JP Morgan Chase 2008 Annual Report Download - page 146

Notes to consolidated financial statements
144 JPMorgan Chase & Co./ 2008 Annual Report
els, which are consistently applied. Where derivative products have
been established for some time, the Firm uses models that are widely
accepted in the financial services industry. These models reflect the
contractual terms of the derivatives, including the period to maturity,
and market-based parameters such as interest rates, volatility, and
the credit quality of the counterparty. Further, many of these models
do not contain a high level of subjectivity, as the methodologies used
in the models do not require significant judgment, and inputs to the
model are readily observable from actively quoted markets, as is the
case for “plain vanilla” interest rate swaps and option contracts and
credit default swaps (“CDS”). Such instruments are generally classi-
fied within level 2 of the valuation hierarchy.
Derivatives that are valued based upon models with significant unob-
servable market parameters and that are normally traded less active-
ly, have trade activity that is one way, and/or are traded in less-
developed markets are classified within level 3 of the valuation hier-
archy. Level 3 derivatives, for example, include credit default swaps
referenced to mortgage-backed securities, certain types of CDO
transactions, options on baskets of single-name stocks, and callable
exotic interest rate options. Such derivatives are primarily used for
risk management purposes.
For certain derivative products, such as credit default swaps refer-
enced to mortgage-backed securities, the value is based on the
underlying mortgage risk. As these instruments are not actively quoted,
the estimate of fair value considers the valuation of the underlying
collateral (mortgage loans). Inputs to the valuation will include avail-
able information on similar underlying loans or securities in the cash
market. The prepayments and loss assumptions on the underlying
loans or securities are estimated using a combination of historical
data, prices on market transactions, and other prepayment and
default scenarios and analysis. Relevant observable market indices
such as the ABX or CMBX, are considered, as well as any relevant
transaction activity.
Other complex products, such as those sensitive to correlation
between two or more underlyings, also fall within level 3 of the
hierarchy. Such instruments include complex credit derivative prod-
ucts which are illiquid and non-standard in nature, including CDOs
and CDO-squared. A CDO is a debt security collateralized by a vari-
ety of debt obligations, including bonds and loans of different matu-
rities and credit qualities. The repackaging of such securities and
loans within a CDO results in the creation of tranches, which are
instruments with differing risk profiles. In a CDO-squared, the instru-
ment is a CDO where the underlying debt instruments are also
CDOs. For CDO-squared transactions, while inputs such as CDS
spreads and recovery rates may be observable, the correlation
between the underlying debt instruments is unobservable. The corre-
lation levels are not only modeled on a portfolio basis but are also
calibrated at a transaction level to liquid benchmark tranches. For all
complex credit derivative products, actual transactions, where avail-
able, are used to regularly recalibrate all unobservable parameters.
Correlation sensitivity is also material to the overall valuation of
options on baskets of single-name stocks; the valuation of these bas-
kets is typically not observable due to their non-standardized struc-
turing. Correlation for products such as these are typically estimated
based on an observable basket of stocks and then adjusted to reflect
the differences between the underlying equities.
For callable exotic interest rate options, while most of the assump-
tions in the valuation can be observed in active markets (e.g. interest
rates and volatility), the callable option transaction flow is essentially
one-way, and as such, price observability is limited. As pricing infor-
mation is limited, assumptions are based upon the dynamics of the
underlying markets (e.g. the interest rate markets) including the
range and possible outcomes of the applicable inputs. In addition,
the models used are calibrated, as relevant, to liquid benchmarks
and valuation is tested against monthly independent pricing services
and actual transactions.
Mortgage servicing rights and certain retained interests in
securitizations
Mortgage servicing rights (“MSRs”) and certain retained interests
from securitization activities do not trade in an active, open market
with readily observable prices. While sales of MSRs do occur, the pre-
cise terms and conditions typically are not readily available.
Accordingly, the Firm estimates the fair value of MSRs and certain
other retained interests in securitizations using discounted cash flow
(“DCF”) models.
• For MSRs, the Firm uses an option-adjusted spread (“OAS”) valu-
ation model in conjunction with the Firm’s proprietary prepayment
model to project MSR cash flows over multiple interest rate sce-
narios, which are then discounted at risk-adjusted rates to esti-
mate an expected fair value of the MSRs. The OAS model consid-
ers portfolio characteristics, contractually specified servicing fees,
prepayment assumptions, delinquency rates, late charges, other
ancillary revenue, costs to service and other economic factors. The
Firm reassesses and periodically adjusts the underlying inputs and
assumptions used in the OAS model to reflect market conditions
and assumptions that a market participant would consider in valu-
ing the MSR asset. Due to the nature of the valuation inputs,
MSRs are classified within level 3 of the valuation hierarchy.
• For certain retained interests in securitizations (such as interest-
only strips), a single interest rate path discounted cash flow
model is used and generally includes assumptions based upon
projected finance charges related to the securitized assets, esti-
mated net credit losses, prepayment assumptions and contractual
interest paid to third-party investors. Changes in the assumptions
used may have a significant impact on the Firm’s valuation of
retained interests, and such interests are therefore typically classi-
fied within level 3 of the valuation hierarchy.
For both MSRs and certain other retained interests in securitizations,
the Firm compares its fair value estimates and assumptions to
observable market data where available and to recent market activity
and actual portfolio experience. For further discussion of the most
significant assumptions used to value retained interests in securitiza-
tions and MSRs, as well as the applicable stress tests for those
assumptions, see Note 16 and Note 18 on pages 180–188 and
198–201, respectively, of this Annual Report.