JP Morgan Chase 2006 Annual Report Download - page 85

JPMorgan Chase & Co. / 2006 Annual Report 83
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 an appropriate manner. The Firm believes its estimates for determin-
ing the valuation of its assets and liabilities are appropriate. The following is a
brief description of the Firm’s critical accounting estimates involving signifi-
cant 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 credit losses is intended to adjust the
value of the Firm’s loan assets for probable credit losses as of the balance
sheet date. For further discussion of the methodologies used in establishing
the Firm’s Allowance for credit losses, see Note 13 on pages 113–114 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 deteri-
orating. Second, it involves judgment in establishing the inputs used to esti-
mate the allowances. Third, it involves management judgment to evaluate cer-
tain macroeconomic factors, underwriting standards, and other relevant inter-
nal 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 whole-
sale loans. Wholesale loans are reviewed for information affecting the oblig-
or’s ability to fulfill its obligations. In assessing the risk rating of a particular
loan, among the factors considered are the obligor’s debt capacity and finan-
cial 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 anoth-
er or considering additional factors could impact the risk rating assigned by
the Firm to that loan.
The Firm applies its judgment to establish loss factors used in calculating the
allowances. Wherever possible, the Firm uses independent, verifiable data or
the Firm’s own historical loss experience in its models for estimating the
allowances. Many factors can affect estimates of loss, including volatility of
loss given default, probability of default and rating migrations. Consideration
is given as to whether the loss estimates should be calculated as an average
over the entire credit cycle or at a particular point in the credit cycle, as well
as to which external data should be used and when they should be used.
Choosing data that are not reflective of the Firm’s specific loan portfolio char-
acteristics could also affect loss estimates. The application of different inputs
would change the amount of the allowance for credit losses determined
appropriate by the Firm.
Management also applies its judgment to adjust the loss factors derived, tak-
ing 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 deter-
mined by creating estimated ranges using historical experience of both loss
given default and probability of default. Factors related to concentrated and
deteriorating industries also are 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 macro-
economic 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, 2006, was $903 million based
upon management’s assessment of current economic conditions.
Consumer loans
For scored loans in the consumer lines of business, loss is determined primarily
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, 2006, was $1.2 billion based
upon management’s assessment of current economic conditions.
Fair value of financial instruments, MSRs and commodities inventory
A portion of JPMorgan Chase’s assets and liabilities are carried at fair value,
including trading assets and liabilities, AFS securities, private equity investments
and mortgage servicing rights (“MSRs”). Held-for-sale loans and physical com-
modities are carried at the lower of fair value or cost. At December 31, 2006,
approximately $526.8 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 upon 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
traded actively 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