SECURITIES AND EXCHANGE COMMISSION
FORM 10-K
J.P. Morgan Chase & Co.
Registrant’s telephone number, including area code: (212) 270-6000
Securities registered pursuant to Section 12(b) of the Act:
Title of each class
All securities named above are listed on the New York Stock Exchange.
Securities registered pursuant to Section 12(g) of the Act: None
Number of shares of common stock outstanding on February 28, 2002: 1,977,052,699
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes þ No o
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. þ
The aggregate market value of J.P. Morgan Chase & Co. common stock held by non-affiliates of J.P. Morgan Chase & Co. on February 28, 2002 was $57,772,000,000.
Form 10-K Index
TABLE OF CONTENTS
Part I
Item 1: Business
Overview
J.P. Morgan Chase & Co. (“JPMorgan Chase” or “the Firm”) is a financial holding company incorporated under Delaware law in 1968. As of December 31, 2001, JPMorgan Chase was one of the largest banking institutions in the United States, with $694 billion in assets and $41 billion in stockholders’ equity.
On December 31, 2000, J.P. Morgan & Co. Incorporated (“J.P. Morgan”) merged with and into The Chase Manhattan Corporation (“Chase”). Upon completion of the merger, Chase changed its name to “J.P. Morgan Chase & Co.” The merger was accounted for as a pooling of interests. As a result, the financial information provided herein presents the combined results of Chase and J.P. Morgan as if the merger had been in effect for all periods presented. In addition, certain prior-period amounts for the predecessor institutions’ financial statements have been reclassified to conform to the current presentation.
JPMorgan Chase is a global financial services firm with operations in over 50 countries. Its principal bank subsidiaries are JPMorgan Chase Bank (“JPMorgan Chase Bank”), a New York banking corporation headquartered in New York City, and Chase Manhattan Bank USA, National Association, headquartered in Delaware (“Chase USA”). The Firm’s principal nonbank subsidiary is its investment bank, J.P. Morgan Securities Inc. (“JPMSI”).
The bank and nonbank subsidiaries of JPMorgan Chase operate nationally as well as through overseas branches and subsidiaries, representative offices and affiliated banks.
Business segments
JPMorgan Chase’s activities are internally organized, for management reporting purposes, into five major business segments (Investment Bank, Treasury & Securities Services, Investment Management & Private Banking, JPMorgan Partners and Retail & Middle Market Financial Services). A description of the Firm’s business segments and the products and services they provide to their respective client bases are discussed in the “Segment results” section of Management’s Discussion and Analysis (“MD&A”) beginning on page 28 and Note 29 on page 96.
Competition
JPMorgan Chase and its subsidiaries and affiliates operate in a highly competitive environment. Competitors include other banks, brokerage firms, investment banking companies, merchant banks, insurance companies, mutual fund companies, credit card companies, mortgage banking companies, automobile financing companies, leasing companies, e-commerce and other Internet-based companies, and a variety of other financial services and advisory companies. JPMorgan Chase’s businesses compete with these other firms with respect to the range of products and services offered and the types of clients, customers, industries and geographies served. In addition, the Firm competes with these firms in attracting and retaining its professional and other personnel, particularly as it has continued to build its Investment Bank and Investment Management & Private Banking platforms.
The financial services industry has experienced consolidation and convergence in recent years, as financial institutions involved in a broad range of financial services industries have merged, of which the merger of Chase and J.P. Morgan is an example. This convergence trend is expected to continue and could result in competitors of JPMorgan Chase gaining greater capital and other resources, such as a broader range of products and services and geographic diversity. It is possible that competition will become even more intense as a result of the enactment of the financial modernization legislation discussed in more detail below.
Supervision and regulation
Permissible business activities; financial modernization legislation; conversion to financial holding company:The Firm is subject to regulation under state and federal law, including the Bank Holding Company Act of 1956, as amended (the “BHCA”). In November 1999, the Gramm-Leach-Bliley Act (“GLBA”) was enacted which eliminated certain legal barriers separating the conduct of various types of financial services businesses, such as commercial banking, investment banking and insurance. In addition, GLBA substantially revamped the regulatory scheme within which financial institutions such as JPMorgan Chase operate.
Under GLBA, bank holding companies meeting certain eligibility criteria may elect to become “financial holding companies,” which may engage in any activities that are “financial in nature,” as well as in additional activities that the Board of Governors of the Federal Reserve System (the “Federal Reserve Board”) and the United States Department of the Treasury (“U.S. Treasury Department”) determine are financial in nature or incidental or complementary to financial activities. Under GLBA, “financial activities” specifically include insurance, securities underwriting and dealing, merchant banking, investment advisory and lending activities. JPMorgan Chase elected to become a financial holding company as of March 13, 2000. Upon the Firm’s election to become a financial holding company:
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Under regulations implemented by the Federal Reserve Board, if any depository institution controlled by a financial holding company ceases to be “well-capitalized” or “well-managed” (as defined below), the Federal Reserve Board may impose corrective capital or managerial requirements on the financial holding company and place limitations on its ability to conduct the broader financial activities permissible for financial holding companies.
In addition, the Federal Reserve Board may require divestiture of the holding company’s depository institutions if the deficiencies persist. The regulations also provide that if any depository institution controlled by a financial holding company fails to maintain a satisfactory rating under the Community Reinvestment Act (“CRA”), the Federal Reserve Board must prohibit the financial holding company and its subsidiaries from engaging in any additional activities other than those permissible for bank holding companies that are not financial holding companies. The depository institution subsidiaries of JPMorgan Chase currently meet the capital, management and CRA requirements necessary to permit the Firm to conduct the broader activities permitted under GLBA. However, there can be no assurance that this will continue to be the case in the future.
Regulation by Federal Reserve Board under GLBA: Under GLBA’s system of “functional regulation,” the Federal Reserve Board acts as an “umbrella regulator,” and certain of JPMorgan Chase’s subsidiaries are regulated directly by additional regulatory authorities based on the particular activities of those subsidiaries (e.g., securities and investment advisory activities are regulated by the Securities and Exchange Commission (the “SEC”), and insurance activities are regulated by state insurance commissioners). The Firm must continue to file reports and other information with, and submit to examination by, the Federal Reserve Board as umbrella regulator. However, under GLBA, with respect to matters affecting functionally regulated subsidiaries, the Federal Reserve Board is required to defer to the applicable functional regulators unless the Federal Reserve Board concludes that the activities at issue pose a risk to a depository institution or breach a specific law the Federal Reserve Board has authority to enforce.
