JP Morgan Chase 2006 Annual Report Download - page 73

JPMorgan Chase & Co. / 2006 Annual Report 71
The Firm actively pursues the use of collateral agreements to mitigate
counterparty credit risk in derivatives. The percentage of the Firm’s derivatives
transactions subject to collateral agreements decreased slightly, to 80% as
of December 31, 2006, from 81% at December 31, 2005.
The Firm posted $27 billion of collateral as of both December 31, 2006 and
2005. Certain derivative and collateral agreements include provisions that
require the counterparty and/or the Firm, upon specified downgrades in their
respective credit ratings, to post collateral for the benefit of the other party.
As of December 31, 2006, the impact of a single-notch ratings downgrade to
JPMorgan Chase Bank, N.A., from its rating of AA- to A+ at December 31,
2006, would have required $1.1 billion of additional collateral to be posted by
the Firm; the impact of a six-notch ratings downgrade (from AA- to BBB-)
would have required $3.1 billion of additional collateral. Certain derivative con-
tracts also provide for termination of the contract, generally upon a downgrade
of either the Firm or the counterparty, at the then-existing MTM value of the
derivative contracts.
Credit derivatives
The following table presents the Firm’s notional amounts of credit derivatives
protection purchased and sold by the respective businesses as of December 31,
2006 and 2005:
Credit derivatives positions
Notional amount
Credit portfolio Dealer/client
December 31, Protection Protection Protection Protection
(in billions) purchased sold purchased sold Total
2006 $ 52(a) $ 1 $ 2,277 $ 2,289 $ 4,619
2005 31 1 1,096 1,113 2,241
(a) Includes $23 billion which represents the notional amount for structured portfolio protection;
the Firm retains the first risk of loss on this portfolio.
In managing wholesale credit exposure, the Firm purchases single-name and
portfolio credit derivatives; this activity does not reduce the reported level
of assets on the balance sheet or the level of reported off–balance sheet
commitments. The Firm also diversifies exposures by providing (i.e., selling)
credit protection, which increases exposure to industries or clients where the
Firm has little or no client-related exposure. This activity is not material to the
Firm’s overall credit exposure.
The following table summarizes the ratings profile of the Firm’s Derivative receivables MTM, net of other liquid securities collateral, for the dates indicated:
Ratings profile of derivative receivables MTM
Rating equivalent 2006 2005
December 31, Exposure net of % of exposure net Exposure net of % of exposure net
(in millions, except ratios) all collateral of all collateral all collateral of all collateral
AAA to AA-(a) $ 28,150 58% $ 20,735 48%
A+ to A- 7,588 15 8,074 18
BBB+ to BBB- 8,044 16 8,243 19
BB+ to B- 5,150 11 6,580 15
CCC+ and below 78 — 155 —
Total $ 49,010 100% $ 43,787 100%
(a) The increase in AAA to AA- was due primarily to exchange-traded commodity activities.
The MTM value of the Firm’s derivative receivables incorporates an adjustment,
the CVA, to reflect the credit quality of counterparties. The CVA is based
upon the Firm’s AVG to a counterparty and the counterparty’s credit spread in
the credit derivatives market. The primary components of changes in CVA are
credit spreads, new deal activity or unwinds, and changes in the underlying
market environment. The Firm believes that active risk management is essen-
tial to controlling the dynamic credit risk in the derivatives portfolio. The Firm
risk manages exposure to changes in CVA by entering into credit derivative
transactions, as well as interest rate, foreign exchange, equity and commodity
derivative transactions.