JP Morgan Chase 2012 Annual Report Download - page 169

JPMorgan Chase & Co./2012 Annual Report 179
inputs or assumptions, could affect the estimate of the
allowance for loan losses for the consumer credit portfolio.
Overall, 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. Significant judgment is required to
estimate the duration of current weak overall economic
conditions, as well as the impact on housing prices and the
labor market. The allowance for credit losses is highly
sensitive to both home prices and unemployment rates, and
in the current market it is difficult to estimate how potential
changes in one or both of these factors might affect the
allowance for credit losses. For example, while both factors
are important determinants of overall allowance levels,
changes in one factor or the other may not occur at the
same rate, or changes may be directionally inconsistent
such that improvement in one factor may offset
deterioration in the other. In addition, changes in these
factors would not necessarily be consistent across all
geographies or product types. Finally, it is difficult to
predict the extent to which changes in both or either of
these factors would ultimately affect the frequency of
losses, the severity of losses or both.
PCI loans
In connection with the Washington Mutual transaction,
JPMorgan Chase acquired certain PCI loans, which are
accounted for as described in Note 14 on pages 250–275 of
this Annual Report. The allowance for loan losses for the PCI
portfolio is based on quarterly estimates of the amount of
principal and interest cash flows expected to be collected
over the estimated remaining lives of the loans.
These cash flow projections are based on estimates
regarding default rates, loss severities, the amounts and
timing of prepayments and other factors that are reflective
of current and expected future market conditions. These
estimates are dependent on assumptions regarding the
level of future home price declines, and the duration of
current weak overall economic conditions, among other
factors. These estimates and assumptions require
significant management judgment and certain assumptions
are highly subjective.
Wholesale loans and lending-related commitments
The Firm’s methodology for determining the allowance for
loan losses and the allowance for lending-related
commitments requires the early identification of credits
that are deteriorating. 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 calculating 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 estimates of loss,
including volatility of loss given default, probability of
default and rating migrations. Consideration is given as to
the particular source of external data used as well as the
time period to which loss data relates (for example, point-
in-time loss estimates and estimates that reflect longer
views of the credit cycle). Finally, differences in loan
characteristics between the Firm’s specific loan portfolio
and those reflected in the external data 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
deteriorating industries also are incorporated where
relevant. These estimates are based on management’s view
of uncertainties that relate to current macroeconomic and
political conditions, quality of underwriting standards and
other relevant internal and external factors affecting the
credit quality of the current portfolio.
Allowance for credit losses sensitivity
As noted above, the Firm’s allowance for credit losses is
sensitive to numerous factors, depending on the portfolio.
Changes in economic conditions or in the Firm’s
assumptions could affect the Firm’s estimate of probable
credit losses inherent in the portfolio at the balance sheet
date. For example, deterioration in the following inputs
would have the following effects on the Firm’s modeled loss
estimates as of December 31, 2012, without consideration
of any offsetting or correlated effects of other inputs in the
Firm’s allowance for loan losses:
• A 5% decline in housing prices from current levels,
accompanied by an assumed corresponding change in
the unemployment rate, for the residential real estate
portfolio, excluding PCI loans, could result in an increase
to modeled annual loss estimates of approximately
$200 million.
• A 5% decline in housing prices from current levels,
accompanied by an assumed corresponding change in
the unemployment rate, could result in an increase in
credit loss estimates for PCI loans of approximately
$600 million.