Impact of GLBA on activities of subsidiaries of banks:Under GLBA, subject to certain conditions imposed by their respective banking regulators, national and state-chartered banks are permitted to form “financial subsidiaries” that may conduct financial or incidental activities, thereby permitting bank subsidiaries to engage in certain activities that previously were impermissible. In order to insulate the parent bank from the risk of these new financial activities, GLBA imposes several safeguards and restrictions on financial subsidiaries, including that the bank’s equity investment in the financial subsidiary be deducted from the bank’s assets and tangible equity for purposes of calculating the bank’s capital adequacy. In addition, GLBA imposes new restrictions on transactions between the bank and its financial subsidiaries similar to restrictions applicable to transactions between banks and nonbank affiliates. See “FDICIA” and “Other supervision and regulation” below.
Effect of GLBA on bank broker-dealer and investment advisory activities: To promote the system of functional regulation described above, GLBA provides for the amendment of certain federal securities laws to eliminate various exemptions previously available to banks. For example, banks will no longer be generally exempt from the broker-dealer provisions of the Securities Exchange Act of 1934. As a result, JPMorgan Chase’s bank subsidiaries will either need to register with the SEC as broker-dealers or cease conducting many activities deemed broker-dealer activities. GLBA does retain a more limited exemption from broker-dealer registration for certain “banking” products and activities, including, among others, municipal and exempted securities transactions; safe keeping and custody arrangements; and trust, securitization and derivatives products and activities. The Investment Advisers Act of 1940 has also been amended to eliminate certain provisions exempting banks from the registration requirements of that statute, and the Investment Company Act of 1940 has been amended to provide the SEC with regulatory authority over various bank mutual fund activities. The provisions discussed in this paragraph had an original effective date of May 12, 2001. The SEC has delayed the effective date of the provisions dealing with broker-dealer registration requirements until May 12, 2002 and has stated that banks will be given sufficient lead time to comply with the SEC’s implementing regulations.
Dividend restrictions: Federal law imposes limitations on the payment of dividends by the subsidiaries of JPMorgan Chase that are chartered by a state and are member banks of the Federal Reserve System (a “state member bank”) or national banks. Nonbank subsidiaries of JPMorgan Chase are not subject to those limitations. The amount of dividends that may be paid by a state member bank, such as JPMorgan Chase Bank, or by a national bank, such as Chase USA, is limited to the lesser of the amounts calculated under a “recent earnings” test and an “undivided profits” test. Under the recent earnings test, a dividend may not be paid if the total of all dividends declared by a bank in any calendar year is in excess of the current year’s net income combined with the retained net income of the two preceding years, unless the bank obtains the approval of its appropriate federal banking regulator (which, in the case of a state member bank, is the Federal Reserve Board and, in the case of a national bank, is the Office of the Comptroller of the Currency (the “Comptroller of the Currency”)). Under the undivided profits test, a dividend may not be paid in excess of a bank’s “undivided profits.” Similar restrictions on the payment of dividends by JPMorgan Chase Bank are imposed by New York law. See Note 20 on page 88 for the amount of dividends that the Firm’s principal bank subsidiaries could pay, at December 31, 2001 and 2000, to their respective bank holding companies without the approval of their relevant banking regulators.
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In addition to the dividend restrictions described above, the Federal Reserve Board, the Comptroller of the Currency and the Federal Deposit Insurance Corporation (“FDIC”) have authority to prohibit or to limit the payment of dividends by the banking organizations they supervise, including JPMorgan Chase and its bank and bank holding company subsidiaries, if, in the banking regulator’s opinion, payment of a dividend would constitute an unsafe or unsound practice in light of the financial condition of the banking organization.
Capital requirements: The federal banking regulators have adopted risk-based capital and leverage guidelines that require that the Firm’s capital-to-assets ratios meet certain minimum standards.
The risk-based capital ratio is determined by allocating assets and specified off-balance sheet financial instruments into four weighted categories, with higher levels of capital being required for the categories perceived as representing greater risk. Under the guidelines, capital is divided into two tiers: Tier 1 capital and Tier 2 capital. For a further discussion of Tier 1 capital and Tier 2 capital, see Note 21 on page 88. The amount of Tier 2 capital may not exceed the amount of Tier 1 capital. Total capital is the sum of Tier 1 capital and Tier 2 capital.
Banking organizations are required to maintain a total capital ratio (total capital to risk-weighted assets) of 8% and a Tier 1 capital ratio of 4%.
The risk-based capital requirements explicitly identify concentrations of credit risk and certain risks arising from non-traditional activities, and the management of those risks, as important factors to consider in assessing an institution’s overall capital adequacy. Other factors taken into consideration by federal regulators include: interest rate exposure; liquidity, funding and market risk; the quality and level of earnings; the quality of loans and investments; the effectiveness of loan and investment policies; and management’s overall ability to monitor and control financial and operational risks, including the risks presented by concentrations of credit and non-traditional activities. In addition, the risk-based capital rules incorporate a measure for market risk in foreign exchange and commodity activities and in the trading of debt and equity instruments. The market risk-based capital rules require banking organizations with large trading activities (such as JPMorgan Chase) to maintain capital for market risk in an amount calculated by using the banking organizations’ own internal Value-at-Risk models (subject to parameters set by the regulators).
Subject to certain transition rules, the federal banking agencies amended their regulatory capital standards effective January 1, 2002 to address the treatment of residual interests, recourse obligations and direct credit substitutes.
The amendment defines “residual interests” as on-balance sheet interests that are retained by a seller after a securitization or other transfer of financial assets and that expose the seller to a greater thanpro rata share of the credit risk in such assets. Under the amendment, risk-based capital must be held in an amount equal to such residual interests even if that amount exceeds the full risk-based capital charge that would have been required to be held against the assets transferred. The amendment also imposes a concentration limit of 25% of Tier 1 capital on credit-enhancing interest-only strips (a type of residual interest), requiring any amount in excess of that limit to be deducted from Tier 1 capital.
The amendment also treats recourse obligations and direct credit substitutes (such as letters of credit) more consistently for risk-based capital purposes than previously. The amendment introduces a multi-level approach to assessing capital requirements to positions in certain asset securitizations based on the credit ratings assigned to such position by nationally recognized statistical rating organizations (NRSROs). For certain unrated positions other than residual interests, the amendment provides alternative methods for assessing capital requirements, including the limited use of a banking organization’s internal risk rating system, and, for positions arising under securitization programs covering multiple participants, ratings assigned to the program by NRSROs.
