JP Morgan Chase 2010 Annual Report Download - page 239

JPMorgan Chase & Co./2010 Annual Report 239
Note 15 – Allowance for credit losses
JPMorgan Chase’s allowance for loan losses covers the wholesale
and consumer, including credit card loan portfolios, and represents
management’s estimate of probable credit losses inherent in the
Firm’s loan portfolio. Management also computes an allowance for
wholesale and consumer lending-related commitments using meth-
odologies similar to those used to compute the allowance on the
underlying loans. During 2010, the Firm did not make any significant
changes to the methodologies or policies used to determine its al-
lowance for credit losses, which policies are described in the follow-
ing paragraphs.
The allowance for loan losses includes an asset-specific component, a
formula-based component and a component related to PCI loans.
The asset-specific component relates to loans considered to be im-
paired, which includes loans that have been modified in a troubled
debt restructuring as well as risk-rated loans that have been placed
on nonaccrual status. An asset-specific allowance for impaired loans
is established when the loan’s discounted cash flows (or, in certain
cases, the loan’s observable market price) is lower than the recorded
investment in the loan. To compute the asset-specific component of
the allowance, larger loans are evaluated individually, while smaller
loans are evaluated as pools using historical loss experience for the
respective class of assets. Risk-rated loans (primarily wholesale loans)
are pooled by risk rating, while scored loans (i.e., consumer loans)
are pooled by product type.
The Firm generally measures the asset-specific allowance as the
difference between the recorded investment in the loan and the
present value of the cash flows expected to be collected, discounted
at the loan’s original effective interest rate. Subsequent changes in
impairment due to the impact of discounting are reported as an
adjustment to the provision for loan losses, not as an adjustment to
interest income. An asset-specific allowance for an impaired loan that
is determined using an observable market price is measured as the
difference between the recorded investment in the loan and the
loan’s fair value.
Certain loans are deemed collateral-dependent because repay-
ment of the loan is expected to be provided solely by the underly-
ing collateral, rather than by cash flows from the borrower’s
operations, income or other resources. Impaired collateral-
dependent loans are charged-off to the fair value of the collateral,
less costs to sell, rather than being subject to an asset-specific
reserve as for other impaired loans.
The determination of the fair value of the collateral depends on
the type of collateral (e.g., securities, real estate). In cases where
the collateral is in the form of liquid securities, the fair value is
based on quoted market prices or broker quotes. For illiquid
securities or other financial assets, the fair value of the collateral
is estimated using a discounted cash flow model.
For residential real estate loans, collateral values are based upon
external valuation sources. When it becomes likely that a bor-
rower is either unable or unwilling to pay, the Firm obtains a
broker’s price opinion of the home based on an exterior-only
valuation (“exterior opinions”). As soon as practicable after
taking physical possession of the property through foreclosure,
the Firm obtains an appraisal based on an inspection that in-
cludes the interior of the home (“interior appraisals”). Exterior
opinions and interior appraisals are discounted based upon the
Firm’s experience with actual liquidation values as compared to
the estimated values provided by exterior opinions and interior
appraisals, considering state- and product-specific factors.
For commercial real estate loans, the collateral value is generally
based on appraisals from internal and external valuation sources.
Collateral values are typically updated every six to twelve months,
either by obtaining a new appraisal or by performing an internal
analysis, in accordance with the Firm’s policies. The Firm also
considers both borrower- and market-specific factors, which may
result in obtaining appraisal updates or broker price opinions at
more frequent intervals.
See Note 3 on pages 170–187 of this Annual Report for further
information on the fair value hierarchy for impaired collateral-
dependent loans.
The formula-based component is based on a statistical calculation to
provide for probable principal losses inherent in performing risk-rated
loans and consumer loans, except for loans restructured in troubled
debt restructurings and PCI loans. See Note 14 on pages 220–238 of
this Annual Report for more information on PCI loans.
For risk-rated loans, the statistical calculation is the product of an
estimated probability of default and an estimated loss given default.
These factors are differentiated by risk rating and expected maturity.
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 repay-
ment, 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 informa-
tion, and involve subjective assessment and interpretation. Emphasiz-
ing one factor over another or considering additional factors could
impact the risk rating assigned by the Firm to that loan. PD estimates
are based on observable external through-the-cycle data, using
credit-rating agency default statistics. LGD estimates are based on the
Firm’s history of actual credit losses over more than one credit cycle.
For scored loans, the statistical calculation is performed on pools of
loans with similar risk characteristics (e.g., product type) and gener-
ally computed as the product of actual outstandings, an expected-
loss factor and an estimated-loss coverage period. Expected-loss
factors are statistically derived and consider historical factors such as
loss frequency and severity. In developing loss frequency and severity
assumptions, the Firm considers known and anticipated changes in
the economic environment, including changes in housing prices,
unemployment rates and other risk indicators.
A nationally recognized home price index measure is used to develop
loss severity estimates on defaulted residential real estate loans at
the metropolitan statistical areas (“MSA”) level. These loss severity
estimates are regularly validated by comparison to actual losses