JP Morgan Chase 2006 Annual Report Download - page 135

JPMorgan Chase & Co. / 2006 Annual Report 133
in market value of the assets or a downgrade in the rating of JPMorgan
Chase Bank, N.A. These agreements may cause the Firm to purchase an asset
from the SPE at an amount above the asset’s fair value, in effect providing a
guarantee of the initial value of the reference asset as of the date of the
agreement. In most instances, third-party credit enhancements of the SPE mit-
igate the Firm’s potential losses on these agreements.
Standby letters of credit and financial guarantees
Standby letters of credit and financial guarantees are conditional lending
commitments issued by JPMorgan Chase to guarantee the performance of
a customer to a third party under certain arrangements, such as commercial
paper facilities, bond financings, acquisition financings, trade and similar
transactions. Approximately 50% of these arrangements mature within
three years. The Firm typically has recourse to recover from the customer any
amounts paid under these guarantees; in addition, the Firm may hold cash
or other highly liquid collateral to support these guarantees.
Securities lending indemnification
Through the Firm’s securities lending program, customers’ securities, via cus-
todial and non-custodial arrangements, may be lent to third parties. As part of
this program, the Firm issues securities lending indemnification agreements to
the lender which protects it principally against the failure of the third-party
borrower to return the lent securities. To support these indemnification agree-
ments, the Firm obtains cash or other highly liquid collateral with a market
value exceeding 100% of the value of the securities on loan from the borrower .
Collateral is marked to market daily to help assure that collateralization is
adequate. Additional collateral is called from the borrower if a shortfall exists
or released to the borrower in the event of overcollateralization. If an indem-
nifiable default by a borrower occurs, the Firm would expect to use the collat-
eral held to purchase replacement securities in the market or to credit the
lending customer with the cash equivalent thereof.
Also, as part of this program, the Firm invests cash collateral received from
the borrower in accordance with approved guidelines. On an exceptional
basis the Firm may indemnify the lender against this investment risk when
certain types of investments are made.
Based upon historical experience, management believes that these risks of
loss are remote.
Indemnification agreements – general
In connection with issuing securities to investors, the Firm may enter into con-
tractual arrangements with third parties that may require the Firm to make a
payment to them in the event of a change in tax law or an adverse interpreta-
tion of tax law. In certain cases, the contract also may include a termination
clause, which would allow the Firm to settle the contract at its fair value; thus,
such a clause would not require the Firm to make a payment under the indemni-
fication agreement. Even without the termination clause, management does not
expect such indemnification agreements to have a material adverse effect on the
consolidated financial condition of JPMorgan Chase. The Firm may also enter
into indemnification clauses when it sells a business or assets to a third party,
pursuant to which it indemnifies that third party for losses it may incur due to
actions taken by the Firm prior to the sale. See below for more information
regarding the Firm’s loan securitization activities. It is difficult to estimate the
Firm’s maximum exposure under these indemnification arrangements, since
this would require an assessment of future changes in tax law and future claims
that may be made against the Firm that have not yet occurred. However, based
upon historical experience, management expects the risk of loss to be remote.
Securitization-related indemnifications
As part of the Firm’s loan securitization activities, as described in Note 14 on
pages 114–118 of this Annual Report, the Firm provides representations and
warranties that certain securitized loans meet specific requirements. The Firm
may be required to repurchase the loans and/or indemnify the purchaser of the
loans against losses due to any breaches of such representations or warranties.
Generally, the maximum amount of future payments the Firm would be
required to make under such repurchase and/or indemnification provisions
would be equal to the current amount of assets held by such securitization-
related SPEs as of December 31, 2006, plus, in certain circumstances, accrued
and unpaid interest on such loans and certain expenses. The potential loss due
to such repurchase and/or indemnity is mitigated by the due diligence the Firm
performs before the sale to ensure that the assets comply with the requirements
set forth in the representations and warranties. Historically, losses incurred on
such repurchases and/or indemnifications have been insignificant, and therefore
management expects the risk of material loss to be remote.
Credit card charge-backs
The Firm is a partner with one of the leading companies in electronic payment
services in a joint venture operating under the name of Chase Paymentech
Solutions, LLC (the “joint venture”). The joint venture was formed in October
2005, as a result of an agreement by the Firm and First Data Corporation, its
joint venture partner, to integrate the companies’ jointly owned Chase
Merchant Services (“CMS”) and Paymentech merchant businesses. The joint
venture provides merchant processing services in the United States and Canada.
Under the rules of Visa USA, Inc. and Mastercard International, JPMorgan Chase
Bank, N.A., is liable primarily for the amount of each processed credit card sales
transaction that is the subject of a dispute between a cardmember and a mer-
chant. The joint venture is contractually liable to JPMorgan Chase Bank, N.A.
for these disputed transactions. If a dispute is resolved in the cardmember’s
favor, the joint venture will (through the cardmember’s issuing bank) credit or
refund the amount to the cardmember and will charge back the transaction
to the merchant. If the joint venture is unable to collect the amount from the
merchant, the joint venture will bear the loss for the amount credited or
refunded to the cardmember. The joint venture mitigates this risk by withhold-
ing future settlements, retaining cash reserve accounts or by obtaining other
security. However, in the unlikely event that: (1) a merchant ceases operations
and is unable to deliver products, services or a refund; (2) the joint venture
does not have sufficient collateral from the merchant to provide customer
refunds; and (3) the joint venture does not have sufficient financial resources
to provide customer refunds, JPMorgan Chase Bank, N.A. would be liable for
the amount of the transaction, although it would have a contractual right to
recover from its joint venture partner an amount proportionate to such part-
ner’s equity interest in the joint venture. For the year ended December 31,
2006, the joint venture incurred aggregate credit losses of $9 million on $661
billion of aggregate volume processed. At December 31, 2006, the joint ven-
ture held $893 million of collateral. For the year ended December 31, 2005,
the CMS and Paymentech ventures incurred aggregate credit losses of $11
million on $563 billion of aggregate volume processed. At December 31,
2005, the joint venture held $909 million of collateral. The Firm believes that,
based upon historical experience and the collateral held by the joint venture,
the fair value of the Firm’s chargeback-related obligations would not be differ-
ent materially from the credit loss allowance recorded by the joint venture;
therefore, the Firm has not recorded any allowance for losses in excess of the
allowance recorded by the joint venture.