JP Morgan Chase 2010 Annual Report Download - page 261

JPMorgan Chase & Co./2010 Annual Report
261
tutions. However, trading and transaction comparables are used as
general indicators to assess the general reasonableness of the
estimated fair values. Management also takes into consideration a
comparison between the aggregate fair value of the Firm’s report-
ing units and JPMorgan Chase’s market capitalization. In evaluat-
ing this comparison, management considers several factors,
including (a) a control premium that would exist in a market trans-
action, (b) factors related to the level of execution risk that would
exist at the firm-wide level that do not exist at the reporting unit
level and (c) short-term market volatility and other factors that do
not directly affect the value of individual reporting units.
While no impairment of goodwill was recognized during 2010,
the Firm’s consumer lending businesses in RFS and CS remain at
elevated risk of goodwill impairment due to their exposure to U.S.
consumer credit risk and the effects of regulatory and legislative
changes. The valuation of these businesses is particularly dependent
upon economic conditions (including new unemployment claims and
home prices), and regulatory and legislative changes that may affect
consumer credit card use. The assumptions used in the discounted
cash flow model were determined using management’s best esti-
mates. The cost of equity reflected the related risk and uncertainty,
and was evaluated in comparison to relevant market peers. Deteriora-
tion in these assumptions could cause the estimated fair values of
these reporting units and their associated goodwill to decline, which
may result in a material impairment charge to earnings in a future
period related to some portion of the associated goodwill.
Mortgage servicing rights
Mortgage servicing rights represent the fair value of future cash
flows for performing specified mortgage servicing activities (pre-
dominantly with respect to residential mortgage) for others. MSRs
are either purchased from third parties or retained upon sale or
securitization of mortgage loans. Servicing activities include collect-
ing principal, interest, and escrow payments from borrowers; mak-
ing tax and insurance payments on behalf of borrowers; monitoring
delinquencies and executing foreclosure proceedings; and account-
ing for and remitting principal and interest payments to the inves-
tors of the mortgage-backed securities.
JPMorgan Chase made the determination to treat its MSRs as one
class of servicing assets based on the availability of market inputs
used to measure its MSR asset at fair value and its treatment of
MSRs as one aggregate pool for risk management purposes. As
permitted by U.S. GAAP, the Firm elected to account for this one
class of servicing assets at fair value. The Firm estimates the fair
value of MSRs using an option-adjusted spread model (“OAS”),
which projects MSR cash flows over multiple interest rate scenarios
in conjunction with the Firm’s prepayment model, and then dis-
counts these cash flows at risk-adjusted rates. The model considers
portfolio characteristics, contractually specified servicing fees,
prepayment assumptions, delinquency rates, late charges, other
ancillary revenue and 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 condi-
tions and assumptions that a market participant would consider in
valuing the MSR asset. During 2010 and 2009, the Firm continued
to refine its proprietary prepayment model based on a number of
market-related factors, including a downward trend in home prices,
general tightening of credit underwriting standards and the associ-
ated impact on refinancing activity. The Firm compares fair value
estimates and assumptions to observable market data where avail-
able, and to recent market activity and actual portfolio experience.
The fair value of MSRs is sensitive to changes in interest rates,
including their effect on prepayment speeds. JPMorgan Chase uses
combinations of derivatives and securities to manage changes in
the fair value of MSRs. The intent is to offset any changes in the fair
value of MSRs with changes in the fair value of the related risk
management instruments. MSRs decrease in value when interest
rates decline. Conversely, securities (such as mortgage-backed
securities), principal-only certificates and certain derivatives (when
the Firm receives fixed-rate interest payments) increase in value
when interest rates decline.
The following table summarizes MSR activity for the years ended
December 31, 2010, 2009 and 2008.
Year ended December 31,
(in millions, except where
otherwise noted) 2010 2009 2008
Fair value at beginning of period
$
15,5
31
$ 9,403 $ 8,632
MSR activity
Originations of MSRs
3,153
3,615 3,061
Purchase of MSRs 26 2 6,755(f)
Disposition of MSRs
(407
)
(10) —
Total net additions
2,772
3,607 9,816
Change in valuation due to inputs
and assumptions(a) (2,268) 5,807 (6,933)
Other changes in fair value(b) (2,386) (3,286) (2,112)
Total change in fair value of
MSRs(c) (4,654) 2,521 (9,045)
Fair value at December 31(d) $13,649 $ 15,531 $ 9,403
Change in unrealized gains/ (loss
es)
included in income related to
MSRs held at December 31 $ (2,268) $ 5,807 $ (6,933)
Contractual service fees, late fees
and other ancillary fees included
in income $ 4,484 $ 4,818 $ 3,353
Third
-
party mortgage loans se
r
viced
at December 31 (in billions) $ 976 $ 1,091 $ 1,185
Servicer advances, net at D
e
cember
31 (in billions)(e) $ 9.9 $ 7.7 $ 5.2
(a) Represents MSR asset fair value adjustments due to changes in inputs, such as
interest rates and volatility, as well as updates to assumptions used in the valuation
model. “Total realized/unrealized gains/(losses)” columns in the Changes in level 3
recurring fair value measurements tables in Note 3 on pages 170–187 of this An-
nual Report include these amounts.
(b) Includes changes in MSR value due to modeled servicing portfolio runoff (or time
decay). “Purchases, issuances, settlements, net” columns in the Changes in level 3
recurring fair value measurements tables in Note 3 on pages 170–187 of this An-
nual Report include these amounts.
(c) Includes changes related to commercial real estate of $(1) million, $(4) million and
$(4) million for the years ended December 31, 2010, 2009 and 2008, respectively.
(d) Includes $40 million, $41 million and $55 million related to commercial real estate
at December 31, 2010, 2009 and 2008, respectively.
(e) Represents amounts the Firm pays as the servicer (e.g., scheduled principal and
interest to a trust, taxes and insurance), which will generally be reimbursed within
a short period of time after the advance from future cash flows from the trust or the
underlying loans. The Firm’s credit risk associated with these advances is minimal
because reimbursement of the advances is senior to all cash payments to investors.
In addition, the Firm maintains the right to stop payment if the collateral is insuffi-
cient to cover the advance.