Effective April 1, 2002, the federal banking agencies adopted regulations that impose increased capital charges on a banking organization’s equity investments in nonfinancial companies. In general, the new risk-based capital requirements apply to such investments regardless of the legal authority under which they are made. The level of capital charge increases as the banking organization’s concentration in such investments increases. If the aggregate value of a banking organization’s nonfinancial equity investments is less than 15% of its Tier 1 capital, then 8% of such value is required to be deducted from the banking organization’s Tier 1 capital. If the aggregate value of a banking organization’s nonfinancial equity investments is more than 15% but less than 25% of the banking organization’s Tier 1 capital, then the deduction increases to 12% of such value, and if such aggregate value is more than 25% of the banking organization’s Tier 1 capital then the deduction rises to 25%. The new charges do not apply to investments made prior to March 13, 2000. Equity investments made through small business investment companies in an amount up to 15% of the banking organization’s Tier 1 capital are exempt from the new charges, but the full amount of the equity investments are still included when calculating the aggregate value of the banking organization’s nonfinancial equity investments.
The federal banking regulators have established minimum leverage ratio guidelines. The leverage ratio is defined as Tier 1 capital divided by average total assets (net of allowance for loan losses, goodwill and certain intangible assets). The minimum leverage ratio is 3% for strong bank holding companies (i.e., those rated composite 1 under the Bank subsidiaries, Other subsidiaries, Parent company, Earnings and Capital adequacy, or “BOPEC,” rating system) and for bank holding companies that have implemented the Federal Reserve Board’s risk-based capital measure for market risk. Other bank holding companies must have a minimum leverage ratio of 4%. Bank holding companies may be expected to maintain ratios well above the minimum levels depending upon their particular condition, risk profile and growth plans.
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Tier 1 components: capital surplus and common stock remain the most important forms of capital at JPMorgan Chase. Because common equity has no maturity date and because dividends on common stock are paid only when and if declared by the Board of Directors, common equity is available to absorb losses over long periods of time. Noncumulative perpetual preferred stock is similar to common stock in its ability to absorb losses. If the Board of Directors does not declare a dividend on noncumulative perpetual preferred stock in any dividend period, the holders of the instrument are never entitled to receive that dividend payment. JPMorgan Chase’s outstanding noncumulative preferred stock is a type commonly referenced as a “FRAP”: a fixed-rate/adjustable preferred stock. However, because the interest rate on FRAPs may increase (up to a pre-determined ceiling), the Federal Reserve Board treats the Firm’s noncumulative FRAPs in a manner similar to cumulative perpetual preferred and trust preferred securities. The Federal Reserve Board permits cumulative perpetual preferred stock and trust preferred securities to be included in Tier 1 capital but only up to certain limits, as these financial instruments do not provide as strong protection against losses as common equity and noncumulative, non-FRAP securities. Cumulative perpetual preferred stock does not have a maturity date, similar to other forms of Tier 1 capital. However, any dividends not declared on cumulative preferred stock accumulate and thus continue to be due to the holder of the instrument until all arrearages are satisfied. Trust preferred securities are a type of security generally issued by a special purpose trust established and owned by JPMorgan Chase. Proceeds from the issuance to the public of the trust preferred security are lent to the Firm for at least 30 (but not more than 50) years. The intercompany note that evidences this loan provides that the interest payments by JPMorgan Chase on the note may be deferred for up to five years. During the period of any such deferral, no payments of dividends may be made on any outstanding JPMorgan Chase preferred or common stock nor on the outstanding trust preferred securities issued to the public.
Tier 2 components: Long-term subordinated debt (generally having an initial maturity of 10-12 years) is the primary form of JPMorgan Chase’s Tier 2 capital. Subordinated debt is deemed a form of regulatory capital because payments on the debt are subordinated to other creditors of JPMorgan Chase, including holders of senior and medium long-term debt and counterparties on derivative contracts.
Under GLBA, all financial holding companies are bank holding companies for purposes of the capital requirements described above. However, GLBA specifically prohibits the Federal Reserve Board from imposing capital adequacy rules on certain functionally regulated subsidiaries (such as broker-dealers and insurance companies) that are in compliance with the applicable capital requirements of their functional regulators.
The minimum risk-based capital requirements adopted by the federal banking agencies follow the Capital Accord of the Basel Committee on Banking Supervision. The Basel Committee, which is comprised of bank supervisors and central banks from the Group of Ten countries, issued its Capital Accord in 1988 to achieve convergence in the capital regulations applicable to internationally active banking organizations. The Basel Committee issued a proposed replacement for the Capital Accord in January 2001, and, subsequently, it issued a number of working papers supplementing various aspects of that replacement (the “New Accord”). Based on these documents, the New Accord would adopt a three-pillar framework for addressing capital adequacy. These pillars would include minimum capital requirements, more emphasis on supervisory assessment of capital adequacy and greater reliance on market discipline. Under the New Accord, minimum capital requirements would be more differentiated based upon perceived distinctions in creditworthiness. Such requirements would be based either on ratings assigned by rating agencies or, in the case of a banking organization that met certain supervisory standards, on the organization’s internal credit ratings. The minimum capital requirements in the New Accord would also incorporate a capital charge for operational risk. At present, the target date for implementing the New Accord is 2005.
FDICIA: The Federal Deposit Insurance Corporation Improvement Act of 1991 (“FDICIA”) revised certain provisions of the Federal Deposit Insurance Act, as well as certain other federal banking statutes. In general, FDICIA provides for expanded regulation of depository institutions and their affiliates, including parent holding companies, by their federal banking regulators and requires the relevant federal banking regulator to take “prompt corrective action” with respect to a depository institution if that institution does not meet certain capital adequacy standards.
Pursuant to FDICIA, the Federal Reserve Board, the FDIC and the Comptroller of the Currency adopted regulations setting forth a five-tier scheme for measuring the capital adequacy of the depository institutions they supervise. Under the regulations (commonly referred to as the “prompt corrective action” rules), an institution would be placed in one of the following five capital categories when these ratios fall within the prescribed ranges:
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An institution may be treated as being in a capital category lower than that indicated based on other supervisory criteria.
Supervisory actions by the appropriate federal banking regulator under the “prompt corrective action” rules generally will depend upon an institution’s classification within the five capital categories. The regulations apply only to banks and not to bank holding companies such as JPMorgan Chase; however, subject to limitations that may be imposed pursuant to GLBA, as described below, the Federal Reserve Board is authorized to take appropriate action at the holding company level based on the undercapitalized status of the holding company’s subsidiary banking institutions. In certain instances relating to an undercapitalized banking institution, the bank holding company would be required to guarantee the performance of the undercapitalized subsidiary and may be liable for civil money damages for failure to fulfill its commitments on that guarantee.
