JP Morgan Chase 2005 Annual Report Download - page 84

Management’s discussion and analysis
JPMorgan Chase & Co.
82 JPMorgan Chase & Co. /2005 Annual Report
factors such as liquidity and concentration concerns and, for the derivatives
portfolio, counterparty credit risk (see the discussion of CVA on page 70 of
this Annual Report). For example, there is often limited market data to rely
on when estimating the fair value of a large or aged position. Similarly,
judgment must be applied in estimating prices for less readily observable
external parameters. Finally, other factors such as model assumptions, market
dislocations and unexpected correlations can affect estimates of fair value.
Imprecision in estimating these factors can impact the amount of revenue or
loss recorded for a particular position.
Trading and available-for-sale portfolios
Substantially all of the Firm’s securities held for trading and investment
purposes (“long” positions) and securities that the Firm has sold to other
parties but does not own (“short” positions) are valued based upon quoted
market prices. However, certain securities are less actively traded and, therefore,
are not always able to be valued based upon quoted market prices. The
determination of their fair value requires management judgment, as this
determination may require benchmarking to similar instruments or analyzing
default and recovery rates. Examples include certain collateralized mortgage
and debt obligations and high-yield debt securities.
As few derivative contracts are listed on an exchange, the majority of the
Firm’s derivative positions are valued using internally developed models that
use as their basis readily observable market parameters – that is, parameters
that are actively quoted and can be validated to external sources, including
industry-pricing services. Certain derivatives, however, are valued based upon
models with significant unobservable market parameters – that is, parameters
that must be estimated and are, therefore, subject to management judgment
to substantiate the model valuation. These instruments are normally either
less actively traded or trade activity is one-way. Examples include long-dated
interest rate or currency swaps, where swap rates may be unobservable for
longer maturities, and certain credit products, where correlation and recovery
rates are unobservable. Due to the lack of observable market data, the Firm
defers the initial trading profit for these financial instruments. The deferred
profit is recognized in Trading revenue on a systematic basis and when observable
market data becomes available. Management’s judgment also includes
recording fair value adjustments (i.e., reductions) to model valuations to
account for parameter uncertainty when valuing complex or less actively traded
derivative transactions. The following table summarizes the Firm’s trading and
available-for-sale portfolios by valuation methodology at December 31, 2005:
Trading assets Trading liabilities
Securities Securities AFS
purchased(a) Derivatives(b) sold(a) Derivatives(b) securities
Fair value based upon:
Quoted market prices 86% 2% 97% 2% 91%
Internal models with significant
observable market parameters 12 96 2 97 6
Internal models with significant
unobservable market parameters 2211 3
Total 100% 100% 100% 100% 100%
(a) Reflected as debt and equity instruments on the Firm’s Consolidated balance sheets.
(b) Based upon gross mark-to-market valuations of the Firm’s derivatives portfolio prior to netting positions pursuant to FIN 39, as cross-product netting is not relevant to an analysis based upon valua-
tion methodologies.
To ensure that the valuations are appropriate, the Firm has various controls in
place. These include: an independent review and approval of valuation models;
detailed review and explanation for profit and loss analyzed daily and over
time; decomposing the model valuations for certain structured derivative
instruments into their components and benchmarking valuations, where possible,
to similar products; and validating valuation estimates through actual cash
settlement. As markets and products develop and the pricing for certain
derivative products becomes more transparent, the Firm refines its valuation
methodologies. The Valuation Control Group within the Finance area, a group
independent of the risk-taking function, is responsible for reviewing the accuracy
of the valuations of positions taken within the Investment Bank.
For a discussion of market risk management, including the model review
process, see Market risk management on pages 75–78 of this Annual Report.
For further details regarding the Firm’s valuation methodologies, see Note 29
on pages 126–128 of this Annual Report.
Loans held-for-sale
The fair value of loans in the held-for-sale portfolio is generally based upon
observable market prices of similar instruments, including bonds, credit
derivatives and loans with similar characteristics. If market prices are not
available, fair value is based upon the estimated cash flows adjusted for credit
risk that is discounted using a rate appropriate for each maturity that incor-
porates the effects of interest rate changes.
Commodities inventory
The majority of commodities inventory includes bullion and base metals
where fair value is determined by reference to prices in highly active and
liquid markets.The fair value of other commodities inventory is determined
primarily using prices and data derived from less liquid and developing markets
where the underlying commodities are traded.
Private equity investments
Valuation of private investments held primarily by the Private Equity business
within Corporate requires significant management judgment due to the
absence of quoted market prices, inherent lack of liquidity and the long-term
nature of such assets. Private investments are initially valued based upon cost.
The carrying values of private investments are adjusted from cost to reflect
both positive and negative changes evidenced by financing events with third-
party capital providers. In addition, these investments are subject to ongoing
impairment reviews by Private Equity’s senior investment professionals.A variety
of factors are reviewed and monitored to assess impairment including, but
not limited to, operating performance and future expectations of the particular
portfolio investment, industry valuations of comparable public companies,
changes in market outlook and the third-party financing environment over
time. The Valuation Control Group within the Finance area is responsible for
reviewing the accuracy of the carrying values of private investments held by
Private Equity. For additional information about private equity investments,