JP Morgan Chase 2003 Annual Report Download - page 107

J.P. Morgan Chase & Co. / 2003 Annual Report 105
The Firm structures credit-linked notes in w hich the VIE
purchases highly-rated assets (such as asset-backed securities)
and enters into a credit derivative contract w ith the Firm to
obtain exposure to a referenced credit not held by the VIE.
Credit-linked notes are issued by the VIE to transfer the risk of
the referenced credit to the investors in the VIE. Clients and
investors often prefer a VIE structure, since the credit-linked
notes generally carry a higher credit rating than they would if
issued directly by JPM organ Chase. The Firm’s derivative contract
is not considered a significant variable interest in the VIE,
because it does not absorb risk but rather adds risk to the
vehicle, w hich is ultimately absorbed by the investors. The fair
value of the Firm’s derivative contracts w ith credit-linked notes
vehicles w as not material at December 31, 2003. Assets of
$2.1 billion and $1.3 billion reported in the table above w ere
recorded on the Firm' s Consolidated balance sheet at December
31, 2003 and December 31, 2002, respectively, due to other
contractual relationships held by the Firm that relate to the col-
lateral held by the VIE.
The Firm is involved w ith municipal bond vehicles for the pur-
pose of creating a series of secondary market trusts that allow
tax-exempt investors to finance their investments at short-term
tax-exempt rates. The VIE purchases fixed-rate, longer-term
highly rated municipal bonds by issuing puttable floating-rate
certificates and inverse floating-rate certificates; the investors in
the inverse floating-rate certificates are exposed to the residual
losses of the VIE (the “ residual interests” ). The Firm often serves
as remarketing agent for the VIE and provides liquidity to support
the remarketing; total liquidity commitments w ere $1.8 billion
and $1.5 billion at December 31, 2003 and 2002, respectively.
In circumstances w here the Firm ow ns the residual interests, the
Firm consolidates the VIE; total amounts consolidated w ere
$2.5 billion and $1.3 billion at December 31, 2003 and 2002,
respectively, w hich are reported in the table above. In circum-
stances w here third party investors ow n the residual interests,
the Firm' s exposure is limited because of the high credit quality
of the underlying municipal bonds, the market-value triggers
based on the value of the underlying collateral and the residual
interests held by third parties. The Firm' s maximum credit
exposure to all municipal bond vehicles w as $4.3 billion at
December 31, 2003.
Additionally, JPM organ Chase structures, on behalf of clients,
other client intermediation vehicles in w hich the Firm transfers
the risks and returns of the assets held by the VIE, typically debt
and equity instruments, to clients through derivative contracts.
The Firm’s net exposure arising from these intermediation trans-
actions is not significant. The Firm’s current exposure to all of
these vehicles is reflected in its Consolidated financial
statements, as the fair value of the derivative contracts are
recorded in Trading assets or Trading liabilities, and changes in
fair value are recognized in Trading revenue.
Finally, the Firm may enter into transactions w ith VIEs structured
by other parties. These transactions can include, for example, act-
ing as a derivative counterparty, liquidity provider, investor,
underw riter, placement agent, trustee or custodian. These trans-
actions are conducted at arm’s length, and individual credit
decisions are based upon the analysis of the specific VIE, taking
into consideration the quality of the underlying assets. JPM organ
Chase records and reports these positions similarly to any other
third-party transaction. For example, derivative contracts are
recorded at fair value and reported in Note 31 on pages 120–123
of this Annual Report, w hereas liquidity facilities are included
w ithin the Firm’s lending-related commitments, described in more
detail in Note 29 on pages 117–119 of this Annual Report. Fees
received w hen the Firm operates in an administrative capacity,
such as underw riter, trustee or custodian, are recorded in Fees
and commissions. These activities do not cause JPM organ Chase
to absorb a majority of the expected losses of the VIEs or receive
a majority of the residual returns of the VIE, and they are not con-
sidered significant for disclosure purposes.
FIN 46 Transition
Effective February 1, 2003, JPM organ Chase implemented FIN 46
for VIEs created or modified after January 31, 2003, in w hich the
Firm has an interest. Effective July 1, 2003, the Firm implemented
FIN 46 for all VIEs originated prior to February 1, 2003, excluding
certain investments made by its private equity business, as
discussed below. The effect of adoption w as an incremental
increase in the Firm’s assets and liabilities of approximately $17
billion at July 1, 2003, and $10 billion at December 31, 2003.
The increase primarily related to Firm-sponsored multi-seller
asset-backed commercial paper conduits and other entities in
w hich the Firm’s trading and investment functions have interests
that absorb a majority of the expected losses in the structures.
In addition, certain VIEs w ith assets of approximately $2 billion
at December 31, 2003 that had been consolidated under prior
accounting literature continue to be consolidated in accordance
w ith FIN 46. As a result of its adoption of FIN 46, the Firm also
deconsolidated certain vehicles, primarily the w holly-ow ned
Delaware statutory business trusts further discussed in Note 18
on pages 110–111 of this Annual Report.
The Firm’s private equity business is involved w ith entities that
may be deemed VIEs. The FASB permitted nonregistered invest-
ment companies to defer consolidation of VIEs w ith w hich they
are involved until the proposed Statement of Position on the clar-
ification of the scope of the Investment Company Audit Guide is
finalized, which is expected in mid-2004. Follow ing issuance of
the Statement of Position, the FASB will consider further modifi-
cation to FIN 46 to provide an exception for companies that
qualify to apply the revised Audit Guide. The Firm applied this
deferral provision and did not consolidate $2.7 billion of