JP Morgan Chase 2010 Annual Report Download - page 173

JPMorgan Chase & Co./2010 Annual Report 173
tive to that of residential mortgages. These loans are classified
within level 2 or 3 of the valuation hierarchy, depending on the
level of liquidity and activity in the markets for the particular
product.
Securities
Where quoted prices for identical securities are available in an
active market, securities are classified in level 1 of the valuation
hierarchy. Level 1 securities include highly liquid government
bonds; mortgage products for which there are quoted prices in
active markets such as U.S. government agency or U.S. govern-
ment-sponsored enterprise (collectively, “U.S. government agen-
cies”) markets; pass-through mortgage-backed securities
(“MBS”); and exchange-traded equities (e.g., common and
preferred stocks).
If quoted market prices are not available for the specific security,
the Firm may estimate the value of such instruments using a
combination of observed transaction prices, independent pricing
services and relevant broker quotes. Consideration is given to the
nature of the quotes (e.g., indicative or firm) and the relationship
of recently evidenced market activity to the prices provided from
independent pricing services. The Firm may also use pricing
models or discounted cash flows. The majority of such instru-
ments are classified within level 2 of the valuation hierarchy;
however, in cases where there is limited activity or less transpar-
ency around inputs to the valuation, securities are classified
within level 3 of the valuation hierarchy.
For mortgage-backed securities, where market activity is not
occurring or is limited, fair value is estimated considering the
value of the collateral and the specific attributes of the securities
held by the Firm. The value of the collateral pool supporting the
securities is analyzed using the same techniques and factors
described above for residential mortgage loans, albeit in a more
aggregated manner across the pool. For example, for residential
MBS, factors evaluated may include average FICO scores, average
delinquency rates, average loss severities and prepayment rates,
among other metrics. For commercial MBS, factors evaluated may
include average delinquencies, loan or geographic concentrations,
and average debt-service coverage ratios, among other metrics.
In addition, as each securitization vehicle distributes cash in a
manner or order that is predetermined at the inception of the
vehicle, the priority in which each particular MBS is allocated cash
flows, and the level of credit enhancement in place to support
those cash flows, are key considerations in deriving the value of
MBS. Finally, the risk premium that investors demand for securi-
tized products in the current market is factored into the valuation.
To benchmark its valuations, the Firm looks to transactions for
similar instruments and uses independent pricing provided by
third-party vendors, broker quotes and relevant market indices,
such as the ABX index, as applicable. While none of those
sources are solely indicative of fair value, they serve as directional
indicators for the appropriateness of the Firm’s estimates.
For certain collateralized mortgage and debt obligations, asset-
backed securities (“ABS”) and high-yield debt securities, the
determination of fair value may require benchmarking to similar
instruments or analyzing default and recovery rates. For cash
collateralized debt obligations (“CDOs”), external price infor-
mation is not available. Therefore, cash CDOs are valued using
market-standard models, such as Intex, to model the specific
collateral composition and cash flow structure of each deal; key
inputs to the model are market spread data for each credit
rating, collateral type and other relevant contractual features.
Asset-backed securities are valued based on external prices or
market spread data, using current market assumptions on
prepayments and defaults. For ABS where the external price
data is not observable or the limited available data is opaque,
the collateral performance is monitored and considered in the
valuation of the security. To benchmark its valuations, the Firm
looks to transactions for similar instruments and uses inde-
pendent prices provided by third-party vendors, broker quotes
and relevant market indices, such as the ABX index, as applica-
ble. While none of those sources are solely indicative of fair
value, they serve as directional indicators for the appropriate-
ness of the Firm’s estimates. The majority of collateralized
mortgage and debt obligations, high-yield debt securities and
ABS are currently classified in level 3 of the valuation hierarchy.
Collateralized loan obligations (“CLOs”) are securities backed by
corporate loans, and they are predominantly held in the Firm’s
available-for-sale (“AFS”) securities portfolio. For these securities,
external pricing information is not readily available. They are there-
fore valued using market-standard models to model the specific
collateral composition and cash flow structure of each deal; key
inputs to the model are market spread data for each credit rating,
collateral type and other relevant contractual features. For further
discussion, see Note 12 on pages 214–218 of this Annual Report.
Commodities
Commodities inventory is generally carried at the lower of cost or
fair value. The fair value of commodities inventory is determined
primarily using pricing and data derived from the markets on
which the commodities are traded. The majority of commodities
inventory is classified within level 1 of the valuation hierarchy.
The Firm also has positions in commodities-based derivatives that
can be traded on an exchange or over-the-counter (“OTC”) and
carried at fair value. The pricing inputs to these derivatives in-
clude forward curves of underlying commodities, basis curves,
volatilities, correlations, and occasionally other model parameters.
The valuation of these derivatives is based on calibrating to
market transactions, as well as to independent pricing informa-
tion from sources such as brokers and consensus pricing services.
Where inputs are historical time series data, they are adjusted for
uncertainty where appropriate. The majority of commodities-
based derivatives are classified within level 2 of the valuation
hierarchy.