JP Morgan Chase 2010 Annual Report Download - page 197

JPMorgan Chase & Co./2010 Annual Report 197
The following table shows the current credit risk of derivative receivables after netting adjustments, and the current liquidity risk of derivative
payables after netting adjustments, as of December 31, 2010 and 2009.
Derivative recei
v
ables
Derivative
pa
y
ables
December 31, (in millions)
2010
2009
2010
2009
Gross derivative fair value
$
1,529,412
$ 1,565,518
$
1,485,109
$ 1,519,183
Netting adjustment – offsetting receivables/payables
(1,376,969)
(1,419,840)
(1,376,969)
(1,419,840 )
Netting adjustment – cash collateral received/paid
(71,962)
(65,468)
(38,921)
(39,218 )
Carrying value on Consolidated Balance Sheets
$
80,481
$ 80,210
$
69,219
$ 60,125
In addition to the collateral amounts reflected in the table above, at
December 31, 2010 and 2009, the Firm had received liquid securi-
ties and other cash collateral in the amount of $16.5 billion and
$15.5 billion, respectively, and had posted $10.9 billion and $11.7
billion, respectively. The Firm also receives and delivers collateral at
the initiation of derivative transactions, which is available as secu-
rity against potential exposure that could arise should the fair value
of the transactions move in the Firm’s or client’s favor, respectively.
Furthermore, the Firm and its counterparties hold collateral related
to contracts that have a non-daily call frequency for collateral to be
posted, and collateral that the Firm or a counterparty has agreed to
return but has not yet settled as of the reporting date. At December
31, 2010 and 2009, the Firm had received $18.0 billion and $16.9
billion, respectively, and delivered $8.4 billion and $5.8 billion,
respectively, of such additional collateral. These amounts were not
netted against the derivative receivables and payables in the table
above, because, at an individual counterparty level, the collateral
exceeded the fair value exposure at December 31, 2010 and 2009.
Credit derivatives
Credit derivatives are financial instruments whose value is derived
from the credit risk associated with the debt of a third-party issuer
(the reference entity) and which allow one party (the protection
purchaser) to transfer that risk to another party (the protection
seller). Credit derivatives expose the protection purchaser to the
creditworthiness of the protection seller, as the protection seller is
required to make payments under the contract when the reference
entity experiences a credit event, such as a bankruptcy, a failure to
pay its obligation or a restructuring. The seller of credit protection
receives a premium for providing protection but has the risk that
the underlying instrument referenced in the contract will be subject
to a credit event.
The Firm is both a purchaser and seller of protection in the credit
derivatives market and uses these derivatives for two primary
purposes. First, in its capacity as a market-maker in the
dealer/client business, the Firm actively risk manages a portfolio of
credit derivatives by purchasing and selling credit protection, pre-
dominantly on corporate debt obligations, to meet the needs of
customers. As a seller of protection, the Firm’s exposure to a given
reference entity may be offset partially, or entirely, with a contract
to purchase protection from another counterparty on the same or
similar reference entity. Second, the Firm uses credit derivatives to
mitigate credit risk associated with its overall derivative receivables
and traditional commercial credit lending exposures (loans and
unfunded commitments) as well as to manage its exposure to
residential and commercial mortgages. See Note 3 on pages 170–
187 of this Annual Report for further information on the Firm’s
mortgage-related exposures. In accomplishing the above, the Firm
uses different types of credit derivatives. Following is a summary of
various types of credit derivatives.
Credit default swaps
Credit derivatives may reference the credit of either a single refer-
ence entity (“single-name”) or a broad-based index. The Firm
purchases and sells protection on both single- name and index-
reference obligations. Single-name CDS and index CDS contracts
are OTC derivative contracts. Single-name CDS are used to manage
the default risk of a single reference entity, while index CDS con-
tracts are used to manage the credit risk associated with the
broader credit markets or credit market segments. Like the S&P 500
and other market indices, a CDS index comprises a portfolio of CDS
across many reference entities. New series of CDS indices are
periodically established with a new underlying portfolio of reference
entities to reflect changes in the credit markets. If one of the refer-
ence entities in the index experiences a credit event, then the
reference entity that defaulted is removed from the index. CDS can
also be referenced against specific portfolios of reference names or
against customized exposure levels based on specific client de-
mands: for example, to provide protection against the first $1
million of realized credit losses in a $10 million portfolio of expo-
sure. Such structures are commonly known as tranche CDS.
For both single-name CDS contracts and index CDS contracts, upon
the occurrence of a credit event, under the terms of a CDS contract
neither party to the CDS contract has recourse to the reference
entity. The protection purchaser has recourse to the protection
seller for the difference between the face value of the CDS contract
and the fair value of the reference obligation at the time of settling
the credit derivative contract, also known as the recovery value. The
protection purchaser does not need to hold the debt instrument of
the underlying reference entity in order to receive amounts due
under the CDS contract when a credit event occurs.
Credit-related notes
A credit-related note is a funded credit derivative where the issuer of
the credit-related note purchases from the note investor credit protec-
tion on a referenced entity. Under the contract, the investor pays the
issuer the par value of the note at the inception of the transaction,
and in return, the issuer pays periodic payments to the investor,
based on the credit risk of the referenced entity. The issuer also
repays the investor the par value of the note at maturity unless the
reference entity experiences a specified credit event. If a credit event