JP Morgan Chase 2005 Annual Report Download - page 129

JPMorgan Chase & Co. /2005 Annual Report 127
• Liquidity adjustments are necessary when the Firm may not be able to
observe a recent market price for a financial instrument that trades in inactive
(or less active) markets.Thus, valuation adjustments for risk of loss due to
a lack of liquidity are applied to those positions to arrive at fair value. The
Firm tries to ascertain the amount of uncertainty in the initial valuation
based upon the liquidity or illiquidity, as the case may be, of the market in
which the instrument trades and makes liquidity adjustments to the financial
instruments. The Firm measures the liquidity adjustment based upon the
following factors: (1) the amount of time since the last relevant pricing
point; (2) whether there was an actual trade or relevant external quote;
and (3) the volatility of the principal component of the financial instrument.
• Concentration valuation adjustments are necessary to reflect the cost of
unwinding larger-than-normal market-size risk positions.The cost is deter-
mined based upon the size of the adverse market move that is likely to
occur during the extended period required to bring a position down to a
nonconcentrated level. An estimate of the period needed to reduce, without
market disruption, a position to a nonconcentrated level is generally based
upon the relationship of the position to the average daily trading volume of
that position. Without these adjustments, larger positions would be valued
at a price greater than the price at which the Firm could exit the positions.
Valuation adjustments are determined based upon established policies and are
controlled by a price verification group independent of the risk-taking function.
Economic substantiation of models, prices, market inputs and revenue through
price/input testing, as well as backtesting, is done to validate the appropriateness
of the valuation methodology. Any changes to the valuation methodology are
reviewed by management to ensure the changes are justified.
The methods described above may produce a fair value calculation that may
not be indicative of net realizable value or reflective of future fair values.
Furthermore, the use of different methodologies to determine the fair value
of certain financial instruments could result in a different estimate of fair
value at the reporting date.
Certain financial instruments and all nonfinancial instruments are excluded
from the scope of SFAS 107. Accordingly, the fair value disclosures required
by SFAS 107 provide only a partial estimate of the fair value of JPMorgan
Chase. For example, the Firm has developed long-term relationships with its
customers through its deposit base and credit card accounts, commonly
referred to as core deposit intangibles and credit card relationships. In the
opinion of management, these items, in the aggregate, add significant value
to JPMorgan Chase, but their fair value is not disclosed in this Note.
The following items describe the methodologies and assumptions used, by
financial instrument, to determine fair value.
Financial assets
Assets for which fair value approximates carrying value
The Firm considers fair values of certain financial assets carried at cost – including
cash and due from banks, deposits with banks, securities borrowed, short-term
receivables and accrued interest receivable – to approximate their respective car-
rying values, due to their short-term nature and generally negligible credit risk.
Assets where fair value differs from cost
The Firm’s debt, equity and derivative trading instruments are carried at their
estimated fair value. Quoted market prices, when available, are used to determine
the fair value of trading instruments. If quoted market prices are not available,
then fair values are estimated by using pricing models, quoted prices of instru-
ments with similar characteristics, or discounted cash flows.
Federal funds sold and securities purchased under resale agreements
Federal funds sold and securities purchased under resale agreements are
typically short-term in nature and, as such, for a significant majority of the
Firm’s transactions, cost approximates carrying value. This balance sheet item
also includes structured resale agreements and similar products with long-
dated maturities. To estimate the fair value of these instruments, cash flows
are discounted using the appropriate market rates for the applicable maturity.
Securities
Fair values of actively traded securities are determined by the secondary
market, while the fair values for nonactively traded securities are based upon
independent broker quotations.
Derivatives
Fair value for derivatives is determined based upon the following:
• position valuation, principally based upon liquid market pricing as evidenced
by exchange-traded prices, broker-dealer quotations or related input
parameters, which assume all counterparties have the same credit rating;
• credit valuation adjustments to the resulting portfolio valuation, to reflect
the credit quality of individual counterparties; and
• other fair value adjustments to take into consideration liquidity, concentration
and other factors.
For those derivatives valued based upon models with significant unobservable
market parameters, the Firm defers the initial trading profit for these financial
instruments. The deferred profit is recognized in Trading revenue on a systematic
basis (typically straight-line amortization over the life of the instruments) and
when observable market data becomes available.
The fair value of derivative payables does not incorporate a valuation adjustment
to reflect JPMorgan Chase’s credit quality.
Interests in purchased receivables
The fair value of variable-rate interests in purchased receivables approximate
their respective carrying amounts due to their variable interest terms and
negligible credit risk. The estimated fair values for fixed-rate interests in
purchased receivables are determined using a discounted cash flow analysis
using appropriate market rates for similar instruments.
Loans
Fair value for loans is determined using methodologies suitable for each type
of loan:
• Fair value for the wholesale loan portfolio is estimated primarily, using the
cost of credit derivatives, which is adjusted to account for the differences
in recovery rates between bonds, upon which the cost of credit derivatives
is based, and loans.
• Fair values for consumer installment loans (including automobile financings)
and consumer real estate, for which market rates for comparable loans
are readily available, are based upon discounted cash flows adjusted for
prepayments. The discount rates used for consumer installment loans are
current rates offered by commercial banks. For consumer real estate,
secondary market yields for comparable mortgage-backed securities,
adjusted for risk, are used.
• Fair value for credit card receivables is based upon discounted expected
cash flows. The discount rates used for credit card receivables incorporate
only the effects of interest rate changes, since the expected cash flows
already reflect an adjustment for credit risk.