JP Morgan Chase 2013 Annual Report Download - page 171

JPMorgan Chase & Co./2013 Annual Report 177
In arriving at an estimate of fair value for an instrument
within level 3, management must first determine the
appropriate model to use. Second, the lack of observability
of certain significant inputs requires management to assess
all relevant empirical data in deriving valuation inputs —
including, for example, transaction details, yield curves,
interest rates, prepayment rates, default rates, volatilities,
correlations, equity or debt prices, valuations of
comparable instruments, foreign exchange rates and credit
curves. For further discussion of the valuation of level 3
instruments, including unobservable inputs used, see Note
3 on pages 195–215 of this Annual Report.
For instruments classified in levels 2 and 3, management
judgment must be applied to assess the appropriate level of
valuation adjustments to reflect counterparty credit quality,
the Firm’s credit-worthiness, liquidity considerations,
unobservable parameters, and for certain portfolios that
meet specified criteria, the size of the net open risk
position. The judgments made are typically affected by the
type of product and its specific contractual terms, and the
level of liquidity for the product or within the market as a
whole.
During the fourth quarter of 2013 the Firm implemented
the FVA framework to incorporate the impact of funding
into its valuation estimates for OTC derivatives and
structured notes, reflecting an industry migration towards
incorporating the market cost of unsecured funding in the
valuation of such instruments. Implementation of the FVA
framework required a number of important management
judgments including: (i) determining when the
accumulation of market evidence was sufficiently
compelling to implement the FVA framework; (ii) estimating
the market clearing price for funding in the relevant market;
and (iii) determining the interaction between DVA and FVA,
given that DVA already reflects credit spreads, which are a
significant component of funding spreads that drive FVA.
For further discussion of valuation adjustments applied by
the Firm, including FVA, see Note 3 on pages 195–215 of
this Annual Report.
Imprecision in estimating unobservable market inputs or
other factors can affect the amount of gain or loss recorded
for a particular position. Furthermore, while the Firm
believes its valuation methods are appropriate and
consistent with those of other market participants, the
methods and assumptions used reflect management
judgment and may vary across the Firm’s businesses and
portfolios.
The Firm uses various methodologies and assumptions in
the determination of fair value. The use of methodologies or
assumptions different than those used by the Firm could
result in a different estimate of fair value at the reporting
date. For a detailed discussion of the Firm’s valuation
process and hierarchy, and its determination of fair value
for individual financial instruments, see Note 3 on pages
195–215 of this Annual Report.
Goodwill impairment
Under U.S. GAAP, goodwill must be allocated to reporting
units and tested for impairment at least annually. The Firm’s
process and methodology used to conduct goodwill
impairment testing is described in Note 17 on pages 299–
304 of this Annual Report.
Management applies significant judgment when estimating
the fair value of its reporting units. Estimates of fair value
are dependent upon estimates of (a) the future earnings
potential of the Firm’s reporting units, including the
estimated effects of regulatory and legislative changes,
such as the Dodd-Frank Act, (b) long-term growth rates and
(c) the relevant cost of equity. Imprecision in estimating
these factors can affect the estimated fair value of the
reporting units.
Based upon the updated valuations for all of its reporting
units, the Firm concluded that goodwill allocated to its
reporting units was not impaired at December 31, 2013,
nor was any goodwill written off during 2013. The fair
values of almost all of the Firm’s reporting units exceeded
their carrying values and did not indicate a significant risk
of goodwill impairment based on current projections and
valuations. For those reporting units where fair value
exceeded carrying value, the excess fair value as a percent
of carrying value ranged from approximately 15% to
180%.
As of December 31, 2013, the estimated fair value of the
Firm’s mortgage lending business within CCB did not exceed
its carrying value. While the implied fair value of the
goodwill allocated to the mortgage lending business
exceeded its carrying value as of December 31, 2013, the
associated goodwill remains at an elevated risk for goodwill
impairment due to its exposure to U.S. consumer credit risk
and the effects of economic, regulatory and legislative
changes. The assumptions used in the valuation of this
business include: (a) estimates of future cash flows for the
business (which are dependent on outstanding loan
balances, net interest margin, operating expense, credit
losses and the amount of capital necessary to meet
regulatory capital requirements), and (b) the cost of equity
used to discount those cash flows to a present value. Each
of these factors requires significant judgment and the
assumptions used are based on management’s current best
estimate and most current projections, including the
anticipated effects of regulatory and legislative changes,
derived from the Firm’s business forecasting process as
reviewed with senior management.
The projections for all of the Firm’s reporting units are
consistent with the short-term assumptions discussed in the
Business Outlook on pages 68–69 of this Annual Report,
and, in the longer term, incorporate a set of macroeconomic
assumptions and the Firm’s best estimates of long-term
growth and returns of its businesses. Where possible, the
Firm uses third-party and peer data to benchmark its
assumptions and estimates.