JP Morgan Chase 2008 Annual Report Download - page 121

JPMorgan Chase & Co./ 2008 Annual Report 119
JPMorgan Chase’s accounting policies and use of estimates are inte-
gral to understanding its reported results. The Firm’s most complex
accounting estimates require management’s judgment to ascertain
the value 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
determining the value of its assets and liabilities are appropriate. The
following is a brief description of the Firm’s critical accounting esti-
mates 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 lend-
ing-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 method-
ologies used in establishing the Firm’s allowance for credit losses,
see Note 15 on pages 178–180 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 signifi-
cant judgment. First and foremost, it involves the early identification
of credits that are deteriorating. Second, it involves judgment in
establishing the inputs used to estimate the allowances. 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 are the
obligor’s debt capacity and financial flexibility, the level of the oblig-
or’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 could impact the risk
rating assigned by the Firm to that loan.
The Firm applies its judgment to establish loss factors used in calcu-
lating the allowances. Wherever possible, the Firm uses independent,
verifiable data or the Firm’s own historical loss experience in its mod-
els 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 port-
folio characteristics 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, taking into consideration model imprecision, external factors
and economic events that have occurred but are not yet reflected in
the loss factors by establishing 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. These estimates 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.
As noted on page 96 of this Annual Report, the Firm’s wholesale
allowance is sensitive to the risk rating assigned to a loan. Assuming
a one-notch downgrade in the Firm’s internal risk ratings for its
entire wholesale portfolio, the allowance for loan losses for the
wholesale portfolio would increase by approximately $1.8 billion as
of December 31, 2008. This sensitivity analysis is hypothetical. In the
Firm’s view, the likelihood of a one-notch downgrade for all whole-
sale loans within a short timeframe is remote. The purpose of this
analysis is to provide an indication of the impact of risk ratings on
the estimate of the allowance for loan losses for wholesale loans. It
is not intended to imply management’s expectation of future deterio-
ration in risk ratings. Given the process the Firm follows in determin-
ing the risk ratings of its loans, management believes the risk ratings
currently assigned to wholesale loans are appropriate.
Consumer loans and lending-related commitments
The allowance for credit losses for the consumer portfolio is sensitive
to changes in the economic environment, delinquency status, credit
bureau scores, the realizable value of collateral, borrower behavior
and other risk factors, and is intended to represent management's
best estimate of incurred losses as of the balance sheet date. The
credit performance of the consumer portfolio across the entire con-
sumer credit product spectrum continues to be negatively affected by
the economic environment, as the weak labor market and weak over-
all economic conditions have resulted in increased delinquencies,
while continued weak housing prices have driven a significant
increase in loss severity. Significant judgment is required to estimate
the duration and severity of the current economic downturn, as well
as its potential impact on housing prices and the labor market. While
the allowance for credit losses is highly sensitive to both home prices
and unemployment rates, in the current market it is difficult to esti-
mate how potential changes in one or both of these factors might
impact the allowance for credit losses. For example, while both factors
are important determinants of overall allowance levels, changes in
one factor or the other may not occur at the same rate, or changes
may be directionally inconsistent such that improvement in one factor
CRITICAL ACCOUNTING ESTIMATES USED BY THE FIRM