Year ended December 31, (in millions) 2003 2002 2001
Balance at beginning of year $4,864 $ 7,749 $ 6,461
Additions 3,201 2,071 3,394
Sales ——(103)
Other-than-temporary impairment (283) — —
SFAS 133 hedge valuation adjustments (226) (3,589) (880)
Amortization (1,397) (1,367) (1,123)
Balance at end of year 6,159 4,864 7,749
Less: Valuation allowance (1,378) (1,634) (1,170)
Balance at end of year, after valuation allowance $4,781 $ 3,230 $ 6,579
Estimated fair value at year-end $4,781 $ 3,230 $ 6,579
2003
Weighted-average prepayment speed assumption (CPR) 17.67%
Impact on fair value with 10% adverse change $(287)
Impact on fair value with 20% adverse change (544)
Weighted-average discount rate 7.31%
Impact on fair value with 10% adverse change $(114)
Impact on fair value with 20% adverse change (223)
CPR: Constant prepayment rate.