JP Morgan Chase 2010 Annual Report Download - page 149

JPMorgan Chase & Co./2010 Annual Report 149
CRITICAL ACCOUNTING ESTIMATES USED BY THE FIRM
JPMorgan Chase’s accounting policies and use of estimates are
integral to understanding its reported results. The Firm’s most com-
plex accounting estimates require management’s judgment to ascer-
tain 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 pro-
cedures are intended to ensure that the process for changing meth-
odologies 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 estimates involving significant valuation judgments.
Allowance for credit losses
JPMorgan Chase’s allowance for credit losses covers the retained
wholesale and consumer loan portfolios, as well as the Firm’s
wholesale and consumer lending-related commitments. The allow-
ance for loan losses is intended to adjust the value of the Firm’s
loan assets to reflect probable credit losses inherent in the portfolio
as of the balance sheet date. The allowance for lending-related
commitments is established to cover probable losses in the lending-
related commitments portfolio. For a further discussion of the
methodologies used in establishing the Firm’s allowance for credit
losses, see Note 15 on pages 239–243 of this Annual Report.
Wholesale loans and lending-related commitments
The methodology for calculating the allowance for loan losses and
the allowance for lending-related commitments involves significant
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 obligor’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 on an evaluation of historical and current information
and involve subjective assessment and interpretation. Emphasizing
one factor over another or considering additional factors could
affect 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
models for estimating the allowances. Many factors can affect esti-
mates 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. Historical experience of both loss given
default and probability of default are considered when estimating
these adjustments. Factors related to concentrated and deteriorat-
ing industries also are incorporated where relevant. These esti-
mates are based on management’s view of uncertainties that relate
to current macroeconomic and political conditions, quality of un-
derwriting standards and other relevant internal and external
factors affecting the credit quality of the current portfolio.
As noted above, the Firm’s wholesale allowance is sensitive to the
risk rating assigned to a loan. As of December 31, 2010, 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 $1.3 billion. This sensitivity
analysis is hypothetical. In the Firm’s view, the likelihood of a one-
notch downgrade for all wholesale 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 expec-
tation of future deterioration in risk ratings. Given the process the
Firm follows in determining 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, including
credit card, is sensitive to changes in the economic environment,
delinquency status, the realizable value of collateral, FICO scores,
borrower behavior and other risk factors, and is intended to represent
management’s best estimate of probable losses inherent in the
portfolio as of the balance sheet date. The credit performance of the
consumer portfolio across the entire consumer credit product spec-
trum has stabilized but high unemployment and weak overall eco-
nomic conditions continue to result in an elevated level of charge-
offs, while weak housing prices continue to negatively affect the
severity of losses realized on residential real estate loans that default.
Significant judgment is required to estimate the duration and severity