JP Morgan Chase 2010 Annual Report Download - page 252

Notes to consolidated financial statements
252 JPMorgan Chase & Co./2010 Annual Report
Credit-related note vehicles
The Firm structures transactions with credit-related note vehicles in
which the VIE purchases highly rated assets, such as asset-backed
securities, and enters into a credit derivative contract with the Firm
to obtain exposure to a referenced credit which the VIE otherwise
does not hold. The VIE then issues credit-linked notes (“CLNs”)
with maturities predominantly ranging from one to 10 years in
order to transfer the risk of the referenced credit to the VIE’s inves-
tors. Clients and investors often prefer using a CLN vehicle since
the CLNs issued by the VIE generally carry a higher credit rating
than such notes would if issued directly by JPMorgan Chase. The
Firm’s exposure to the CLN vehicles is generally limited to its rights
and obligations under the credit derivative contract with the VIE, as
the Firm does not provide any additional contractual financial
support to the VIE. In addition, the Firm has not historically pro-
vided any financial support to the CLN vehicles over and above its
contractual obligations. Accordingly, the Firm typically does not
consolidate the CLN vehicles. As a derivative counterparty in a
credit-related note structure, the Firm has a senior claim on the
collateral of the VIE and reports such derivatives on its balance
sheet at fair value. The collateral purchased by such VIEs is largely
investment-grade, with a significant amount being rated “AAA.”
The Firm divides its credit-related note structures broadly into two
types: static and managed.
In a static credit-related note structure, the CLNs and associated
credit derivative contract either reference a single credit (e.g., a
multi-national corporation), or all or part of a fixed portfolio of
credits. The Firm generally buys protection from the VIE under the
credit derivative. In a managed credit-related note structure, the
CLNs and associated credit derivative generally reference all or part
of an actively managed portfolio of credits. An agreement exists
between a portfolio manager and the VIE that gives the portfolio
manager the ability to substitute each referenced credit in the
portfolio for an alternative credit. By participating in a structure
where a portfolio manager has the ability to substitute credits
within pre-agreed terms, the investors who own the CLNs seek to
reduce the risk that any single credit in the portfolio will default.
The Firm does not act as portfolio manager; its involvement with
the VIE is generally limited to being a derivative counterparty. As a
net buyer of credit protection, in both static and managed credit-
related note structures, the Firm pays a premium to the VIE in
return for the receipt of a payment (up to the notional of the de-
rivative) if one or more of the credits within the portfolio defaults,
or if the losses resulting from the default of reference credits exceed
specified levels. Since each CLN is established to the specifications
of the investors, the investors have the power over the activities of
that VIE that most significantly affect the performance of the CLN.
Accordingly, the Firm does not generally consolidate these credit-
related note entities. Furthermore, the Firm does not have a vari-
able interest that could potentially be significant. As a derivative
counterparty, the Firm has a senior claim on the collateral of the
VIE and reports such derivatives on its balance sheet at fair value.
Substantially all of the assets purchased by such VIEs are invest-
ment-grade.
Exposure to nonconsolidated credit-related note VIEs at December 31, 2010 and 2009, was as follows.
Net derivative Trading Total
Par value of
collateral
December 31, 2010 (in billions) receivables assets
(b)
exposure
(c)
held by VIEs(d)
Credit-related notes
(a)
Static structure
$
1.0
$
—
$
1.0
$
9.5
Managed structure
2.8
—
2.8
10.7
Total
$
3.8
$
—
$
3.8
$
20.2
Net derivative Trading Total
Par value of
collateral
December 31, 2009 (in billions) receivables assets
(b)
exposure
(c)
held by VIEs(d)
Credit-related notes
(a)
Static structure
$
1.9
$
0.7
$
2.6
$
10.8
Managed structure
5.0
0.6
5.6
15.2
Total
$ 6.9 $ 1.3 $ 8.2 $ 26.0
(a) Excluded collateral with a fair value of $142 million and $855 million at December 31, 2010 and 2009, respectively, which was consolidated, as the Firm, in its role as
secondary market-maker, held a majority of the issued credit-related notes of certain vehicles.
(b) Trading assets principally comprise notes issued by VIEs, which from time to time are held as part of the termination of a deal or to support limited market-making.
(c) On–balance sheet exposure that includes net derivative receivables and trading assets – debt and equity instruments.
(d) The Firm’s maximum exposure arises through the derivatives executed with the VIEs; the exposure varies over time with changes in the fair value of the derivatives. The
Firm relies on the collateral held by the VIEs to pay any amounts due under the derivatives; the vehicles are structured at inception so that the par value of the collateral
is expected to be sufficient to pay amounts due under the derivative contracts.
Asset swap vehicles
The Firm structures and executes transactions with asset swap vehi-
cles on behalf of investors. In such transactions, the VIE purchases a
specific asset or assets and then enters into a derivative with the Firm
in order to tailor the interest rate or foreign exchange currency risk, or
both, according to investors’ requirements. Generally, the assets are
held by the VIE to maturity, and the tenor of the derivatives would
match the maturity of the assets. Investors typically invest in the notes
issued by such VIEs in order to obtain exposure to the credit risk of
the specific assets, as well as exposure to foreign exchange and