JP Morgan Chase 2008 Annual Report Download - page 124

Management’s discussion and analysis
122 JPMorgan Chase & Co./ 2008 Annual Report
Imprecision in estimating unobservable market inputs can impact the
amount of revenue or loss recorded for a particular position.
Furthermore, while the Firm believes its valuation methods are
appropriate and consistent with those of other market participants,
the use of different methodologies or assumptions to determine the
fair value of certain financial instruments could result in a different
estimate of fair value at the reporting date. For a detailed discussion
of the determination of fair value for individual financial instruments,
see Note 4 on pages 141–145 of this Annual Report. In addition, for
a further discussion of the significant judgments and estimates
involved in the determination of the Firm’s mortgage-related expo-
sures, see “Mortgage-related exposures carried at fair value” in Note
4 on pages 151–153 of this Annual Report.
Purchased credit-impaired loans
JPMorgan Chase acquired, in connection with the Washington Mutual
transaction, certain loans with evidence of deterioration of credit
quality since origination and for which it was probable, at acquisition,
that the Firm would be unable to collect all contractually required
payments receivable. These purchased credit-impaired loans are
accounted for in accordance with SOP 03-3. Many of the assumptions
and estimates underlying the application of SOP 03-3 are both signifi-
cant and judgmental, particularly considering the current economic
environment. The level of future home price declines, the duration and
severity of the current economic downturn and the lack of market liq-
uidity and transparency are factors that have impacted and may con-
tinue to impact these assumptions and estimates.
Determining which loans are included in the scope of SOP 03-3 is
highly subjective and requires the application of significant judgment.
In the Washington Mutual transaction, consumer loans with certain
attributes (e.g., higher loan-to-value ratios, borrowers with lower FICO
scores, delinquencies) were determined to be credit-impaired, provid-
ed that those attributes arose subsequent to loan origination.
Wholesale loans were determined to be credit-impaired if they met
the definition of an impaired loan under SFAS 114 at the acquisition
date. Applying SOP 03-3 to the appropriate population of loans is
important because loans that are not within the scope of SOP 03-3
are subject to different accounting standards. Choosing different
attributes in making the management assessment of which loans
were credit-impaired and within the scope of SOP 03-3 could have
resulted in a different (i.e., larger or smaller) population of loans
deemed credit-impaired at the transaction date.
Loans determined to be within the scope of SOP 03-3 are initially
recorded at fair value. The Firm has estimated the fair value of these
loans by discounting the cash flows expected to be collected at a
market observable discount rate, when available, adjusted for factors
that a market participant would consider in determining fair value.
The initial estimate of cash flows expected to be collected entails sig-
nificant management judgment, as such cash flows were derived from
assumptions such as default rates, loss severities and the amount and
timing of prepayments. Particularly in the current economic environ-
ment, estimating the initial fair value of these loans was highly sub-
jective. The application of different assumptions by management
would have resulted in different initial fair values.
The Firm has elected to aggregate the purchased credit-impaired con-
sumer loans into pools of loans with common risk characteristics.
Significant judgment is required in evaluating whether individual
loans have common risk characteristics for purposes of establishing
these pools. Each resulting pool is considered one loan with a com-
posite interest rate and estimation of cash flows expected to be col-
lected for purposes of applying SOP 03-3 subsequent to acquisition.
The process of estimating cash flows expected to be collected subse-
quent to acquisition is both subjective and judgmental and may have
an impact on the recognition and measurement of impairment losses
and/or interest income. In addition, the decision to pool these loans
and the manner in which they were pooled may have an impact on
the recognition, measurement and/or classification of interest income
and/or impairment losses.
Goodwill impairment
Under SFAS 142, goodwill must be allocated to reporting units and
tested for impairment. SFAS 142 defines reporting units of an entity
as either SFAS 131 operating segments (i.e., one level below the
SFAS 131 reportable segments as disclosed in Note 37 of this Annual
Report) or one level below the SFAS 131 operating segments.
JPMorgan Chase generally determined its reporting units to be one
level below the six major business segments identified in Note 37 on
pages 226–227 of this Annual Report, plus Private Equity which is
included in Corporate. This determination was based on how the
Firm’s operating segments are managed and how they are reviewed
by the Firm’s Operating Committee.
The Firm tests goodwill for impairment at least annually or more fre-
quently if events or circumstances, such as adverse changes in the
business climate, indicate that there may be justification for conduct-
ing an interim test. The first part of the test is a comparison, at the
reporting unit level, of the fair value of each reporting unit to its car-
rying amount, including goodwill. If the fair value is less than the
carrying value, then the second part of the test is needed to measure
the amount of potential goodwill impairment. The implied fair value
of the reporting unit goodwill is calculated and compared with the
carrying amount of goodwill recorded in the Firm’s financial records.
If the carrying value of the reporting unit goodwill exceeds the
implied fair value of that goodwill, then the Firm would recognize an
impairment loss in the amount of the difference, which would be
recorded as a charge against net income.
If the fair value of the reporting unit in the first part of the test is
determined to be greater than the carrying amount of the reporting
unit including goodwill, then and in accordance with SFAS 142
goodwill is deemed not to be impaired. During the fourth quarter of
2008, the Firm performed its annual goodwill impairment testing
and concluded that the fair value of each of its reporting units was
in excess of their respective carrying values including goodwill.
Accordingly, the Firm concluded that its goodwill was not impaired
at December 31, 2008.