JP Morgan Chase 2005 Annual Report Download - page 127

JPMorgan Chase & Co. /2005 Annual Report 125
The Firm holds customers’ securities under custodial arrangements. At times,
these securities are loaned to third parties, and the Firm issues securities lending
indemnification agreements to the customer that protect the customer against
the risk of loss if the third party fails to return the securities. To support these
indemnification agreements, the Firm obtains from the third party cash or other
highly liquid collateral with a market value exceeding 100% of the value of the
loaned securities. If the third-party borrower fails to return the securities, the Firm
would use the collateral to purchase the securities in the market and would be
exposed if the value of the collateral fell below 100%. The Firm invests third-
party cash collateral received in support of the indemnification agreements. In a
few cases where the cash collateral is invested in resale agreements, the Firm
indemnifies the third party against reinvestment risk. At December 31, 2005 and
2004, the Firm held $245.0 billion and $221.6 billion, respectively, in collateral
in support of securities lending indemnification arrangements. Based upon
historical experience, management expects the risk of loss to be remote.
In connection with issuing securities to investors, the Firm may enter into con-
tractual arrangements with third parties that may require the Firm to make a
payment to them in the event of a change in tax law or an adverse interpreta-
tion of tax law. In certain cases, the contract may also include a termination
clause, which would allow the Firm to settle the contract at its fair value; thus,
such a clause would not require the Firm to make a payment under the indemni-
fication agreement. Even without the termination clause, management does not
expect such indemnification agreements to have a material adverse effect on the
consolidated financial condition of JPMorgan Chase. The Firm may also enter
into indemnification clauses when it sells a business or assets to a third party,
pursuant to which it indemnifies that third party for losses it may incur due to
actions taken by the Firm prior to the sale. See below for more information
regarding the Firm’s loan securitization activities. It is difficult to estimate the
Firm’s maximum exposure under these indemnification arrangements, since
this would require an assessment of future changes in tax law and future claims
that may be made against the Firm that have not yet occurred. However, based
upon historical experience, management expects the risk of loss to be remote.
As part of the Firm’s loan securitization activities, as described in Note 13 on
pages 108–111 of this Annual Report, the Firm provides representations and
warranties that certain securitized loans meet specific requirements.The Firm
may be required to repurchase the loans and/or indemnify the purchaser of the
loans against losses due to any breaches of such representations or warranties.
Generally, the maximum amount of future payments the Firm would be
required to make under such repurchase and/or indemnification provisions
would be equal to the current amount of assets held by such securitization-
related SPEs as of December 31, 2005, plus, in certain circumstances, accrued
and unpaid interest on such loans and certain expenses. The potential loss due
to such repurchase and/or indemnity is mitigated by the due diligence the Firm
performs before the sale to ensure that the assets comply with the requirements
set forth in the representations and warranties. Historically, losses incurred on
such repurchases and/or indemnifications have been insignificant, and therefore
management expects the risk of material loss to be remote.
The Firm is a partner with one of the leading companies in electronic payment
services in a joint venture operating under the name of Chase Paymentech
Solutions, LLC (the “joint venture”). The joint venture was formed in October
2005 as a result of an agreement to integrate the Firm’s jointly-owned Chase
Merchant Services (“CMS”) and Paymentech merchant businesses, the latter
of which was acquired as a result of the Merger. The joint venture provides
merchant processing services in the United States and Canada. The joint venture
is liable contingently for processed credit card sales transactions in the event
of a dispute between the cardmember and a merchant. If a dispute is
resolved in the cardmember’s favor, the joint venture will credit or refund the
amount to the cardmember and charge back the transaction to the merchant.
If the joint venture is unable to collect the amount from the merchant, the
joint venture will bear the loss for the amount credited or refunded to the
cardmember. The joint venture mitigates this risk by withholding settlement,
or by obtaining escrow deposits or letters of credit from certain merchants.
However, in the unlikely event that: 1) a merchant ceases operations and is
unable to deliver products, services or a refund; 2) the joint venture does not
have sufficient collateral from the merchants to provide customer refunds;
and 3) the joint venture does not have sufficient financial resources to provide
customer refunds, the Firm would be liable to refund the cardholder in
proportion to its approximate equity interest in the joint venture. For the
year ended December 31, 2005, the joint venture, along with the integrated
businesses of CMS and Paymentech, incurred aggregate credit losses of
$11 million on $563 billion of aggregate volume processed, of which the
Firm shared liability only on $200 billion of aggregate volume processed.
At December 31, 2005, the joint venture held $909 million of collateral.
In 2004, the CMS and Paymentech ventures incurred aggregate credit losses
of $7.1 million on $396 billion of aggregate volume processed, of which the
Firm shared liability only on $205 billion of aggregate volume processed.
At December 31, 2004, the CMS and Paymentech ventures held $620 million
of collateral. The Firm believes that, based upon historical experience and the
collateral held by the joint venture, the fair value of the guarantee would not
be different materially from the credit loss allowance recorded by the joint
venture; therefore, the Firm has not recorded any allowance for losses
in excess of the allowance recorded by the joint venture.
The Firm is a member of several securities and futures exchanges and clearing-
houses both in the United States and overseas. Membership in some of these
organizations requires the Firm to pay a pro rata share of the losses incurred by
the organization as a result of the default of another member. Such obligation
varies with different organizations. It may be limited to members who dealt with
the defaulting member or to the amount (or a multiple of the amount) of the
Firm’s contribution to a members’ guaranty fund, or, in a few cases, it may be
unlimited. It is difficult to estimate the Firm’s maximum exposure under these
membership agreements, since this would require an assessment of future claims
that may be made against the Firm that have not yet occurred. However, based
upon historical experience, management expects the risk of loss to be remote.
In addition to the contracts described above, there are certain derivative
contracts to which the Firm is a counterparty that meet the characteristics of
a guarantee under FIN 45. These derivatives are recorded on the Consolidated
balance sheets at fair value. These contracts include written put options that
require the Firm to purchase assets from the option holder at a specified price
by a specified date in the future, as well as derivatives that effectively guarantee
the return on a counterparty’s reference portfolio of assets. The total notional
value of the derivatives that the Firm deems to be guarantees was $62 billion
and $53 billion at December 31, 2005 and 2004, respectively. The Firm
reduces exposures to these contracts by entering into offsetting transactions
or by entering into contracts that hedge the market risk related to these con-
tracts. The fair value related to these contracts was a derivative receivable of
$198 million and $180 million, and a derivative payable of $767 million and
$622 million at December 31, 2005 and 2004, respectively. Finally, certain
written put options and credit derivatives permit cash settlement and do
not require the option holder or the buyer of credit protection to own the
reference asset. The Firm does not consider these contracts to be guarantees
as described in FIN 45.