JP Morgan Chase 2012 Annual Report Download - page 196

Notes to consolidated financial statements
206 JPMorgan Chase & Co./2012 Annual Report
Changes in and ranges of unobservable inputs
The following discussion provides a description of the
impact on a fair value measurement of a change in each
unobservable input in isolation, and the interrelationship
between unobservable inputs, where relevant and
significant. The impact of changes in inputs may not be
independent as a change in one unobservable input may
give rise to a change in another unobservable input, and
where relationships exist between two unobservable
inputs, those relationships are discussed below.
Relationships may also exist between observable and
unobservable inputs (for example, as observable interest
rates rise, unobservable prepayment rates decline). Such
relationships have not been included in the discussion
below. In addition, for each of the individual relationships
described below, the inverse relationship would also
generally apply.
In addition, the following discussion provides a description
of attributes of the underlying instruments and external
market factors that affect the range of inputs used in the
valuation of the Firm’s positions.
Discount rates and spreads
Yield – The yield of an asset is the interest rate used to
discount future cash flows in a discounted cash flow
calculation. An increase in the yield, in isolation, would
result in a decrease in a fair value measurement.
Credit spread – The credit spread is the amount of
additional annualized return over the market interest rate
that a market participant would demand for taking
exposure to the credit risk of an instrument. The credit
spread for an instrument forms part of the discount rate
used in a discounted cash flow calculation. Generally, an
increase in the credit spread would result in a decrease in
a fair value measurement.
The yield and the credit spread of a particular mortgage-
backed security or CLO primarily reflect the risk inherent
in the instrument. The yield is also impacted by the
absolute level of the coupon paid by the instrument (which
may not correspond directly to the level of inherent risk).
Therefore, the range of yield and credit spreads reflects
the range of risk inherent in various instruments owned by
the Firm. The risk inherent in mortgage-backed securities
is driven by the subordination of the security being valued
and the characteristics of the underlying mortgages within
the collateralized pool, including borrower FICO scores,
loan to value ratios for residential mortgages and the
nature of the property and/or any tenants for commercial
mortgages. For CLOs, credit spread reflects the market’s
implied risk premium based on several factors including
the subordination of the investment, the credit quality of
underlying borrowers, the specific terms of the loans
within the CLO structure, as well as the supply and demand
of the instrument. For corporate debt securities,
obligations of U.S. states and municipalities and other
similar instruments, credit spreads reflect the credit
quality of the obligor and the tenor of the obligation.
Performance rates of underlying collateral in collateralized
obligations (e.g., MBS, CLOs, etc.)
Prepayment speed – The prepayment speed is a measure
of the voluntary unscheduled principal repayments of a
prepayable obligation in a collateralized pool. Prepayment
speeds generally decline as borrower delinquencies rise.
An increase in prepayment speeds, in isolation, would
result in a decrease in a fair value measurement of assets
valued at a premium to par and an increase in a fair value
measurement of assets valued at a discount to par.
Prepayment speeds may vary from collateral pool-to-
collateral pool, and are driven by the type and location of
the underlying borrower, the remaining tenor of the
obligation as well as the level and type (e.g., fixed or
floating) of interest rate being paid by the borrower.
Typically collateral pools with higher borrower credit
quality have a higher prepayment rate than those with
lower borrower credit quality, all other factors being equal.
Conditional default rate – The conditional default rate is a
measure of the reduction in the outstanding collateral
balance underlying a collateralized obligation as a result of
defaults. While there is typically no direct relationship
between conditional default rates and prepayment speeds,
collateralized obligations for which the underlying
collateral have high prepayment speeds will tend to have
lower conditional default rates. An increase in conditional
default rates would generally be accompanied by an
increase in loss severity and an increase in credit spreads.
An increase in the conditional default rate, in isolation,
would result in a decrease in a fair value measurement.
Conditional default rates reflect the quality of the
collateral underlying a securitization and the structure of
the securitization itself. Based on the types of securities
owned in the Firm’s market-making portfolios, conditional
default rates are most typically at the lower end of the
range presented.
Loss severity – The loss severity (the inverse concept is the
recovery rate) is the expected amount of future realized
losses resulting from the ultimate liquidation of a
particular loan, expressed as the net amount of loss
relative to the outstanding loan balance. An increase in
loss severity is generally accompanied by an increase in
conditional default rates. An increase in the loss severity,
in isolation, would result in a decrease in a fair value
measurement.
The loss severity applied in valuing a mortgage-backed
security or a CLO investment depends on a host of factors
relating to the underlying obligations (i.e., mortgages or
loans). For mortgages, this includes the loan-to-value
ratio, the nature of the lender’s charge over the property
and various other instrument-specific factors. For CLO
investments, loss severity is driven by the characteristics
of the underlying loans including the seniority of the loans
and the type and amount of any security provided by the
obligor.