JP Morgan Chase 2008 Annual Report Download - page 197

JPMorgan Chase & Co./ 2008 Annual Report 195
In a managed credit-linked note structure, the CLNs and associated
credit derivative generally reference all or part of an actively managed
portfolio of credits. An agreement exists between a portfolio manager
and the VIE that gives the portfolio manager the ability to substitute
each referenced credit in the portfolio for an alternative credit. By par-
ticipating in a structure where a portfolio manager has the ability to
substitute credits within pre-agreed terms, the investors who own the
CLNs seek to reduce the risk that any single credit in the portfolio will
Asset Swap Vehicles
The Firm also structures and executes transactions with asset swap
vehicles on behalf of investors. In such transactions, the VIE purchas-
es a specific asset or assets and then enters into a derivative with
the Firm in order to tailor the interest rate or currency risk, or both,
of the assets according to investors’ requirements. Generally, the
assets are held by the VIE to maturity, and the tenor of the deriva-
tives would match the maturity of the assets. Investors typically
invest in the notes issued by such VIEs in order to obtain exposure to
the credit risk of the specific assets as well as exposure to foreign
exchange and interest rate risk that is tailored to their specific needs;
for example, an interest rate derivative may add additional interest
rate exposure into the VIE in order to increase the return on the
issued notes; or to convert an interest bearing asset into a zero-
coupon bond.
The Firm’s exposure to the asset swap vehicles is generally limited
to its rights and obligations under the interest rate and/or foreign
exchange derivative contracts, as the Firm does not provide any con-
tractual financial support to the VIE. In addition, the Firm historically
has not provided any financial support to the asset swap vehicles
over and above its contractual obligations. Accordingly, the Firm
typically does not consolidate the asset swap vehicles. As a deriva-
tive counterparty, the Firm has a senior claim on the collateral of
the VIE and reports such derivatives on its balance sheet at fair
value. Substantially all of the assets purchased by such VIEs are
investment-grade.
default. The Firm does not act as portfolio manager; its involvement
with the VIE is generally limited to being a derivative counterparty. As
a net buyer of credit protection, the Firm pays a premium to the VIE in
return for the receipt of a payment (up to the notional of the deriva-
tive) if one or more of the credits within the portfolio defaults, or if
the losses resulting from the default of reference credits exceed speci-
fied levels.
Exposure to nonconsolidated credit-linked note VIEs at December 31, 2008 and 2007, was as follows.
2008 2007
Par value of Par value of
December 31, Derivative Trading Total collateral held Derivative Trading Total collateral held
(in billions) receivables assets(c) exposure(d) by VIEs(e) receivables assets(c) exposure(d) by VIEs(e)
Credit-linked notes(a)
Static structure $ 3.6 $ 0.7 $ 4.3 $ 14.5 $ 0.8 $ 0.4 $ 1.2 $ 13.5
Managed structure(b) 7.7 0.3 8.0 16.6 4.5 0.9 5.4 12.8
Total $11.3 $ 1.0 $12.3 $ 31.1 $ 5.3 $ 1.3 $ 6.6 $ 26.3
(a) Excluded fair value of collateral of $2.1 billion and $2.5 billion at December 31, 2008 and 2007, respectively, which was consolidated as the Firm, in its role as secondary market
maker, held a majority of the issued CLNs of certain vehicles.
(b) Includes synthetic collateralized debt obligation vehicles, which have similar risk characteristics to managed credit-linked note vehicles. At December 31, 2008 and 2007, trading assets
included $7 million and $291 million, respectively, of transactions with subprime collateral.
(c) Trading assets principally comprise notes issued by VIEs, which from time to time are held as part of the termination of a deal or to support limited market-making.
(d) On-balance sheet exposure that includes derivative receivables and trading assets.
(e) The Firm’s maximum exposure arises through the derivatives executed with the VIEs; the exposure varies over time with changes in the fair value of the derivatives. The Firm relies
upon the collateral held by the VIEs to pay any amounts due under the derivatives; the vehicles are structured at inception so that the par value of the collateral is expected to be suffi-
cient to pay amounts due under the derivative contracts.