As of December 31, 2001, each of JPMorgan Chase’s banking subsidiaries was “well-capitalized.”
FDIC insurance assessments: FDICIA also required the FDIC to establish a risk-based assessment system for FDIC deposit insurance. Under the FDIC’s risk-based insurance premium assessment system, each depository institution is assigned to one of nine risk classifications based upon certain capital and supervisory measures and, depending upon its classification, is assessed insurance premiums on its deposits.
Depository institutions insured by the Bank Insurance Fund are required to pay premiums ranging from 0 basis points to 27 basis points of domestic deposits. Each of JPMorgan Chase’s banks, including JPMorgan Chase Bank and Chase USA, currently qualifies for the 0 basis point assessment. Legislation has been introduced in Congress that, if enacted, would require among other things that all depository institutions pay some deposit insurance premiums. In addition, if the ratio of insured deposits to money in the Bank Insurance Fund drops below specified levels the FDIC would be required to impose premiums on all banks insured by the Bank Insurance Fund. All depository institutions must also pay an annual assessment so that the Financing Corporation (“FICO”) may pay interest on bonds it issued in connection with the resolution of savings association insolvencies occurring prior to 1991. The FICO assessment for the first quarter of 2002 is 1.82 basis points of domestic deposits. The rate schedules are subject to future adjustments by the FDIC. In addition, the FDIC has authority to impose special assessments from time to time, subject to certain limitations specified in the Deposit Insurance Funds Act.
Powers of the FDIC upon insolvency of an insured depository institution: An FDIC-insured depository institution can be held liable for any loss incurred or expected to be incurred by the FDIC in connection with another FDIC-insured institution under common control with such institution being in “default” or “in danger of default” (commonly referred to as “cross-guarantee” liability). “Default” is generally defined as the appointment of a conservator or receiver and “in danger of default” is defined as certain conditions indicating that a default is likely to occur absent regulatory assistance. An FDIC cross-guarantee claim against a depository institution is generally superior in right of payment to claims of the holding company and its affiliates against such depository institution.
If the FDIC is appointed the conservator or receiver of an insured depository institution, upon its insolvency or in certain other events, the FDIC has the power: (1) to transfer any of the depository institution’s assets and liabilities to a new obligor without the approval of the depository institution’s creditors; (2) to enforce the terms of the depository institution’s contracts pursuant to their terms; or (3) to repudiate or disaffirm any contract or lease to which the depository institution is a party, the performance of which is determined by the FDIC to be burdensome and the disaffirmance or repudiation of which is determined by the FDIC to promote the orderly administration of the depository institution. The above provisions would be applicable to obligations and liabilities of those of JPMorgan Chase’s subsidiaries that are insured depository institutions, such as JPMorgan Chase Bank and Chase USA, including, without limitation, obligations under senior or subordinated debt issued by those banks to investors (referred to below as “public noteholders”) in the public markets.
Under federal law, the claims of a receiver of an insured depository institution for administrative expenses and the claims of holders of domestic deposit liabilities (including the FDIC, as subrogee of the depositors) have priority over the claims of other unsecured creditors of the institution, including public noteholders, in the event of the liquidation or other resolution of the institution. As a result, whether or not the FDIC ever sought to repudiate any obligations held by public noteholders of any subsidiary of the Firm that is an insured depository institution, such as JPMorgan Chase Bank or Chase USA, the public noteholders would be treated differently from, and could receive, if anything, substantially less than, the depositors of the depository institution.
The USA PATRIOT Act: Following the September 11, 2001 attacks on New York and Washington, D.C., the United States government acted in several ways to tighten control on activities perceived to be connected to money laundering and terrorist funding. Beginning on September 23, 2001, President Bush issued a series of orders which identify terrorists and terrorist organizations and require the blocking of property and assets of, as well as prohibiting all transactions or dealing with, such terrorists, terrorist organizations and those that assist or sponsor them. On October 26, 2001, President Bush signed into law The USA PATRIOT Act of 2001. A number of the provisions of the Act became effective in December 2001; others will go into effect in April and July 2002.
The Act substantially broadens existing anti-money laundering legislation and the extraterritorial jurisdiction of the United States, imposes new compliance and due diligence obligations, creates new crimes and penalties, compels the production of documents located both inside and outside the United States, including those of foreign institutions that have a correspondent relationship in the United States, and clarifies the safe harbor from civil liability to customers. The Act mandates the U.S. Treasury Department to issue a number of regulations to further clarify the Act’s requirements or provide more specific guidance on their application.
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The Act requires all “financial institutions,” as defined, to establish anti-money laundering compliance and due diligence programs no later than April 2002. Such programs must include, among other things, adequate policies, the designation of a compliance officer, employee training programs, and an independent audit function to review and test the program. JPMorgan Chase has had in place, pursuant to previously existing laws and regulations, a “Know Your Customer” policy and an anti-money laundering compliance program which requires, as appropriate based on a risk-based analysis, performing due diligence with respect to establishing the identity and address of the beneficial owners of an account, the source of the account’s funds and the proposed use of the account, as well as requiring the identification and reporting of suspicious transactions to appropriate law enforcement authorities.
The Act requires financial institutions that maintain correspondent accounts for foreign institutions or persons or that are involved in private banking for “non-United States persons” or their representatives, to establish “appropriate, specific and, where necessary, enhanced due diligence policies, procedures, and controls that are reasonably designed to detect and report instances of money laundering through those accounts.” In furtherance of these provisions, the Act mandates specific minimum standards regarding the establishment of private banking accounts and prohibits financial institutions from establishing, maintaining, administering or managing correspondent accounts with any foreign bank that does not have a physical presence in any jurisdiction unless the so-called “shell bank” is affiliated with a regulated physically established bank. JPMorgan Chase will continue to revise and update its “Know Your Customer” policy and its anti-money laundering programs to reflect changes required by the Act, and the U.S. Treasury Department regulations to be issued thereunder, in order to remain in compliance with the Act and its provisions.
Other supervision and regulation:Under current Federal Reserve Board policy, JPMorgan Chase is expected to act as a source of financial strength to its bank subsidiaries and to commit resources to support the bank subsidiaries in circumstances where it might not do so absent such policy. However, because GLBA provides for functional regulation of financial holding company activities by various regulators, GLBA prohibits the Federal Reserve Board from requiring payment by a holding company or subsidiary to a depository institution if the functional regulator of the payor objects to such payment. In such a case, the Federal Reserve Board could instead require the divestiture of the depository institution and impose operating restrictions pending the divestiture.
