JP Morgan Chase 2003 Annual Report Download - page 77

J.P. Morgan Chase & Co. / 2003 Annual Report 75
Allowance for Credit Losses
JPM organ Chase’s Allow ance for credit losses covers the com-
mercial and consumer loan portfolios as w ell as the Firm’s port-
folio of commercial lending-related commitments. The
allow ance for loan losses is intended to adjust the value of the
Firm’s loan assets for probable credit losses as of the balance
sheet date in accordance w ith generally accepted accounting
principles. M anagement also computes an allow ance for lending-
related commercial commitments using a methodology similar
to that used for the commercial loan portfolio. For a further
discussion of the methodologies used in establishing the Firm’s
Allow ance for credit losses, see Note 12 on page 100 of this
Annual Report.
Commercial loans and lending-related commit ments
The methodology for calculating both the Allow ance for loan
losses and the Allow ance for lending-related commitments
involves significant judgment. First and foremost, it involves the
early identification of credits that are deteriorating. Second, it
involves management judgment to derive loss factors.
The Firm uses a risk rating system to determine the credit quality
of its loans. Commercial loans are review ed for information
affecting the obligor’s ability to fulfill its obligations. In assessing
the risk rating of a particular loan, among the factors considered
include the obligor’s debt capacity and financial flexibility, the
level of the obligor’s earnings, the amount and sources of repay-
ment, the level and nature of contingencies, management
strength, and the industry and geography in w hich the obligor
operates. These factors are based on an evaluation of historical
information and current information as w ell as subjective assess-
ment and interpretation. Emphasizing one factor over another
or considering additional factors that may be relevant in deter-
mining the risk rating of a particular loan, but which are not
currently an explicit part of the Firm’s methodology, could
impact the risk rating assigned by the Firm to that loan.
M anagement also applies its judgment to derive loss factors
associated w ith each credit facility. These loss factors are deter-
mined by facility structure, collateral and type of obligor.
Wherever possible, the Firm uses independent, verifiable data or
the Firm’s ow n historical loss experience in its models for esti-
mating these loss factors. M any factors can affect manage-
ment’s estimates of specific loss and expected loss, including
volatility of default probabilities, rating migrations and loss
severity. For example, judgment is required to determine how
many years of data to include w hen estimating the possible
severity of the loss. If a full credit cycle is not captured in the
data, then estimates may be inaccurate. Likewise, judgment is
applied to determine whether the loss-severity factor should be
calculated as an average over the entire credit cycle or whether
to apply the loss-severity factor implied at a particular point in
the credit cycle. The application of different loss-severity factors
w ould change the amount of the allow ance for credit losses
determined appropriate by the Firm. Similarly, there are judg-
ments as to w hich external data on default probabilities should
be used, and w hen they should be used. Choosing data that are
not reflective of the Firm’s specific loan portfolio characteristics
could affect loss estimates.
As noted above, the Firm’s allow ance for loan losses is sensitive
to the risk rating assigned to a loan. Assuming a one-notch
dow ngrade in the Firm’s internal risk ratings for all its commercial
loans, the allow ance for loan losses for the commercial portfolio
w ould increase by approximately $470 million at December 31,
2003. Furthermore, assuming a 10% increase in the loss severity
on all dow ngraded non-criticized loans, the allow ance for com-
mercial loans w ould increase by approximately $50 million at
December 31, 2003. These sensitivity analyses are hypothetical
and should be used w ith caution. The purpose of these analyses
is to provide an indication of the impact risk ratings and loss
severity have on the estimate of the allow ance for loan losses
for commercial loans. It is not intended to imply management’s
expectation of future deterioration in risk ratings or changes in
loss severity. Given the process the Firm follow s in determining
the risk ratings of its loans and assessing loss severity, manage-
ment believes the risk ratings and loss severities currently
assigned to commercial loans are appropriate. Furthermore, the
likelihood of a one-notch dow ngrade for all commercial loans
w ithin a short timeframe is remote.
Consumer loans
The consumer portfolio is segmented into three main business
lines: Chase Home Finance, Chase Cardmember Services and
Chase Auto Finance. For each major portfolio segment w ithin
each line of business, there are three primary factors that are
considered in determining the expected loss component of the
allow ance for loan losses: period-end outstandings, expected loss
factor and average life. The various components of these factors,
such as collateral, prepayment rates, credit score distributions,
collections and the historical loss experience of a business seg-
ment, differ across business lines. For example, credit card revolv-
ing credit has significantly higher charge-off ratios than fixed
mortgage credit. Determination of each factor is based primarily
on statistical data and macroeconomic assumptions.
Residual component
M anagement’s judgments are also applied w hen considering
uncertainties that relate to current macroeconomic and political
conditions, the impact of currency devaluation on cross-border
exposures, changes in underw riting standards, unexpected cor-
relations w ithin the portfolio or other factors. For example,
judgment as to political developments in a particular country
w ill affect management’s assessment of potential loss in the
credits that have exposure to that country. A separate
allow ance component, the residual component, is maintained
to cover these uncertainties, at December 31, 2003, in the