JP Morgan Chase 2008 Annual Report Download - page 144

Notes to consolidated financial statements
142 JPMorgan Chase & Co./ 2008 Annual Report
reflect the cost of exiting larger-than-normal market-size risk
positions (liquidity adjustments are not taken for positions classi-
fied within level 1 of the fair value hierarchy). The Firm tries to
ascertain the amount of uncertainty in the initial valuation based
upon the degree of liquidity of the market in which the financial
instrument trades and makes liquidity adjustments to the carrying
value of the financial instrument. The Firm measures the liquidity
adjustment based upon the following factors: (1) the amount of
time since the last relevant pricing point; (2) whether there was
an actual trade or relevant external quote; and (3) the volatility of
the principal risk component of the financial instrument. Costs to
exit larger-than-normal market-size risk positions are determined
based upon the size of the adverse market move that is likely to
occur during the period required to bring a position down to a
nonconcentrated level.
• Unobservable parameter valuation adjustments are necessary
when positions are valued using internally developed models that
use as their basis unobservable parameters – that is, parameters
that must be estimated and are, therefore, subject to manage-
ment judgment. These positions are normally traded less actively.
Examples include certain credit products where parameters such
as correlation and recovery rates are unobservable. Unobservable
parameter valuation adjustments are applied to mitigate the pos-
sibility of error and revision in the estimate of the market price
provided by the model.
The Firm has numerous controls in place intended to ensure that its fair
valuations are appropriate. An independent model review group
reviews the Firm’s valuation models and approves them for use for spe-
cific products. All valuation models within the Firm are subject to this
review process. A price verification group, independent from the risk-
taking function, ensures observable market prices and market-based
parameters are used for valuation wherever possible. For those prod-
ucts with material parameter risk for which observable market levels do
not exist, an independent review of the assumptions made on pricing is
performed. Additional review includes deconstruction of the model val-
uations for certain structured instruments into their components, and
benchmarking valuations, where possible, to similar products; validating
valuation estimates through actual cash settlement; and detailed
review and explanation of recorded gains and losses, which are ana-
lyzed daily and over time. Valuation adjustments, which are also deter-
mined by the independent price verification group, are based upon
established policies and are applied consistently over time. Any changes
to the valuation methodology are reviewed by management to confirm
the changes are justified. As markets and products develop and the
pricing for certain products becomes more or less transparent, the Firm
continues to refine its valuation methodologies. During 2008, no mate-
rial changes were made to the Firm’s valuation models.
The methods described above to estimate fair value may produce a
fair value calculation that may not be indicative of net realizable value
or reflective of future fair values. Furthermore, while the Firm believes
its valuation methods are appropriate and consistent with other mar-
ket 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.
Valuation Hierarchy
SFAS 157 establishes a three-level valuation hierarchy for disclosure
of fair value measurements. The valuation hierarchy is based upon
the transparency of inputs to the valuation of an asset or liability as
of the measurement date. The three levels are defined as follows.
• Level 1 – inputs to the valuation methodology are quoted prices
(unadjusted) for identical assets or liabilities in active markets.
• Level 2 – inputs to the valuation methodology include quoted
prices for similar assets and liabilities in active markets, and
inputs that are observable for the asset or liability, either directly
or indirectly, for substantially the full term of the financial instru-
ment.
• Level 3 – inputs to the valuation methodology are unobservable
and significant to the fair value measurement. For a level 3 analy-
sis, see pages 150–151 of this Note.
A financial instrument’s categorization within the valuation hierarchy
is based upon the lowest level of input that is significant to the fair
value measurement.
Following is a description of the valuation methodologies used for
instruments measured at fair value, including the general classifica-
tion of such instruments pursuant to the valuation hierarchy.
Assets
Securities purchased under resale agreements (“resale
agreements”)
To estimate the fair value of resale agreements, cash flows are evalu-
ated taking into consideration any derivative features of the resale
agreement and are then discounted using the appropriate market
rates for the applicable maturity. As the inputs into the valuation are
primarily based upon readily observable pricing information, such
resale agreements are generally classified within level 2 of the valua-
tion hierarchy.
Loans and unfunded lending-related commitments
The majority of the Firm’s loans and lending-related commitments
are not carried at fair value on a recurring basis on the Consolidated
Balance Sheets, nor are they actively traded. The fair value of such
loans and lending-related commitments is included in the disclosures
required by SFAS 107 on pages 154–155 of this Note. Loans carried
at fair value on a recurring and nonrecurring basis are included in
the applicable tables that follow.
Wholesale
The fair value of loans and lending-related commitments is calculat-
ed using observable market information, including pricing from actu-
al market transactions or broker quotations where available. Where
pricing information is not available for the specific loan, the valuation
is generally based upon quoted market prices of similar instruments,
such as loans and bonds. These comparable instruments share char-
acteristics that typically include industry, rating, capital structure, sen-
iority, and consideration of counterparty credit risk. In addition, gen-
eral market conditions, including prevailing market spreads for credit
and liquidity risk, are also considered in the valuation process.