JP Morgan Chase 2009 Annual Report Download - page 221

JPMorgan Chase & Co./2009 Annual Report 219
Credit-linked note vehicles
The Firm structures transactions with credit-linked note vehicles in
which the VIE purchases highly rated assets, such as asset-backed
securities, and enters into a credit derivative contract with the Firm
to obtain exposure to a referenced credit which the VIE otherwise
does not hold. The VIE then issues CLNs with maturities predomi-
nantly ranging from one to ten years in order to transfer the risk of
the referenced credit to the VIE’s investors. Clients and investors
often prefer using a CLN vehicle since the CLNs issued by the VIE
generally carry a higher credit rating than such notes would if
issued directly by JPMorgan Chase. The Firm’s exposure to the CLN
vehicles is generally limited to its rights and obligations under the
credit derivative contract with the VIE, as the Firm does not provide
any additional contractual financial support to the VIE. In addition,
the Firm has not historically provided any financial support to the
CLN vehicles over and above its contractual obligations. Accord-
ingly, the Firm typically does not consolidate the CLN vehicles. As a
derivative counterparty in a credit-linked note structure, the Firm
has a senior claim on the collateral of the VIE and reports such
derivatives on its balance sheet at fair value. The collateral pur-
chased by such VIEs is largely investment-grade, with a significant
amount being rated “AAA.” The Firm divides its credit-linked note
structures broadly into two types: static and managed.
In a static credit-linked note structure, the CLNs and associated
credit derivative contract either reference a single credit (e.g., a
multi-national corporation), or all or part of a fixed portfolio of
credits. The Firm generally buys protection from the VIE under the
credit derivative. 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 participating 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 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, in both static and managed credit-
linked note structures, the Firm pays a premium to the VIE in return
for the receipt of a payment (up to the notional of the derivative) 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, 2009 and 2008, was as follows.
2009 2008
December 31,
(in billions)
Derivative
receivables
Trading
assets(b)
Total
exposure(c)
Par value of
collateral held
by VIEs(d)
Derivative
receivables
Trading
assets(b)
Total
exposure(c)
Par value of
collateral held
by VIEs(d)
Credit-linked notes(a)
Static structure $ 1.9 $ 0.7 $ 2.6 $ 10.8 $ 3.6 $ 0.7 $ 4.3 $ 14.5
Managed structure 5.0 0.6 5.6 15.2 7.7 0.3 8.0 16.6
Total $ 6.9 $ 1.3 $ 8.2 $ 26.0 $ 11.3 $ 1.0 $ 12.3 $ 31.1
(a) Excluded collateral with a fair value of $1.5 billion and $2.1 billion at December 31, 2009 and 2008, respectively, which was consolidated as the Firm, in its role as
secondary market maker, held a majority of the issued credit-linked notes of certain vehicles.
(b) 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.
(c) On–balance sheet exposure that includes derivative receivables and trading assets.
(d) 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 on 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 col-
lateral is expected to be sufficient to pay amounts due under the derivative contracts.
Asset Swap Vehicles
The Firm also structures and executes transactions with asset swap
vehicles on behalf of investors. In such transactions, the VIE pur-
chases 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
derivatives would match the maturity of the assets. Investors typi-
cally 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. The derivative transaction between the Firm and the
VIE may include currency swaps to hedge assets held by the VIE
denominated in foreign currency into the investors’ home or in-
vestment currency or interest rate swaps to hedge the interest rate
risk of assets held by the VIE; to add additional interest rate expo-
sure 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
contractual financial support to the VIE. In addition, the Firm his-
torically 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
derivative counterparty, the Firm has a senior claim on the collat-
eral 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.