Subject to the restrictions under GLBA described in the preceding paragraph, any loans by a bank holding company to any of its subsidiary banks are subordinate in right of payment to deposits and to certain other indebtedness of the subsidiary banks. In the event of a bank holding company’s bankruptcy, any commitment by the bank holding company to a federal bank regulatory agency to maintain the capital of a subsidiary bank at a certain level will be assumed by the bankruptcy trustee and entitled to a priority of payment.
The bank subsidiaries of JPMorgan Chase are subject to certain restrictions imposed by federal law on extensions of credit to, and certain other transactions with, the Firm and certain other affiliates and on investments in stock or securities of JPMorgan Chase and those affiliates. These restrictions prevent JPMorgan Chase and other affiliates from borrowing from a bank subsidiary unless the loans are secured in specified amounts.
The Firm’s bank and certain of its nonbank subsidiaries are subject to direct supervision and regulation by various other federal and state authorities (many of which will be considered “functional regulators” under GLBA). JPMorgan Chase Bank as a New York State-chartered bank and a state member bank, is subject to supervision and regulation by the New York State Banking Department as well as by the Federal Reserve Board and the FDIC. JPMorgan Chase’s national bank subsidiaries, such as Chase USA, are subject to substantially similar supervision and regulation by the Comptroller of the Currency. Supervision and regulation by each of the foregoing regulatory agencies generally include comprehensive annual reviews of all major aspects of the relevant bank’s business and condition, as well as the imposition of periodic reporting requirements and limitations on investments and other powers. The Firm also conducts securities underwriting, dealing and brokerage activities through JPMSI and other broker-dealer subsidiaries, all of which are subject to the regulations of the SEC and the National Association of Securities Dealers, Inc. JPMSI is a member of the New York Stock Exchange. The operations of JPMorgan Chase’s mutual funds also are subject to regulation by the SEC. The types of activities in which the foreign branches of JPMorgan Chase Bank and the international subsidiaries of JPMorgan Chase may engage are subject to various restrictions imposed by the Federal Reserve Board. Those foreign branches and international subsidiaries also are subject to the laws and regulatory authorities of the countries in which they operate.
The activities of JPMorgan Chase Bank and Chase USA as consumer lenders also are subject to regulation under various federal laws, including the Truth-in-Lending, the Equal Credit Opportunity, the Fair Credit Reporting, the Fair Debt Collection Practice and the Electronic Funds Transfer Acts, as well as various state laws. These statutes impose requirements on the making, enforcement and collection of consumer loans and on the types of disclosures that need to be made in connection with such loans.
In addition, under the requirements imposed by GLBA, JPMorgan Chase and its subsidiaries are required periodically to disclose to their retail customers the Firm’s policies and practices with respect to (1) the sharing of non-public customer information with JPMorgan Chase affiliates and others and (2) the confidentiality and security of that information. Under GLBA, retail customers also must be given the opportunity to “opt out” of information sharing arrangements with non-affiliates, subject to certain exceptions set forth in GLBA.
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Important factors that may affect future results
From time to time, the Firm has made and will make forward-looking statements. These statements can be identified by the fact that they do not relate strictly to historical or current facts. Forward-looking statements often use words such as “anticipate,” “target,” “expect,” “estimate,” “intend,” “plan,” “goal,” “believe” or other words of similar meaning. Forward-looking statements give JPMorgan Chase’s current expectations or forecasts of future events, circumstances or results. JPMorgan Chase’s disclosure in this report, including in the MD&A section, contains forward-looking statements. The Firm also may make forward-looking statements in its other documents filed with the SEC and in other written materials. In addition, the Firm’s senior management may make forward-looking statements orally to analysts, investors, representatives of the media and others.
Any forward-looking statements made by or on behalf of the Firm speak only as of the date they are made. JPMorgan Chase does not undertake to update forward-looking statements to reflect the impact of circumstances or events that arise after the date the forward-looking statement was made. The reader should, however, consult any further disclosures of a forward-looking nature JPMorgan Chase may make in its Annual Reports on Form 10-K, its Quarterly Reports on Form 10-Q and its Current Reports on Form 8-K.
All forward-looking statements, by their nature, are subject to risks and uncertainties. The Firm’s actual future results may differ materially from those set forth in JPMorgan Chase’s forward-looking statements. Factors that might cause JPMorgan Chase’s future financial performance to vary from that described in its forward-looking statements include the credit, market, operational, liquidity, interest rate and other risks discussed in the MD&A section of this report and in other periodic reports filed with the SEC. In addition, the following discussion sets forth certain risks and uncertainties that the Firm believes could cause its actual future results to differ materially from expected results. However, other factors besides those listed below or discussed in JPMorgan Chase’s reports to the SEC also could adversely affect the Firm’s results, and the reader should not consider any such list of factors to be a complete set of all potential risks or uncertainties. This discussion is provided as permitted by the Private Securities Litigation Reform Act of 1995.
Merger of Chase and J.P. Morgan. JPMorgan Chase may fail to realize the growth opportunities and cost savings anticipated to be derived from the merger of Chase and J.P. Morgan. In addition, the anticipated benefits from the merger may not be realized fully or at all or may take longer to realize than expected. For example, it is possible that the integration process could result in the loss of key employees, the disruption of ongoing businesses or inconsistencies in standards, controls, procedures and policies that could adversely affect JPMorgan Chase’s ability to maintain relationships with employees, clients or suppliers.
Business conditions and general economy. The profitability of JPMorgan Chase’s businesses could be adversely affected by a worsening of general economic conditions in the United States or abroad. During 2001, the global economy was entering into a recession and this challenging environment could persist for some period of time in 2002. Factors such as the liquidity of the global financial markets, the level and volatility of equity prices and interest rates, investor sentiment, inflation, and the availability and cost of credit could significantly affect the activity level of clients with respect to size, number and timing of transactions effected by the Firm’s investment banking business, including its underwriting and advisory businesses, and also may affect the realization of cash returns from JPMorgan Chase’s private equity business. A continued market downturn would likely lead to a decline in the volume of transactions that JPMorgan Chase executes for its customers and, therefore, lead to a decline in the revenues it receives from commissions and spreads. Higher interest rates or a downturn in the market also could impact the willingness of financial investors to participate in loan syndications or underwritings managed by JPMorgan Chase. The Firm generally maintains large trading portfolios in the fixed income, currency, commodity and equity markets and has significant investment positions, including merchant banking investments at JPMorgan Partners. The revenues derived from mark-to-market values of JPMorgan Chase’s business are affected by many factors, including JPMorgan Chase’s credit standing; its success in proprietary positioning; volatility in interest rates and in equity and debt markets; and the economic, political and business factors described below. JPMorgan Chase anticipates that these revenues will experience volatility from time to time. A continued market downturn or worsening of the economy could cause the Firm to incur mark-to-market losses in the values of these positions.
