JP Morgan Chase 2005 Annual Report Download - page 72

Management’s discussion and analysis
JPMorgan Chase & Co.
70 JPMorgan Chase & Co. /2005 Annual Report
JPMorgan Chase has limited counterparty exposure as a result of credit
derivatives transactions. Of the $50 billion of total Derivative receivables at
December 31, 2005, approximately $4 billion, or 8%, was associated with
credit derivatives, before the benefit of liquid securities collateral.
Dealer/client
At December 31, 2005, the total notional amount of protection purchased and
sold in the dealer/client business increased $1.2 trillion from year-end 2004 as
a result of increased trade volume in the market. This business has a mismatch
between the total notional amounts of protection purchased and sold. However,
in the Firm’s view, the risk positions are largely matched when securities used
to risk manage certain derivative positions are taken into consideration and
the notional amounts are adjusted to a duration-based equivalent basis or to
reflect different degrees of subordination in tranched structures.
Use of single-name and portfolio credit derivatives
December 31, Notional amount of protection purchased
(in millions) 2005 2004
Credit derivatives used to manage:
Loans and lending-related commitments $ 18,926 $ 25,002
Derivative receivables 12,088 12,235
Total $ 31,014 $ 37,237
Credit portfolio management activities
The credit derivatives used by JPMorgan Chase for portfolio management
activities do not qualify for hedge accounting under SFAS 133, and therefore,
effectiveness testing under SFAS 133 is not performed. These derivatives are
reported at fair value, with gains and losses recognized as Trading revenue.
The MTM value incorporates both the cost of credit derivative premiums and
changes in value due to movement in spreads and credit events; in contrast,
the loans and lending-related commitments being risk-managed are accounted
for on an accrual basis. Loan interest and fees are generally recognized in
Net interest income, and impairment is recognized in the Provision for credit
losses. This asymmetry in accounting treatment, between loans and lending-
related commitments and the credit derivatives utilized in portfolio management
activities, causes earnings volatility that is not representative, in the Firm’s
view, of the true changes in value of the Firm’s overall credit exposure.The
MTM related to the Firm’s credit derivatives used for managing credit exposure,
as well as the mark related to the CVA, which reflects the credit quality of
derivatives counterparty exposure, are included in the table below:
For the year ended December 31,
(in millions) 2005 2004(c)
Hedges of lending-related commitments(a) $24 $ (234)
CVA and hedges of CVA(a) 84 188
Net gains (losses)(b) $ 108 $ (46)
(a) These hedges do not qualify for hedge accounting under SFAS 133.
(b) Excludes $8 million and $52 million in 2005 and 2004, respectively, of other credit portfolio
trading results that are not associated with hedging activities.
(c) Includes six months of the combined Firm’s results and six months of heritage JPMorgan
Chase results.
The Firm also actively manages wholesale credit exposure through loan
and commitment sales. During 2005 and 2004, the Firm sold $4.0 billion
and $5.9 billion of loans and commitments, respectively, recognizing gains
of $76 million and losses of $8 million in 2005 and 2004, respectively.
These activities are not related to the Firm’s securitization activities, which
are undertaken for liquidity and balance sheet management purposes. For a
further discussion of securitization activity, see Note 13 on pages 108–111
of this Annual Report.
Lending-related commitments
The contractual amount of wholesale lending-related commitments
was $324 billion at December 31, 2005, compared with $309 billion at
December 31, 2004. In the Firm’s view, the total contractual amount of these
instruments is not representative of the Firm’s actual credit risk exposure or
funding requirements. In determining the amount of credit risk exposure the
Firm has to wholesale lending-related commitments, which is used as the
basis for allocating credit risk capital to these instruments, the Firm has
established a “loan-equivalent” amount for each commitment; this amount
represents the portion of the unused commitment or other contingent expo-
sure that is expected, based upon average portfolio historical experience, to
become outstanding in the event of a default by an obligor. The loan equivalent
amount of the Firm’s lending-related commitments as of December 31, 2005
and 2004, was $178 billion and $162 billion, respectively.
Country exposure
The Firm has a comprehensive process for measuring and managing exposures
and risk in emerging markets countries – defined as those countries potentially
vulnerable to sovereign events. Exposures to a country include all credit-related
lending, trading, and investment activities, whether cross-border or locally
funded. Exposure amounts are adjusted for credit enhancements (e.g.,
guarantees and letters of credit) provided by third parties located outside the
country, if the enhancements fully cover the country risk as well as the business
risk. As of December 31, 2005, the Firm’s exposure to any individual emerging
markets country was not material.