JP Morgan Chase 2005 Annual Report Download - page 83

JPMorgan Chase & Co. /2005 Annual Report 81
JPMorgan Chase’s accounting policies and use of estimates are integral to
understanding its reported results. The Firm’s most complex accounting
estimates require management’s judgment to ascertain the valuation of
assets and liabilities. The Firm has established detailed policies and control
procedures intended to ensure that valuation methods, including any judgments
made as part of such methods, are well controlled, independently reviewed
and applied consistently from period to period. In addition, the policies and
procedures are intended to ensure that the process for changing methodologies
occurs in a controlled and appropriate manner. The Firm believes its estimates
for determining the valuation of its assets and liabilities are appropriate. The
following is a brief description of the Firm’s critical accounting estimates
involving significant valuation judgments.
Allowance for credit losses
JPMorgan Chase’s allowance for credit losses covers the wholesale and
consumer loan portfolios as well as the Firm’s portfolio of wholesale lending-
related commitments. The Allowance 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. For a further discussion of the methodologies used in establishing
the Firm’s Allowance for credit losses, see Note 12 on pages 107–108 of this
Annual Report.
Wholesale loans and lending-related commitments
The methodology for calculating both the Allowance for loan losses and the
Allowance 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.
Third, it involves management judgment to evaluate certain macroeconomic
factors, underwriting standards, and other relevant internal and external factors
affecting the credit quality of the current portfolio and to refine loss factors to
better reflect these conditions.
The Firm uses a risk rating system to determine the credit quality of its wholesale
loans. Wholesale loans are reviewed 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 for
repayment, the level and nature of contingencies, management strength, and
the industry and geography in which the obligor operates. These factors are
based upon an evaluation of historical and current information, and involve
subjective assessment and interpretation. Emphasizing one factor over another,
or considering additional factors that may be relevant in determining 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.
Management applies its judgment to derive loss factors associated with each
credit facility. These loss factors are determined by facility structure, collateral
and type of obligor. Wherever possible, the Firm uses independent, verifiable
data or the Firm’s own historical loss experience in its models for estimating
these loss factors. Many factors can affect management’s estimates of loss,
including volatility of loss given default, probability of default and rating
migrations. Judgment is applied to determine whether the loss given default
should be calculated as an average over the entire credit cycle or at a particular
point in the credit cycle. The application of different loss given default factors
would change the amount of the Allowance for credit losses determined
appropriate by the Firm. Similarly, there are judgments as to which external
data on probability of default should be used and when they should be used.
Choosing data that are not reflective of the Firm’s specific loan portfolio
characteristics could also affect loss estimates.
Management also applies its judgment to adjust the loss factors derived,
taking into consideration model imprecision, external factors and economic
events that have occurred but are not yet reflected in the loss factors. The
resultant adjustments to the statistical calculation on the performing portfolio
are determined by creating estimated ranges using historical experience of both
loss given default and probability of default. Factors related to concentrated
and deteriorating industries are also incorporated where relevant. The
estimated ranges and the determination of the appropriate point within
the range are based upon 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. The adjustment to the statistical calculation
for the wholesale loan portfolio for the period ended December 31, 2005, was
$621 million, the higher-end within the range, based upon management’s
assessment of current economic conditions.
Consumer loans
For scored loans in the consumer lines of business, loss is primarily determined
by applying statistical loss factors and other risk indicators to pools of loans by
asset type. These loss estimates are sensitive to changes in delinquency status,
credit bureau scores, the realizable value of collateral and other risk factors.
Adjustments to the statistical calculation are accomplished in part by analyzing
the historical loss experience for each major product segment. Management
analyzes the range of credit loss experienced for each major portfolio segment,
taking into account economic cycles, portfolio seasoning and underwriting
criteria, and then formulates a range that incorporates relevant risk factors that
impact overall credit performance. The recorded adjustment to the statistical
calculation for the period ended December 31, 2005, was $1.2 billion, based
upon management’s assessment of current economic conditions.
Fair value of financial instruments
A portion of JPMorgan Chase’s assets and liabilities are carried at fair value,
including trading assets and liabilities, AFS securities and private equity
investments. Held-for-sale loans, mortgage servicing rights (“MSRs”) and
commodities inventory are carried at the lower of fair value or cost. At
December 31, 2005, approximately $386 billion of the Firm’s assets were
recorded at fair value.
The fair value of a financial instrument is defined as the amount at which the
instrument could be exchanged in a current transaction between willing
parties, other than in a forced or liquidation sale. The majority of the Firm’s assets
reported at fair value are based upon quoted market prices or on internally
developed models that utilize independently sourced market parameters,
including interest rate yield curves, option volatilities and currency rates.
The degree of management judgment involved in determining the fair value
of a financial instrument is dependent upon the availability of quoted market
prices or observable market parameters. For financial instruments that are
actively traded and have quoted market prices or parameters readily available,
there is little-to-no subjectivity in determining fair value. When observable
market prices and parameters do not exist, management judgment is necessary
to estimate fair value. The valuation process takes into consideration
Critical accounting estimates used by the Firm