JP Morgan Chase 2008 Annual Report Download - page 103

JPMorgan Chase & Co./ 2008 Annual Report 101
The increase in noninvestment grade derivative receivables reflects a
weakening credit environment. The Firm actively pursues the use of
collateral agreements to mitigate counterparty credit risk in deriva-
tives. The percentage of the Firm’s derivatives transactions subject to
collateral agreements was 83% as of December 31, 2008, largely
unchanged from 82% at December 31, 2007.
The Firm posted $99.1 billion and $33.5 billion of collateral at
December 31, 2008 and 2007, respectively.
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. The impact of a single-notch ratings downgrade to
JPMorgan Chase Bank, N.A., from its rating of “AA-” to “A+” at
December 31, 2008, would have required $2.2 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 $6.4 billion
of additional collateral. Certain derivative contracts 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
Credit derivatives are financial contracts that isolate credit risk from
an underlying instrument (such as a loan or security) and transfer that
risk from one party (the buyer of credit protection) to another (the
seller of credit protection). The Firm is both a purchaser and seller of
credit protection. As a purchaser of credit protection, the Firm has risk
that the counterparty providing the credit protection will default. As a
seller of credit protection, the Firm has risk that the underlying instru-
ment referenced in the contract will be subject to a credit event. Of
the Firm’s $162.6 billion of total derivative receivables MTM at
December 31, 2008, $44.7 billion, or 27%, was associated with cred-
it derivatives, before the benefit of liquid securities collateral.
One type of credit derivatives the Firm enters into with counterpar-
ties are credit default swaps (“CDS”). For further detailed discussion
of these and other types of credit derivatives, see Note 32 on pages
214–217 of this Annual Report. The large majority of CDS are sub-
ject to collateral arrangements to protect the Firm from counterparty
credit risk. In 2008, the frequency and size of defaults for both trad-
ing counterparties and the underlying debt referenced in credit deriv-
atives were well above historical norms. The use of collateral to settle
against defaulting counterparties generally performed as designed in
significantly mitigating the Firm’s exposure to these counterparties.
During 2008, the Firm worked with other significant market partici-
pants to develop mechanisms to reduce counterparty credit risk,
including the cancellation of offsetting trades. In 2009, it is anticipat-
ed that one or more central counterparties for CDS will be estab-
lished and JPMorgan Chase will face these central counterparties, or
clearing houses, for an increasing portion of its CDS business.
The Firm uses credit derivatives for two primary purposes: first, in its
capacity as a market-maker in the dealer/client business to meet the
needs of customers; and second, in order to mitigate the Firm’s own
credit risk associated with its overall derivative receivables and tradi-
tional commercial credit lending exposures (loans and unfunded
commitments), as well as its exposure to residential and commercial
mortgages.
The following table presents the Firm’s notional amounts of credit
derivatives protection purchased and sold as of December 31, 2008
and 2007, distinguishing between dealer/client activity and credit
portfolio activity.
Notional amount
Dealer/client Credit portfolio
December 31, Protection Protection Protection Protection
(in billions) purchased(a) sold(a) purchased(b) sold Total
2008 $4,097 $ 4,198 $ 92 $ 1 $8,388
2007 $ 3,999 $ 3,896 $ 70 $ 2 $ 7,967
(a) Includes $3.9 trillion at December 31, 2008, of notional exposure within protection
purchased and protection sold where the underlying reference instrument is identi-
cal. The remaining exposure includes single name and index CDS which the Firm
purchased to manage the remaining net protection sold. For a further discussion on
credit derivatives, see Note 32 on pages 214–217 of this Annual Report.
(b) Includes $34.9 billion and $31.1 billion at December 31, 2008 and 2007, respec-
tively, that represented the notional amount for structured portfolio protection; the
Firm retains a minimal first risk of loss on this portfolio.
Dealer/client business
Within the dealer/client business, the Firm actively utilizes credit
derivatives by buying and selling credit protection, predominantly on
corporate debt obligations, in response to client demand for credit
risk protection on the underlying reference instruments. Protection
may be bought or sold by the Firm on single reference debt instru-
ments (“single-name” credit derivatives), portfolios of referenced
instruments (“portfolio” credit derivatives) or quoted indices
(“indexed” credit derivatives).The risk positions are largely matched
as the Firm’s exposure to a given reference entity under a contract to
sell protection to a counterparty may be offset partially, or entirely,
with a contract to purchase protection from another counterparty on
the same underlying instrument. Any residual default exposure and
spread risk is actively managed by the Firm’s various trading desks.
At December 31, 2008, the total notional amount of protection pur-
chased and sold increased $421 billion from year-end 2007. The
increase was primarily as a result of the merger with Bear Stearns,
partially offset by the impact of industry efforts to reduce offsetting
trade activity.
Credit portfolio activities
In managing its wholesale credit exposure the Firm purchases pro-
tection through single-name and portfolio credit derivatives to man-
age the credit risk associated with loans, lending-related commit-
ments and derivative receivables. Gains or losses on the credit deriv-
atives are expected to offset the unrealized increase or decrease in