JP Morgan Chase 2013 Annual Report Download - page 200

Notes to consolidated financial statements
206 JPMorgan Chase & Co./2013 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.
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 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
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.
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 investment depends on a host of factors relating to
the underlying mortgages. This includes the loan-to-value
ratio, the nature of the lender’s charge over the property
and various other instrument-specific factors.