JP Morgan Chase 2005 Annual Report Download - page 125

JPMorgan Chase & Co. /2005 Annual Report 123
Litigation reserve
The Firm maintains litigation reserves for certain of its litigations, including
its material legal proceedings. While the outcome of litigation is inherently
uncertain, management believes, in light of all information known to it at
December 31, 2005, that the Firm’s litigation reserves were adequate at such
date. Management reviews litigation reserves periodically, and the reserves
may be increased or decreased in the future to reflect further litigation devel-
opments. The Firm believes it has meritorious defenses to claims asserted
against it in its currently outstanding litigation and, with respect to such liti-
gation, intends to continue to defend itself vigorously, litigating or settling
cases according to management’s judgment as to what is in the best interest
of stockholders.
Note 26 – Accounting for derivative
instruments and hedging activities
Derivative instruments enable end users to increase, reduce or alter exposure
to credit or market risks.The value of a derivative is derived from its reference
to an underlying variable or combination of variables such as equity, foreign
exchange, credit, commodity or interest rate prices or indices. JPMorgan Chase
makes markets in derivatives for customers and also is an end-user of derivatives
in order to manage the Firm’s exposure to credit and market risks.
SFAS 133, as amended by SFAS 138 and SFAS 149, establishes accounting
and reporting standards for derivative instruments, including those used for
trading and hedging activities, and derivative instruments embedded in other
contracts. All free-standing derivatives, whether designated for hedging rela-
tionships or not, are required to be recorded on the balance sheet at fair value.
The accounting for changes in value of a derivative depends on whether the
contract is for trading purposes or has been designated and qualifies for
hedge accounting. The majority of the Firm’s derivatives are entered into for
trading purposes. The Firm also uses derivatives as an end user to hedge
market exposures, modify the interest rate characteristics of related balance
sheet instruments or meet longer-term investment objectives. Both trading and
end-user derivatives are recorded at fair value in Trading assets and Trading
liabilities as set forth in Note 3 on page 94 of this Annual Report.
In order to qualify for hedge accounting, a derivative must be considered highly
effective at reducing the risk associated with the exposure being hedged. Each
derivative must be designated as a hedge, with documentation of the risk
management objective and strategy, including identification of the hedging
instrument, the hedged item and the risk exposure, and how effectiveness is
to be assessed prospectively and retrospectively. The extent to which a hedging
instrument is effective at achieving offsetting changes in fair value or cash
flows must be assessed at least quarterly. Any ineffectiveness must be reported
in current-period earnings.
For qualifying fair value hedges, all changes in the fair value of the derivative
and in the fair value of the item for the risk being hedged are recognized in
earnings. If the hedge relationship is terminated, then the fair value adjust-
ment to the hedged item continues to be reported as part of the basis of the
item and is 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 and recognized in the income
statement when the hedged cash flows affect earnings. The ineffective portions
of cash flow hedges are immediately recognized in earnings. If the hedge
relationship is terminated, then the change in fair value of the derivative
recorded in Other comprehensive income is recognized when the cash flows
that were hedged occur, consistent with the original hedge strategy. For hedge
relationships discontinued because the forecasted transaction is not expected to
occur according to the original strategy, any related derivative amounts recorded
in Other comprehensive income 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 Other comprehensive
income. Any ineffective portions of net investment hedges are immediately
recognized in earnings.
JPMorgan Chase’s fair value hedges primarily include hedges of fixed-rate
long-term debt, loans,AFS securities and MSRs. Interest rate swaps are the most
common type of derivative contract used to modify exposure to interest rate risk,
converting fixed-rate assets and liabilities to a floating rate. Interest rate options,
swaptions and forwards are also used in combination with interest rate swaps
to hedge the fair value of the Firm’s MSRs. For a further discussion of MSR risk
management activities, see Note 15 on pages 114–116 of this Annual Report.
All amounts have been included in earnings consistent with the classification
of the hedged item, primarily Net interest income, Mortgage fees and related
income, and Other income. The Firm did not recognize any gains or losses during
2005 on firm commitments that no longer qualify as fair value hedges.
JPMorgan Chase also enters into derivative contracts to hedge exposure to
variability in cash flows from floating-rate financial instruments and forecasted
transactions, primarily the rollover of short-term assets and liabilities, and
foreign currency-denominated revenues and expenses. Interest rate swaps,
futures and forward contracts are the most common instruments used to
reduce the impact of interest rate and foreign exchange rate changes on
future earnings. All amounts affecting earnings have been recognized consistent
with the classification of the hedged item, primarily Net interest income.
The Firm uses forward foreign exchange contracts and foreign currency-
denominated debt instruments to protect the value of net investments in
foreign currencies in non-U.S. subsidiaries.The portion of the hedging instru-
ments excluded from the assessment of hedge effectiveness (forward points)
is recorded in Net interest income.
The following table presents derivative instrument hedging-related activities
for the periods indicated:
Year ended December 31, (in millions)(a) 2005 2004
Fair value hedge ineffective net gains/(losses)(b) $ (58) $ 199
Cash flow hedge ineffective net gains/(losses)(b) (2) —
Cash flow hedging gains on forecasted
transactions that failed to occur —1
(a) 2004 results include six months of the combined Firm’s results and six months of heritage
JPMorgan Chase results.
(b) Includes ineffectiveness and the components of hedging instruments that have been
excluded from the assessment of hedge effectiveness.
Over the next 12 months, it is expected that $44 million (after-tax) of net
gains recorded in Other comprehensive income at December 31, 2005, will
be recognized in earnings. The maximum length of time over which forecasted
transactions are hedged is 10 years, and such transactions primarily relate to
core lending and borrowing activities.
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 standard credit derivatives 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 derivatives used as economic hedges.