A market downturn also could result in a decline in the fees JPMorgan Chase earns for managing assets. For example, a higher level of domestic or foreign interest rates or a downturn in trading markets could affect the flows of moneys to or from the mutual funds managed by the Firm. Moreover, even in the absence of a market downturn, below-market performance by JPMorgan Chase’s mutual funds could result in a decline in assets under management and, therefore, in the fees it receives.
An economic downturn or significantly higher interest rates could adversely affect the credit quality of JPMorgan Chase’s on-balance sheet and off-balance sheet assets by increasing the risk that a greater number of the Firm’s customers would become delinquent on their loans or other obligations to JPMorgan Chase. Further, a continuing challenging economic environment could lead to a higher rate of delinquencies by customers or counterparties which, in turn, would result in a higher level of charge-offs and a higher level of provision for JPMorgan Chase, all of which could adversely affect the Firm’s earnings. See also “Factors affecting allowances for credit losses” below.
7
Competition. JPMorgan Chase operates in a highly competitive environment and expects various factors to cause competitive conditions to continue to intensify. For example, technological advances and the growth of e-commerce have made it possible for non-depository institutions to offer products and services that traditionally were banking products and for financial institutions to compete with technology companies in providing electronic and Internet-based financial solutions. In addition, the Firm expects cross-industry competition to continue to intensify, particularly as continued merger activity in the financial services industry produces larger, better-capitalized companies that are capable of offering a wider array of financial products and services.
Foreign operations; trading in foreign securities. The Firm does business throughout the world, including in developing regions of the world commonly known as emerging markets. JPMorgan Chase’s businesses and revenues derived from foreign operations are subject to risk of loss from unfavorable political and diplomatic developments, currency fluctuations, social instability, changes in governmental policies or policies of central banks, expropriation, nationalization, confiscation of assets and changes in legislation relating to foreign ownership. JPMorgan Chase also invests in the securities of corporations located in foreign jurisdictions, including emerging markets. Revenues from the trading of foreign securities also may be subject to negative fluctuations as a result of the above factors. The impact of these fluctuations could be accentuated because, generally, foreign trading markets, particularly in emerging market countries, are smaller, less liquid and more volatile than U.S. trading markets.
Operational risk. JPMorgan Chase, like all large corporations, is exposed to many types of operational risk, including the risk of fraud by employees or outsiders, unauthorized transactions by employees or operational errors, including clerical or recordkeeping errors or errors resulting from faulty computer or telecommunications systems. Given the high volume of transactions at JPMorgan Chase, certain errors may be repeated or compounded before they are discovered and successfully rectified. In addition, the Firm’s necessary dependence upon automated systems to record and process its transaction volume may further increase the risk that technical system flaws or employee tampering or manipulation of those systems will result in losses that are difficult to detect. Although JPMorgan Chase maintains a system of controls designed to keep operational risk at appropriate levels, the Firm has in the past suffered losses from operational risk, and there can be no assurance that JPMorgan Chase will not suffer losses from operational risks in the future.
Government monetary policies and economic controls.JPMorgan Chase’s businesses and earnings are affected by general economic conditions, both domestic and international. JPMorgan Chase’s businesses and earnings also are affected by the fiscal or other policies that are adopted by various regulatory authorities of the U.S., foreign governments and international agencies. For example, policies and regulations of the Federal Reserve Board influence, directly and indirectly, the rate of interest paid by commercial banks on their interest-bearing deposits and also may impact the value of financial instruments held by the Firm. These actions of the Federal Reserve Board also determine to a significant degree the cost to JPMorgan Chase of funds for lending and investing. The nature and impact of future changes in economic and market conditions and fiscal policies are not predictable and are beyond JPMorgan Chase’s control. In addition, these policies and conditions can impact the Firm’s customers and counterparties, both in the U.S. and abroad, which may increase the risk that such customers or counterparties default on their obligations to JPMorgan Chase.
Credit, market, liquidity and private equity risk. JPMorgan Chase’s revenues also are dependent upon the extent to which management can successfully achieve its business strategies within a disciplined risk environment. JPMorgan Chase’s ability to grow its businesses is affected by pricing and competitive pressures, as well as by the costs associated with the introduction of new products and services and the expansion and development of new distribution channels. The ability of management to utilize the “Shareholder Value Added” methodology to evaluate investment opportunities and the ability to maintain expense discipline will be important factors in determining the extent to which the Firm achieves its financial targets. For a further discussion of the Shareholder Value Added methodology, see Segment results on page 29. In addition, to the extent any of the instruments and strategies JPMorgan Chase uses to hedge or otherwise manage its exposure to market, credit and private equity risk are not effective, the Firm may not be able to mitigate effectively its risk exposures in particular market environments or against particular types of risk. JPMorgan Chase’s balance sheet growth will be dependent upon the economic conditions described above, as well as upon discretionary decisions as to how properly to determine and assess cost of credit, concentration of risk and credit limits for portfolio diversification and whether to securitize, sell, purchase or syndicate particular loans or loan portfolios. JPMorgan Chase’s trading revenues and interest rate risk are dependent upon its ability to identify properly changes in the value of financial instruments caused by changes in market prices or rates. The successful management of credit, market, operational and private equity risk is an important consideration in managing the Firm’s liquidity risk, as evaluation by rating agencies of the management of these risks affects their determinations as to the Firm’s credit ratings and, therefore, its cost of funds.
Factors affecting allowances for credit losses. Estimating losses for purposes of determining the appropriate level of the allowance for credit losses is inherently uncertain. In addition, the estimation process assumes that past experience is a valid indicator for estimating prospective losses, which may not always be the case. For a further discussion of the Firm’s allowance for credit losses and the assumptions employed by management in determining the allowance for credit losses, see pages 41, 54, and 76-77.
8
Foreign operations
For geographic distributions of total revenue, total expense, income before income tax expense and net income, see Note 28 on page 95. For a discussion of foreign loans, see Note 8 on page 76 and the sections entitled “Commercial loans” and “Country exposure” in the MD&A on pages 51 through 52 and “Cross-border outstandings” on page 109.
