JP Morgan Chase 2008 Annual Report Download - page 194

Notes to consolidated financial statements
192 JPMorgan Chase & Co./ 2008 Annual Report
Consolidation analysis
The multi-seller conduits administered by the Firm were not consoli-
dated at December 31, 2008 and 2007, because each conduit had
issued expected loss notes (“ELNs”), the holders of which are com-
mitted to absorbing the majority of the expected loss of each
respective conduit.
Implied support
The Firm did not have and continues not to have any intent to pro-
tect any ELN holders from potential losses on any of the conduits’
holdings and has no plans to remove any assets from any conduit
unless required to do so in its role as administrator. Should such a
transfer occur, the Firm would allocate losses on such assets
between itself and the ELN holders in accordance with the terms of
the applicable ELN.
Expected loss modeling
In determining the primary beneficiary of the conduits the Firm uses
a Monte Carlo–based model to estimate the expected losses of
each of the conduits and considers the relative rights and obliga-
tions of each of the variable interest holders. The Firm’s expected
loss modeling treats all variable interests, other than the ELNs, as its
own to determine consolidation. The variability to be considered in
the modeling of expected losses is based on the design of the enti-
ty. The Firm’s traditional multi-seller conduits are designed to pass
credit risk, not liquidity risk, to its variable interest holders, as the
assets are intended to be held in the conduit for the longer term.
Under FIN 46(R), the Firm is required to run the Monte Carlo-based
expected loss model each time a reconsideration event occurs. In
applying this guidance to the conduits, the following events, are
considered to be reconsideration events, as they could affect the
determination of the primary beneficiary of the conduits:
• New deals, including the issuance of new or additional variable
interests (credit support, liquidity facilities, etc);
• Changes in usage, including the change in the level of outstand-
ing variable interests (credit support, liquidity facilities, etc);
• Modifications of asset purchase agreements; and
• Sales of interests held by the primary beneficiary.
From an operational perspective, the Firm does not run its Monte
Carlo-based expected loss model every time there is a reconsideration
event due to the frequency of their occurrence. Instead, the Firm runs
its expected loss model each quarter and includes a growth assump-
tion for each conduit to ensure that a sufficient amount of ELNs exists
for each conduit at any point during the quarter.
As part of its normal quarterly modeling, the Firm updates, when
applicable, the inputs and assumptions used in the expected loss
model. Specifically, risk ratings and loss given default assumptions are
continually updated. The total amount of expected loss notes out-
standing at December 31, 2008 and 2007, were $136 million and
$130 million, respectively. Management has concluded that the model
assumptions used were reflective of market participants’ assumptions
and appropriately considered the probability of changes to risk ratings
and loss given defaults.
Qualitative considerations
The multi-seller conduits are primarily designed to provide an effi-
cient means for clients to access the commercial paper market. The
Firm believes the conduits effectively disperse risk among all parties
and that the preponderance of the economic risk in the Firm’s multi-
seller conduits is not held by JPMorgan Chase.
Consolidated sensitivity analysis on capital
The table below shows the impact on the Firm’s reported assets, lia-
bilities, Tier 1 capital ratio and Tier 1 leverage ratio if the Firm were
required to consolidate all of the multi-seller conduits that it admin-
isters at their current carrying value.
December 31, 2008
(in billions, except ratios) Reported Pro forma(a)(b)
Assets $ 2,175.1 $ 2,218.2
Liabilities 2,008.2 2,051.3
Tier 1 capital ratio 10.9% 10.9%
Tier 1 leverage ratio 6.9 6.8
(a) The table shows the impact of consolidating the assets and liabilities of the multi-
seller conduits at their current carrying value; as such, there would be no income
statement or capital impact at the date of consolidation. If the Firm were required to
consolidate the assets and liabilities of the conduits at fair value, the Tier 1 capital
ratio would be approximately 10.8%. The fair value of the assets is primarily based
upon pricing for comparable transactions. The fair value of these assets could change
significantly because the pricing of conduit transactions is renegotiated with the
client, generally, on an annual basis and due to changes in current market conditions.
(b) Consolidation is assumed to occur on the first day of the quarter, at the quarter-end
levels, in order to provide a meaningful adjustment to average assets in the denomi-
nator of the leverage ratio.
The Firm could fund purchases of assets from VIEs should it
become necessary.
2007 activity
In July 2007, a reverse repurchase agreement collateralized by
prime residential mortgages held by a Firm-administered multi-seller
conduit was put to JPMorgan Chase under its deal-specific liquidity
facility. The asset was transferred to and recorded by JPMorgan
Chase at its par value based on the fair value of the collateral that
supported the reverse repurchase agreement. During the fourth
quarter of 2007, additional information regarding the value of the
collateral, including performance statistics, resulted in the determi-
nation by the Firm that the fair value of the collateral was impaired.
Impairment losses were allocated to the ELN holder (the party that
absorbs the majority of the expected loss from the conduit) in accor-
dance with the contractual provisions of the ELN note.
On October 29, 2007, certain structured CDO assets originated in
the second quarter of 2007 and backed by subprime mortgages
were transferred to the Firm from two Firm-administered multi-seller
conduits. It became clear in October that commercial paper
investors and rating agencies were becoming increasingly concerned
about CDO assets backed by subprime mortgage exposures.
Because of these concerns, and to ensure the continuing viability of
the two conduits as financing vehicles for clients and as investment
alternatives for commercial paper investors, the Firm, in its role as
administrator, transferred the CDO assets out of the multi-seller con-
duits. The structured CDO assets were transferred to the Firm at