JP Morgan Chase 2008 Annual Report Download - page 122

Management’s discussion and analysis
120 JPMorgan Chase & Co./ 2008 Annual Report
may offset deterioration in the other. In addition, changes in these
factors would not necessarily be consistent across geographies or
product types. Finally, it is difficult to predict the extent to which
changes in both or either of these factors will ultimately impact the
frequency of losses, the severity of losses, or both, and overall loss
rates are a function of both the frequency and severity of individual
loan losses.
The allowance is calculated by applying statistical loss factors and
other risk indicators to pools of loans with similar risk characteristics
to arrive at an estimate of incurred losses in the portfolio.
Management applies judgment to the statistical loss estimates for
each loan portfolio category using delinquency trends and other risk
characteristics to estimate charge-offs. Management utilizes addi-
tional statistical methods and considers portfolio and collateral valu-
ation trends to review the appropriateness of the primary statistical
loss estimate.
The statistical calculation is adjusted to take into consideration
model imprecision, external factors and current economic events that
have occurred but are not yet reflected in the factors used to derive
the statistical calculation, and is accomplished in part by analyzing
the historical loss experience for each major product segment. In the
current economic environment, it is difficult to predict whether his-
torical loss experience is indicative of future loss levels. Management
applies judgment within estimated ranges in determining this adjust-
ment, taking into account the numerous uncertainties inherent in the
current economic environment. The estimated ranges and the deter-
mination of the appropriate point within the range are based upon
management’s judgment related to uncertainties associated with cur-
rent macroeconomic and political conditions, quality of underwriting
standards, and other relevant internal and external factors affecting
the credit quality of the portfolio.
Fair value of financial instruments, MSRs and commodities
inventory
JPMorgan Chase carries a portion of it assets and liabilities at fair
value. The majority of such assets and liabilities are carried at fair
value on a recurring basis. In addition, certain assets are carried at
fair value on a nonrecurring basis, including loans accounted for at
the lower of cost or fair value that are only subject to fair value
adjustments under certain circumstances.
On January 1, 2007, the Firm adopted SFAS 157, which established a
three-level valuation hierarchy for disclosure of fair value measure-
ments. An instrument’s categorization within the hierarchy is based
upon the lowest level of input that is significant to the fair value
measurement. Therefore, for instruments classified in levels 1 and 2
of the hierarchy, where inputs are principally based on observable
market data, there is less judgment applied in arriving at a fair value
measurement. For instruments classified within level 3 of the hierar-
chy, judgments are more significant. The Firm reviews and updates
the fair value hierarchy classifications on a quarterly basis. Changes
from one quarter to the next related to the observability of inputs to
a fair value measurement may result in a reclassification between
hierarchy levels.