Item 2: Properties
The headquarters of JPMorgan Chase is located in New York City at 270 Park Avenue, which is a 50-story bank and office building owned by JPMorgan Chase. This location contains approximately 1.3 million square feet of commercial office and retail space.
JPMorgan Chase occupies or is in the process of readying for occupancy approximately 2.2 million square feet of leased office space in two midtown Manhattan office buildings, 277 Park Avenue and 245 Park Avenue. JPMorgan Chase also has a number of other large office leaseholds in various locations in Manhattan.
JPMorgan Chase owns and occupies a 60-story building at One Chase Manhattan Plaza in New York City. This location has approximately 2 million square feet of commercial office and retail space, of which approximately 800,000 square feet is leased to outside tenants.
JPMorgan Chase also owns and occupies a 22-story building at 4 New York Plaza, New York City, with 900,000 square feet of commercial office and retail space.
On November 1, 2001 JPMorgan Chase sold to an affiliate of Deutsche Bank AG, its building at 60 Wall Street in New York City, a 47-story bank and office building comprising approximately 1.6 million square feet. At the time of the sale, JPMorgan Chase leased back approximately 1.3 million square feet for its operations. JPMorgan Chase is vacating and turning over the leased back space to Deutsche Bank AG in phases with the final phase to be delivered by December 31, 2002, subject to extension with respect to two floors.
JPMorgan Chase entered into a contract with the City of New York dated May 31, 2001 to sell to the City of New York or its designee the two-building complex at 23 Wall Street/15 Broad Street in New York City comprising approximately 1 million square feet of commercial office and retail space. The City of New York and the New York Stock Exchange had previously announced their intention to build a new Exchange on the land currently occupied by these facilities. JPMorgan Chase vacated these facilities in anticipation of closing the sale on or before the originally contractually specified date of December 31, 2001. Following the attack on the World Trade Center on September 11, 2001, the City of New York requested that JPMorgan Chase license the facilities to the New York Economic Development Agency so that it could sublicense them to The Bank of New York which had been displaced from certain of its properties by damage that occurred to them on September 11, 2001. The license expired on December 31, 2001, but The Bank of New York remains in the property under “hold-over” provisions of the license. The closing date with the City of New York is currently under review.
JPMorgan Chase built in 1992 and fully occupies a two-building complex known as Chase MetroTech Center in downtown Brooklyn, New York. This facility contains approximately 1.75 million square feet and houses, among other things, operations and product support functions.
In 2000 JPMorgan Chase entered into leases for two “build to suit” office buildings at The Newport Office Center in Jersey City, New Jersey. The first of the two buildings comprising approximately 800,000 square feet of office and retail space is available for occupancy and JPMorgan Chase operations are relocating there as interior spaces are completed. The second building comprising approximately 332,000 square feet of office and retail space is expected to be fully occupied by JPMorgan Chase in 2002.
JPMorgan Chase and its subsidiaries also own and occupy administrative and operational facilities in Hicksville, New York; Tampa, Florida; Tempe, Arizona; Newark, Delaware; and in Houston, Arlington and El Paso, Texas.
JPMorgan Chase occupies, in the aggregate, approximately 2.9 million square feet of space in the United Kingdom. The most significant components of leased space in London are 350,000 square feet at 125 London Wall, 325,000 square feet at Aldermanbury, 211,000 square feet at One Angel Court and a 715,000 square-foot office complex at 60 Victoria Embankment. JPMorgan Chase also owns and occupies a 300,000 square-foot operations center in Bournemouth. JPMorgan Chase previously owned 60 Victoria Embankment subject to a financing arrangement which involved the sale of a partial interest in this complex to the lender. In 2001, JPMorgan Chase sold its remaining ownership interest in this property, but remains in occupancy as lessee.
In addition, JPMorgan Chase and its subsidiaries occupy branch offices and other administrative and operational facilities through-out the U.S. and in foreign countries under various types of ownership and leasehold agreements.
The majority of the properties occupied by JPMorgan Chase are used across all of JPMorgan Chase’s business segments and for corporate purposes.
As part of the Firm’s merger integration efforts, JPMorgan Chase has begun, and will continue, to combine and consolidate redundant operations conducted by both predecessor firms. For a further discussion of the Firm’s merger and restructuring costs, see page 44 and Note 6 on page 73.
9
Item 3: Legal proceedings
In June 1999, Sumitomo Corporation filed a lawsuit against The Chase Manhattan Bank (“Chase Bank”) in the United States District Court for the Southern District of New York. The complaint alleges that during the period from 1994 to 1996, Chase Bank assisted a Sumitomo employee in making copper trades by funding unauthorized loans to the Sumitomo employee. The complaint alleges that Chase Bank knew the employee did not have authority to enter into the transactions on behalf of Sumitomo. The complaint asserts claims under the Racketeer Influenced and Corrupt Practices Act (“RICO”) and New York common law and alleges damages of $532 million (subject to trebling under RICO), plus punitive damages.
In August 1999, Sumitomo Corporation filed a separate action against J.P. Morgan & Co. Incorporated, Morgan Guaranty Trust Company of New York, and a former J.P. Morgan employee (collectively “Morgan”) in the United States District Court for the Southern District of New York. The complaint in this action contains allegations, similar to the allegations in the complaint filed by Sumitomo against Chase Bank, that during the period from 1993 to 1996, Morgan assisted a Sumitomo employee in making copper trades by funding unauthorized loans to the Sumitomo employee. The complaint alleges that Morgan knew the employee did not have authority to enter into the transactions on behalf of Sumitomo. The complaint asserts claims under RICO and New York common law and alleges damages of $735 million (subject to trebling under RICO), plus punitive damages. The separate actions against Chase Bank and Morgan have been consolidated for discovery purposes.
J.P. Morgan Securities Inc. (“JPMSI”; formerly known as Chase Securities Inc.) has been named as a defendant or third-party defendant in 16 actions that were filed in either the United States District Court for the Northern District of Oklahoma or in Oklahoma state court beginning in October 1999 arising out of the failure of Commercial Financial Services, Inc. (“CFS”). Plaintiffs in these actions are institutional investors who purchased over $1.6 billion in original face amount of asset-backed securities issued by CFS. The securities were backed by delinquent credit card receivables. In addition to JPMSI, the defendants in various of the actions are the founders and key executives of CFS, as well as its auditors, its outside counsel and the rating agencies that rated the securities. JPMSI is alleged to have been the investment banker to CFS and to have acted as an initial purchaser and as placement agent in connection with the issuance of certain of the securities. Plaintiffs allege that defendants either knew or were reckless in not knowing that the securities were sold to plaintiffs on the basis of misleading misrepresentations and omissions of material facts. The complaints against JPMSI assert claims under the Securities Exchange Act of 1934, the Oklahoma Securities Act, and under common law theories of fraud and negligent misrepresentation. In the actions against JPMSI, damages in the amount of approximately $1.2 billion allegedly suffered as a result of defendants’ misrepresentations and omissions, plus punitive damages, are being claimed.
