JP Morgan Chase 2006 Annual Report Download - page 133

JPMorgan Chase & Co. / 2006 Annual Report 131
Litigation reserve
The Firm maintains litigation reserves for certain of its outstanding litigation.
In accordance with the provisions of SFAS 5, JPMorgan Chase accrues for a
litigation-related liability when it is probable that such a liability has been
incurred and the amount of the loss can be reasonably estimated. While the
outcome of litigation is inherently uncertain, management believes, in light of
all information known to it at December 31, 2006, 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 developments. The Firm believes it has meritorious
defenses to claims asserted against it in its currently outstanding litigation
and, with respect to such litigation, intends to continue to defend itself vigor-
ously, litigating or settling cases according to management’s judgment as to
what is in the best interests of stockholders.
Insurance recoveries related to certain material legal proceedings were $512
million and $208 million in 2006 and 2005, respectively. Charges related to
certain material legal proceedings were $2.8 billion and $3.7 billion in 2005
and 2004, respectively. There were no charges in 2006 related to material legal
proceedings.
Note 28 – 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 hedge market exposures, modify the interest rate char-
acteristics of related balance sheet instruments or meet longer-term invest-
ment objectives. The majority of the Firm’s derivatives are entered into for trad-
ing purposes. Both trading and end-user derivatives are recorded at fair value
in Trading assets and Trading liabilities as set forth in Note 4 on pages 98–99
of this Annual Report.
SFAS 133, as amended by SFAS 138, SFAS 149, and SFAS 155, 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 hedg-
ing relationships or not, are required to be recorded on the Consolidated bal-
ance sheets at fair value. The accounting for changes in value of a derivative
depends on whether the contract is for trading purposes or has been designat-
ed and qualifies for hedge accounting.
In order to qualify for hedge accounting, a derivative must be considered highly
effective at reducing the risk associated with the exposure being hedged. In order
for a derivative to be designated as a hedge, there must be 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. To assess effectiveness, the Firm uses
statistical methods such as regression analysis, as well as nonstatistical methods
including dollar value comparisons of the change in the fair value of the derivative
to the change in the fair value or cash flows of the hedged item. The extent to
which a hedging instrument has been and is expected to continue to be effective
at achieving offsetting changes in fair value or cash flows must be assessed and
documented at least quarterly. Any ineffectiveness must be reported in current-
period earnings. If it is determined that a derivative is not highly effective at hedg-
ing the designated exposure, hedge accounting is discontinued.
For qualifying fair value hedges, all changes in the fair value of the derivative
and in the fair value of the hedged item for the risk being hedged are recog-
nized in earnings. If the hedge relationship is terminated, then the fair value
adjustment to the hedged item continues to be reported as part of the basis of
the item and continues to be 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 Consolidated statement of income when the hedged cash flows affect earn-
ings. 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 strat-
egy. 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.
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. Prior to
the adoption of SFAS 156, interest rate options, swaptions and forwards were
also used in combination with interest rate swaps to hedge the fair value of
the Firm’s MSRs in SFAS 133 hedge relationships. For a further discussion of
MSR risk management activities, see Note 16 on pages 121–122 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 2006, 2005 or 2004 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 forecast-
ed 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 consis-
tent 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 invest-
ments in subsidiaries whose functional currency is not the U.S. dollar. The por-
tion of the hedging instruments 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) 2006 2005 2004(b)
Fair value hedge ineffective net gains/(losses)(a) $51 $ (58) $ 199
Cash flow hedge ineffective net gains/(losses)(a) 2(2) —
Cash flow hedging gains/(losses) on forecasted
transactions that failed to occur ——1
(a) Includes ineffectiveness and the components of hedging instruments that have been
excluded from the assessment of hedge effectiveness.
(b) 2004 results include six months of the combined Firm’s results and six months of heritage
JPMorgan Chase results.