JP Morgan Chase 2008 Annual Report Download - page 217

JPMorgan Chase & Co./ 2008 Annual Report 215
to be reported as part of the basis of the item and continues to be
amortized to earnings as a yield adjustment. For qualifying cash flow
hedges, the effective portion of the change in the fair value of the
derivative is recorded in other comprehensive income (loss) and rec-
ognized in the Consolidated Statements of Income when the hedged
cash flows affect earnings. The ineffective portions of cash flow
hedges are immediately recognized in earnings. If the hedge relation-
ship is terminated, then the change in fair value of the derivative
recorded in accumulated other comprehensive income (loss) is recog-
nized when the cash flows that were hedged occur, consistent with
the original hedge strategy. For hedge relationships that are discon-
tinued because the forecasted transaction is not expected to occur
according to the original strategy, any related derivative amounts
recorded in accumulated other comprehensive income (loss) are
immediately recognized in earnings. For qualifying net investment
hedges, changes in the fair value of the derivative or the revaluation
of the foreign currency–denominated debt instrument are recorded
in the translation adjustments account within accumulated other
comprehensive income (loss).
JPMorgan Chase’s fair value hedges primarily include hedges of the
interest rate risk inherent in fixed-rate long-term debt, warehouse
loans, AFS securities, and the overall price of gold inventory. All
changes in the hedging derivative’s fair value are included in earn-
ings consistent with the classification of the hedged item, primarily
net interest income for long-term debt and AFS securities; other
income for warehouse loans; and principal transactions revenue for
gold inventory. The Firm did not recognize any gains or losses during
2008, 2007 or 2006 on firm commitments that no longer qualified
as fair value hedges.
JPMorgan Chase also enters into derivative contracts to hedge expo-
sure to variability in cash flows from floating-rate financial instru-
ments and forecasted transactions, primarily the rollover of short-
term assets and liabilities, and foreign currency–denominated rev-
enue and expense. All hedging derivative amounts affecting earnings
are recognized consistent with the classification of the hedged item,
primarily net interest income.
The Firm uses forward foreign exchange contracts and foreign cur-
rency–denominated debt instruments to protect the value of net
investments in subsidiaries whose functional currency is not the U.S.
dollar. The portion of the hedging derivative excluded from the
assessment of hedge effectiveness (i.e., forward points) is recorded in
net interest income.
JPMorgan Chase does not seek to apply hedge accounting to all of
the Firm’s economic hedges. For example, the Firm does not apply
hedge accounting to purchased credit default swaps used to manage
the credit risk of loans and commitments because of the difficulties
in qualifying such contracts as hedges under SFAS 133. Similarly, the
Firm does not apply hedge accounting to certain interest rate deriva-
tives used as economic hedges.
The following table presents derivative instrument hedging-related
activities for the periods indicated.
Year ended December 31, (in millions) 2008 2007 2006
Fair value hedge ineffective net gains(a) $ 434 $ 111 $ 51
Cash flow hedge ineffective net gains(a) 18 29 2
Cash flow hedging net gains on forecasted
transactions that failed to occur —15(b) —
(a) Includes ineffectiveness and the components of hedging instruments that have been
excluded from the assessment of hedge effectiveness.
(b) During the second half of 2007, the Firm did not issue short-term fixed rate
Canadian dollar denominated notes due to the weak credit market for Canadian
short-term debt.
Over the next 12 months, it is expected that $348 million (after-tax)
of net losses recorded in accumulated other comprehensive income
(loss) at December 31, 2008, will be recognized in earnings. The
maximum length of time over which forecasted transactions are
hedged is ten years, and such transactions primarily relate to core
lending and borrowing activities.
Credit derivatives
Credit derivatives are financial instruments whose value is derived from
the credit risk associated with the debt of a third party issuer (the ref-
erence entity) and which allow one party (the protection purchaser) to
transfer that risk to another party (the protection seller). Credit deriva-
tives expose the protection purchaser to the creditworthiness of the
protection seller, as the protection seller is required to make payments
under the contract when the reference entity experiences a credit
event, such as a bankruptcy, failure to pay its obligation, or a restruc-
turing. The seller of credit protection receives a premium for providing
protection, but has the risk that the underlying instrument referenced
in the contract will be subjected to a credit event.
The Firm is both a purchaser and seller of credit protection in the
credit derivatives market and uses credit derivatives for two primary
purposes. First, in its capacity as a market-maker in the
dealer/client business, the Firm actively risk manages a portfolio of
credit derivatives by purchasing and selling credit protection, pre-
dominantly on corporate debt obligations, to meet the needs of
customers. As a seller of protection, the Firm’s exposure to a given
reference entity may be offset partially, or entirely, with a contract
to purchase protection from another counterparty on the same or
similar reference entity. Second, the Firm uses credit derivatives in
order to mitigate the Firm’s credit risk associated with the overall
derivative receivables and traditional commercial credit lending
exposures (loans and unfunded commitments) as well as to man-
age its exposure to residential and commercial mortgages. See
Note 4 on pages 141–155 of this Annual Report for further infor-
mation on the Firm’s mortgage-related exposures. In accomplishing
the above, the Firm uses different types of credit derivatives.
Following is a summary of various types of credit derivatives.