JP Morgan Chase 2008 Annual Report Download - page 27

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counterparty credit risk. Actual risk is the mark-
to-market value of the contract after taking into
account netting of risk across all transactions with
a counterparty, collateral and hedging. Actual risk
projections also take into account the potential
future exposure coming from market moves.
• Our counterparty exposures net of collateral and
hedges are $133 billion, and the company manages
those exposures name by name – like a hawk. The
figure is large, but we get paid to take the risks, we
reserve and account for them conservatively, and we
manage them in conjunction with all of our other
credit exposures.
• As the overall amount of counterparty credit risk
has grown, so has the concern that this growth has
increased systemic risk. To address this issue, we
support the development of clearinghouses, which
we believe will reduce the counterparty risk and
increase transparency for standardized contracts. We
already clear a significant portion of our interest rate
and commodities derivatives through clearinghouses,
and we have been active in the development of a
clearinghouse for credit default swaps. Those deriva-
tives that are too customized to be cleared can easily
be monitored by regulators to ensure they do not
cause systemic risk.
• AIG’s downfall wasn’t due to its use of derivatives
per se but to its poor risk management practices.
The insurer took concentrated risks through credit
default swaps insuring mortgage-related assets. On
the other side of the equation, some dealers bought
this insurance from AIG without requiring them to
post collateral until such time as their credit rating
deteriorated. This is a case where bad risk manage-
ment on the part of AIG was compounded by bad
counterparty risk management by AIG’s counterpar-
ties. The potential systemic impact was substantial.
JPMorgan Chase did business with AIG, but, in line
with our general policies, we kept our credit expo-
sure relatively small so that our firm would not be
compromised if AIG had been allowed to fail. With
hindsight, the problem itself could have been better
contained and dramatically mitigated had AIG been
properly regulated and required to provide collateral
(to a clearinghouse or its counterparties).
• There are regulatory gaps that need serious atten-
tion, as was evident with AIG. A way to prevent a
future AIG is by empowering a systemic risk regula-
tor (as described earlier). Such a regulator would
have been in a position to see the risk piling up and
address it before the company failed.
• Recognizing upfront profits for derivative transac-
tions can be problematic. Even though it is not stan-
dard accounting, we believe the profits relating to
the risk positions associated with derivatives should
be booked over the life of the transaction, propor-
tionate to the risk remaining.
With proper management, systemic risks created by
derivatives can be dramatically reduced without com-
promising the ability of companies to use them in
managing their exposures.
C. The reasons for maintaining a fortress balance
sheet and cutting the dividend
Maintaining a fortress balance sheet will always be
essential to us. Our Tier 1 ratio is 10.9%, with tangible
common equity of $81 billion, and we will continue to
increase our loan loss reserves, as appropriate. With
$24 billion in allowance for credit losses at the end of
2008, we believe our loan loss reserves across all our
businesses are among the strongest in the industry.
Out of an abundance of caution to be prepared for the
future during this uncertain environment, we believed
it was prudent to reduce our quarterly dividend from
$0.38 to $0.05 per share, effective with our next sched-
uled dividend payment.
We did not take this action lightly, and we recognize
our tremendous obligation to shareholders to seek to
maintain dividend levels. But extraordinary times
require extraordinary measures. So while our perform-
ance and capital are solid, we have an even higher
obligation to ensure that our fortress balance sheet
remains intact. This will enable us to stay flexible to