JP Morgan Chase 2008 Annual Report Download - page 195

JPMorgan Chase & Co./ 2008 Annual Report 193
their par value of $1.4 billion. As of December 31, 2008 and 2007,
the CDO assets were valued on the Consolidated Balance Sheets at
$5 million and $291 million, respectively.
There were no other structured CDO assets backed by subprime
mortgages remaining in JPMorgan Chase-administered multi-seller
conduits as of December 31, 2008 and 2007.
The Firm does not consider the October 2007 transfer of the structured
CDO assets from the multi-seller conduits to JPMorgan Chase to be an
indicator of JPMorgan Chase’s intent to provide implicit support to the
ELN holders. This transfer was a one-time, isolated event, limited to a
specific type of asset that is not typically funded in the Firm’s adminis-
tered multi-seller conduits. In addition, the Firm has no plans to permit
multi-seller conduits to purchase such assets in the future.
Investor intermediation
As a financial intermediary, the Firm creates certain types of VIEs
and also structures transactions, typically derivative structures, with
these VIEs to meet investor needs. The Firm may also provide liquidi-
ty and other support. The risks inherent in the derivative instruments
or liquidity commitments are managed similarly to other credit, mar-
ket or liquidity risks to which the Firm is exposed. The principal
types of VIEs for which the Firm is engaged in these structuring
activities are municipal bond vehicles, credit-linked note vehicles,
asset swap vehicles and collateralized debt obligation vehicles.
Municipal bond vehicles
The Firm has created a series of secondary market trusts that provide
short-term investors with qualifying tax-exempt investments, and
that allow investors in tax-exempt securities to finance their invest-
ments at short-term tax-exempt rates. In a typical transaction, the
vehicle purchases fixed-rate longer-term highly rated municipal bonds
and funds the purchase by issuing two types of securities: (1) putable
floating-rate certificates and (2) inverse floating-rate residual inter-
ests (“residual interests”). The maturity of each of the putable float-
ing-rate certificates and the residual interests is equal to the life of
the vehicle, while the maturity of the underlying municipal bonds is
longer. Holders of the putable floating-rate certificates may “put,” or
tender, the certificates if the remarketing agent cannot successfully
remarket the floating-rate certificates to another investor. A liquidity
facility conditionally obligates the liquidity provider to fund the pur-
chase of the tendered floating-rate certificates. Upon termination of
the vehicle, if the proceeds from the sale of the underlying municipal
bonds are not sufficient to repay the liquidity facility, the liquidity
provider has recourse either to excess collateralization in the vehicle
or the residual interest holders for reimbursement.
The third-party holders of the residual interests in these vehicles could
experience losses if the face amount of the putable floating-rate cer-
tificates exceeds the market value of the municipal bonds upon termi-
nation of the vehicle. Certain vehicles require a smaller initial invest-
ment by the residual interest holders and thus do not result in excess
collateralization. For these vehicles there exists a reimbursement obli-
gation which requires the residual interest holders to post, during the
life of the vehicle, additional collateral to the vehicle on a daily basis
as the market value of the municipal bonds declines.
JPMorgan Chase often serves as the sole liquidity provider and
remarketing agent of the putable floating-rate certificates. As the liq-
uidity provider, the Firm has an obligation to fund the purchase of
the putable floating-rate certificates; this obligation is triggered by
the failure to remarket the putable floating-rate certificates. The liq-
uidity provider’s obligation to perform is conditional and is limited by
certain termination events, which include bankruptcy or failure to pay
by the municipal bond issuer or credit enhancement provider, and the
immediate downgrade of the municipal bond to below investment
grade. A downgrade of the JPMorgan Chase Bank, N.A.’s short-term
rating does not affect the Firm’s obligation under the liquidity facility.
However, in the event of a downgrade in the Firm’s credit ratings,
holders of the putable floating-rate instruments supported by those
liquidity facility commitments might choose to sell their instruments,
which could increase the likelihood that the liquidity commitments
could be drawn. In vehicles in which third-party investors own the
residual interests, in addition to the termination events, the Firm’s
exposure as liquidity provider is further limited by the high credit
quality of the underlying municipal bonds, and the excess collateral-
ization in the vehicle or the reimbursement agreements with the
residual interest holders. In the fourth quarter of 2008, a drawdown
occurred on one liquidity facility as a result of a failure to remarket
putable floating-rate certificates. The Firm was required to purchase
$19 million of putable floating-rate certificates. Subsequently, the
municipal bond vehicle was terminated and the proceeds from the
sales of the municipal bonds, together with the collateral posted by
the residual interest holder, were sufficient to repay the putable
floating-rate certificates. In 2007, the Firm did not experience a
drawdown on the liquidity facilities.
As remarketing agent, the Firm may hold the putable floating-rate
certificates. At December 31, 2008 and 2007, respectively, the Firm
held $293 million and $617 million of these certificates on its
Consolidated Balance Sheets. The largest amount held by the Firm at
any time during 2008 and 2007 was $2.2 billion and $1.0 billion,
respectively, or 11% and 5%, respectively, of the municipal bond
vehicles’ outstanding putable floating-rate certificates. The Firm did
not have and continues not to have any intent to protect any resid-
ual interest holder from potential losses on any of the municipal
bond holdings.
The long-term credit ratings of the putable floating-rate certificates
are directly related to the credit ratings of the underlying municipal
bonds, and to the credit rating of any insurer of the underlying
municipal bond. A downgrade of a bond insurer would result in a
downgrade of the insured municipal bonds, which would affect the
rating of the putable floating-rate certificates. This could cause
demand for these certificates by investors to decline or disappear, as
putable floating-rate certificate holders typically require an “AA-”
bond rating. At December 31, 2008 and 2007, 97% and 99%,
respectively, of the municipal bonds held by vehicles to which the
Firm served as liquidity provider were rated “AA-” or better, based
upon either the rating of the underlying municipal bond itself, or the
rating including any credit enhancement. At December 31, 2008 and
2007, $2.6 billion and $12.0 billion, respectively, of the bonds were