JP Morgan Chase 2009 Annual Report Download - page 113

JPMorgan Chase & Co./2009 Annual Report 111
The CVA is based on the Firm’s AVG to a counterparty and the
counterparty’s credit spread in the credit derivatives market. The
primary components of changes in CVA are credit spreads, new
deal activity or unwinds, and changes in the underlying market
environment. The Firm believes that active risk management is
essential to controlling the dynamic credit risk in the derivatives
portfolio. In addition, the Firm takes into consideration the poten-
tial for correlation between the Firm’s AVG to a counterparty and
the counterparty’s credit quality within the credit approval process.
The Firm risk manages exposure to changes in CVA by entering into
credit derivative transactions, as well as interest rate, foreign ex-
change, equity and commodity derivative transactions.
The accompanying graph shows exposure profiles to derivatives
over the next ten years as calculated by the DRE and AVG metrics.
The two measures generally show declining exposure after the first
year, if no new trades were added to the portfolio.
0
10
20
30
40
50
60
70
80
$ 90
Exposure profile of derivatives measures
December 31, 2009
(in billions) AVG DRE
1 year 2 years 5 years 10 years
The following table summarizes the ratings profile of the Firm’s derivative receivables MTM, net of other liquid securities collateral, for the
dates indicated.
Ratings profile of derivative receivables MTM
Rating equivalent 2009 2008
December 31, Exposure net of % of exposure net Exposure net of % of exposure net
(in millions, except ratios) of all collateral of all collateral of all collateral of all collateral
AAA/Aaa to AA-/Aa3 $ 25,530 40% $ 68,708 48 %
A+/A1 to A-/A3 12,432 19 24,748 17
BBB+/Baa1 to BBB-/Baa3 9,343 14 15,747 11
BB+/Ba1 to B-/B3 14,571 23 28,186 20
CCC+/Caa1 and below 2,815 4 5,421 4
Total $ 64,691 100% $ 142,810 100 %
The Firm actively pursues the use of collateral agreements to miti-
gate counterparty credit risk in derivatives. The percentage of the
Firm’s derivatives transactions subject to collateral agreements –
excluding foreign exchange spot trades, which are not typically
covered by collateral agreements due to their short maturity – was
89% as of December 31, 2009, largely unchanged from 88% at
December 31, 2008.
The Firm posted $56.7 billion and $99.1 billion of collateral at
December 31, 2009 and 2008, respectively.
Certain derivative and collateral agreements include provisions that
require the counterparty and/or the Firm, upon specified down-
grades in the respective credit ratings of their legal entities, to post
collateral for the benefit of the other party. At December 31, 2009,
the impact of a single-notch and six-notch ratings downgrade to
JPMorgan Chase & Co., and its subsidiaries, primarily JPMorgan
Chase Bank, N.A., would have required $1.2 billion and $3.6
billion, respectively, of additional collateral to be posted by the
Firm. Certain derivative contracts also provide for termination of the
contract, generally upon a downgrade to a specified rating of either
the Firm or the counterparty, at the then-existing MTM value of the
derivative contracts.
Credit derivatives
Credit derivatives are financial contracts that isolate credit risk from
an underlying instrument (such as a loan or security) and transfers
that risk from one party (the buyer of credit protection) to another
(the seller of credit protection). The Firm is both a purchaser and
seller of credit protection. As a purchaser of credit protection, the
Firm has risk that the counterparty providing the credit protection
will default. As a seller of credit protection, the Firm has risk that
the underlying instrument referenced in the contract will be subject
to a credit event. Of the Firm’s $80.2 billion of total derivative
receivables MTM at December 31, 2009, $18.8 billion, or 23%,
was associated with credit derivatives, before the benefit of liquid
securities collateral.
One type of credit derivatives the Firm enters into with counterpar-
ties are credit default swaps (“CDS”). For further detailed discus-
sion of these and other types of credit derivatives, see Note 5 on
pages 175–183 of this Annual Report. The large majority of CDS
are subject to collateral arrangements to protect the Firm from
counterparty credit risk. In 2009, the frequency and size of defaults
for both trading counterparties and the underlying debt referenced
in credit derivatives were well above historical norms. The use of
collateral to settle against defaulting counterparties generally
performed as designed in significantly mitigating the Firm’s expo-
sure to these counterparties.
The Firm uses credit derivatives for two primary purposes: first, in
its capacity as a market-maker in the dealer/client business to
meet the needs of customers; and second, in order to mitigate
the Firm’s own credit risk associated with its overall derivative
receivables and traditional commercial credit lending exposures
(loans and unfunded commitments).