JP Morgan Chase 2006 Annual Report Download - page 74

MANAGEMENT’S DISCUSSION AND ANALYSIS
JPMorgan Chase & Co.
72 JPMorgan Chase & Co. / 2006 Annual Report
JPMorgan Chase has limited counterparty exposure as a result of credit
derivatives transactions. Of the $55.6 billion of total Derivative receivables
MTM at December 31, 2006, approximately $5.7 billion, or 10%, was associ-
ated with credit derivatives, before the benefit of liquid securities collateral.
Dealer/client
At December 31, 2006, the total notional amount of protection purchased and
sold in the dealer/client business increased $2.4 trillion from year-end 2005 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.
Credit portfolio management activities
Use of single-name and portfolio credit derivatives
December 31, Notional amount of protection purchased
(in millions) 2006 2005
Credit derivatives used to manage:
Loans and lending-related commitments $ 40,755 $ 18,926
Derivative receivables 11,229 12,088
Total $ 51,984(a) $ 31,014
(a) Includes $23 billion which represents the notional amount for structured portfolio protection;
the Firm retains the first loss on this portfolio.
The credit derivatives used by JPMorgan Chase for credit portfolio manage-
ment activities do not qualify for hedge accounting under SFAS 133, and
therefore, effectiveness testing under SFAS 133 is not performed. These deriv-
atives are reported at fair value, with gains and losses recognized in Principal
transactions. 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 uti-
lized 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 MTM related to the CVA, which
reflects the credit quality of derivatives counterparty exposure, are included in
the table below. These results can vary from year to year due to market condi-
tions that impact specific positions in the portfolio.
Year ended December 31,
(in millions) 2006 2005 2004(c)
Hedges of lending-related commitments(a) $ (246) $ 24 $ (234)
CVA and hedges of CVA(a) 133 84 188
Net gains (losses)(b) $ (113) $ 108 $ (46)
(a) These hedges do not qualify for hedge accounting under SFAS 133.
(b) Excludes gains of $56 million, $8 million and $52 million for the years ended December 31,
2006, 2005 and 2004, respectively, of other Principal transactions revenues that are not
associated with hedging activities.
(c) 2004 results include 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 2006, 2005 and 2004, the Firm sold $3.1 bil-
lion, $4.0 billion and $5.9 billion of loans and commitments, respectively, rec-
ognizing gains (losses) of $73 million, $76 million and ($8) million in 2006,
2005 and 2004, respectively. The gains include gains on sales of nonperform-
ing loans as discussed on page 67 of this Annual Report. These activities are
not related to the Firm’s securitization activities, which are undertaken for liq-
uidity and balance sheet management purposes. For a further discussion of
securitization activity, see Liquidity Risk Management and Note 14 on pages
62–63 and 114–118, respectively, of this Annual Report.
Lending-related commitments
The contractual amount of wholesale lending-related commitments was
$391.4 billion at December 31, 2006, compared with $321.1 billion at
December 31, 2005. See page 66 of this Annual Report for an explanation of
the increase in exposure. In the Firm’s view, the total contractual amount of
these instruments is not representative of the Firm’s actual credit risk expo-
sure or funding requirements. In determining the amount of credit risk expo-
sure 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 was $212 billion and
$178 billion as of December 31, 2006 and 2005, respectively.
Emerging markets country exposure
The Firm has a comprehensive internal process for measuring and managing
exposures and risk in emerging markets countries – defined as those countries
potentially vulnerable to sovereign events. As of December 31, 2006, based
upon its internal methodology, the Firm’s exposure to any individual emerging-
markets country was not significant, in that total exposure to any such country
did not exceed 0.75% of the Firm’s total assets. In evaluating and managing
its exposures to emerging markets countries, the Firm takes into consideration
all credit-related lending, trading, and investment activities, whether cross-bor-
der or locally funded. Exposure amounts are then adjusted for credit enhance-
ments (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 credit risk. For information regarding the Firm’s cross-border exposure,
based upon guidelines of the Federal Financial Institutions Examination
Council (“FFIEC”), see Part 1, Item 1, “Loan portfolio, Cross-border outstand-
ings,” on page 155, of the Firm’s Annual Report on Form 10-K for the year
ended December 31,2006.