JP Morgan Chase 2006 Annual Report Download - page 124

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
JPMorgan Chase & Co.
122 JPMorgan Chase & Co. / 2006 Annual Report
Prior to the adoption of SFAS 156, the Firm designated certain derivatives
used to risk manage MSRs (e.g., a combination of swaps, swaptions and
floors) as SFAS 133 fair value hedges of benchmark interest rate risk. SFAS
133 hedge accounting allowed the carrying value of the hedged MSRs to be
adjusted through earnings in the same period that the change in value of the
hedging derivatives was recognized through earnings. The designated hedge
period was daily. In designating the benchmark interest rate, the Firm consid-
ered the impact that the change in the benchmark rate had on the prepay-
ment speed estimates in determining the fair value of the MSRs. Hedge effec-
tiveness was assessed using a regression analysis of the change in fair value
of the MSRs as a result of changes in benchmark interest rates and of the
change in the fair value of the designated derivatives. The valuation adjust-
ments to both the MSRs and SFAS 133 derivatives were recorded in Mortgage
fees and related income. With the election to apply fair value accounting to
the MSRs under SFAS 156, SFAS 133 hedge accounting is no longer necessary.
For a further discussion on derivative instruments and hedging activities, see
Note 28 on pages 131–132 of this Annual Report.
The following table summarizes MSR activity, certain key assumptions, and the
sensitivity of the fair value of MSRs to adverse changes in those key assump-
tions for the year ended December 31, 2006, during which MSRs were
accounted for under SFAS 156.
Year ended December 31,
(in millions, except rates and where otherwise noted) 2006
Balance at beginning of period after valuation allowance $ 6,452
Cumulative effect of change in accounting principle 230
Fair value at beginning of period 6,682
Originations of MSRs 1,512
Purchase of MSRs 627
Total additions 2,139
Sales —
Change in valuation due to inputs and assumptions(a) 165
Other changes in fair value(b) (1,440)
Fair value at December 31 $ 7,546
Weighted-average prepayment speed assumption (CPR) 17.02%
Impact on fair value of 10% adverse change $ (381)
Impact on fair value of 20% adverse change (726)
Weighted-average discount rate 9.32%
Impact on fair value of 10% adverse change $ (254)
Impact on fair value of 20% adverse change (491)
Contractual service fees, late fees and other ancillary fees
included in Mortgage fees and related income $ 2,038
Third-party Mortgage loans serviced at December 31 (in billions) $527
CPR: Constant prepayment rate.
(a) Represents MSR asset fair value adjustments due to changes in inputs, such as interest
rates and volatility, as well as updates to assumptions used in the valuation model.
(b) Includes changes in the MSR value due to servicing portfolio runoff (or time decay).
The sensitivity analysis in the preceding table is hypothetical and should be
used with caution. Changes in fair value based upon a 10% and 20% varia-
tion in assumptions generally cannot be easily extrapolated because the rela-
tionship of the change in the assumptions to the change in fair value may not
be linear. Also, in this table, the effect that a change in a particular assump-
tion may have on the fair value is calculated without changing any other
assumption. In reality, changes in one factor may result in changes in another,
which might magnify or counteract the sensitivities.
The following table summarizes MSR activity for the years ended December
31, 2005 and 2004, during which MSRs were accounted for under SFAS 140.
Year ended December 31,
(in millions, except rates and where otherwise noted) 2005(c) 2004(d)
Balance at January 1 $ 6,111 $ 6,159
Originations of MSRs 1,301 1,089
Purchase of MSRs 596 668
Total additions 1,897 1,757
Bank One merger NA 90
Sales — (3)
Other-than-temporary impairment (1) (149)
Amortization (1,295) (1,297)
SFAS 133 hedge valuation adjustments 90 (446)
Balance at December 31 6,802 6,111
Less: valuation allowance(a) 350 1,031
Balance at December 31, after valuation allowance $ 6,452 $ 5,080
Estimated fair value at December 31 $ 6,682 $ 5,124
Weighted-average prepayment speed assumption (CPR) 17.56% 17.29%
Weighted-average discount rate 9.68% 7.93%
Valuation allowance at January 1 $ 1,031 $ 1,378
Other-than-temporary impairment(b) (1) (149)
SFAS 140 impairment (recovery) adjustment (680) (198)
Valuation allowance at December 31 $ 350 $ 1,031
Contractual service fees, late fees and other ancillary
fees included in Mortgage fees and related income $ 1,769 $ 1,721
Third-party Mortgage loans serviced
at December 31 (in billions) $ 468 $ 431
(a) The valuation allowance in the preceding table at December 31, 2005 and 2004, represent-
ed the extent to which the carrying value of MSRs exceeded the estimated fair value for its
applicable SFAS 140 strata. Changes in the valuation allowance were the result of the
recognition of impairment or the recovery of previously recognized impairment charges due
to changes in market conditions during the period.
(b) The Firm recorded an other-than-temporary impairment of its MSRs of $1 million and $149
million in 2005 and 2004, respectively, which permanently reduced the gross carrying value
of the MSRs and the related valuation allowance. The permanent reduction precluded sub-
sequent reversals. This write-down had no impact on the results of operations or financial
condition of the Firm.
(c) During the fourth quarter of 2005, the Firm began valuing MSRs using an option-adjusted
spread (“OAS”) valuation model. Prior to the fourth quarter of 2005, MSRs were valued
using cash flows and discount rates determined by a “static” or single interest rate path
valuation model.
(d) 2004 results include six months of the combined Firm’s results and six months of heritage
JPMorgan Chase results.
CPR: Constant prepayment rate