JPMorgan Chase is involved in a number of lawsuits arising out of its banking relationships with Enron Corp. The Firm initiated a lawsuit in New York in December 2001 against 11 insurance companies. That suit seeks payment of $965 million under Enron-related surety bonds issued by those companies. The Firm also commenced a lawsuit in London against Westdeutsche Landesbank Girozentrale (“WLB”) seeking to compel payment of $165 million under an Enron-related letter of credit issued by WLB. On March 5, 2002, the court in New York denied the Firm’s motion for summary judgment against the insurance companies, ordered discovery, and set a trial date of December 2, 2002. JPMorgan Chase intends to pursue both litigations vigorously. Actions have also been initiated by other parties against JPMorgan Chase and its directors and certain of its officers. Among these, as of March 18, 2002, are five shareholder derivative actions pending against the directors of the firm. These derivative actions were filed in Delaware and New York and seek to redress alleged breaches of fiduciary duties and alleged failures to exercise due care and diligence by the Firm’s directors in the management of JPMorgan Chase. Also pending, as of March 18, 2002, are nine purported class action lawsuits against the Firm and certain of its officers, all in New York, alleging that the Firm issued false and misleading press releases and other public documents relating to Enron in violation of Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder. JPMorgan Chase believes that the lawsuits filed against the Firm, its directors and the named officers are without merit and it intends to defend these actions vigorously. However, there can be no assurance as to the outcome of any of these pending lawsuits or of any other litigation or proceeding that may be brought by or against JPMorgan Chase relating to Enron.
In addition to the matters described above, JPMorgan Chase and its subsidiaries have been named from time to time as defendants in various legal actions and proceedings arising in connection with their respective businesses and have been involved from time to time in investigations and proceedings by governmental agencies. In view of the inherent difficulty of predicting the outcome of such matters, JPMorgan Chase cannot state what the eventual outcome of pending matters will be. JPMorgan Chase is contesting the allegations made in each pending matter and believes, based on current knowledge and after consultation with counsel, that the outcome of such matters will not have a material adverse effect on the consolidated financial condition of JPMorgan Chase but may be material to JPMorgan Chase’s operating results for any particular period, depending on the level of JPMorgan Chase’s income for such period.
Item 4: Submission of matters to a vote of security holders
None.
10
Executive officers of the registrant
Unless otherwise noted, during the five fiscal years ended December 31, 2001, all of JPMorgan Chase’s above-named executive officers have continuously held senior-level positions with JPMorgan Chase or its predecessor institutions, J.P. Morgan & Co. Incorporated and The Chase Manhattan Corporation. There are no family relationships among the foregoing executive officers.
11
Parts II, III & IV
Part II
Item 5: Market for registrant’s common equity and related stockholder matters
The outstanding shares of JPMorgan Chase’s common stock are listed and traded on the New York Stock Exchange, the London Stock Exchange Limited and the Tokyo Stock Exchange. For the quarterly high and low prices of JPMorgan Chase’s common stock on the New York Stock Exchange for the last two years, see the section entitled “Supplementary information – selected quarterly financial data (unaudited)” on page 99. JPMorgan Chase declared quarterly cash dividends on its common stock in the amount of $0.34 per share for each quarter of 2001 and $0.32 per share for each quarter of 2000. At February 28, 2002, there were 135,359 holders of record of JPMorgan Chase’s common stock. During the fourth quarter of 2001, shares of common stock of J.P.Morgan Chase & Co. were issued in transactions exempt from registration under the Securities Act of 1933 pursuant to Section 4(2) thereof as follows: 6,966 shares of common stock were issued to active directors on December 3, 2001 and 505 shares were issued on October 1, 2001 to a retired director who had deferred receipt of such common stock pursuant to the Deferred Compensation Plan for Non-Employee Directors.
Item 6: Selected financial data
For five-year selected financial data, see “Five-year summary of financial highlights (unaudited)” on page 23.
Item 7: Management’s discussion and analysis of financial condition and results of operations
Management’s discussion and analysis of the financial condition and results of operations, entitled “Management’s discussion and analysis,” appears on pages 24 through 63.
Item 7A: Quantitative and qualitative disclosures about market risk
For information related to market risk, see the “Market risk management” section on pages 55 through 57 and Note 24 on page 90.
Item 8: Financial statements and supplementary data
The consolidated financial statements, together with the notes thereto and the report of PricewaterhouseCoopers LLP dated January 15, 2002 thereon, appear on pages 64 through 98.
Supplementary financial data for each full quarter within the two years ended December 31, 2001 are included on page 99 in the table entitled “Supplementary information – selected quarterly financial data (unaudited).” Also included is a “Glossary of terms’’ on pages 100 and 101.
Item 9: Changes in and disagreements with accountants on accounting and financial disclosure
Part III
Item 10: Directors and executive officers of JPMorgan Chase
See Item 13 below.
Item 11: Executive compensation
Item 12: Security ownership of certain beneficial owners and management
Item 13: Certain relationships and related transactions
Information related to JPMorgan Chase’s Executive Officers is included on page 11. Pursuant to Instruction G (3) to Form 10-K, the remainder of the information to be provided in Items 10, 11, 12 and 13 of Form 10-K (other than information pursuant to Item 402 (i), (k) and (l) of Regulation S-K) is incorporated by reference to JPMorgan Chase’s definitive proxy statement for the annual meeting of stockholders, to be held May 21, 2002, which proxy statement will be filed with the Securities and Exchange Commission pursuant to Regulation 14A within 120 days of the close of JPMorgan Chase’s 2001 fiscal year.
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Part IV
Item 14: Exhibits, financial statement schedules and reports on Form 8-K
(A) Exhibits, financial statements and financial statement schedules
13
14
15
16
JPMorgan Chase hereby agrees to furnish to the Securities and Exchange Commission, upon request, copies of instruments defining the rights of holders for the outstanding nonregistered long-term debt of JPMorgan Chase and its subsidiaries. These instruments have not been filed as exhibits hereto by reason that the total amount of each issue of such securities does not exceed 10% of the total assets of JPMorgan Chase and its subsidiaries on a consolidated basis. In addition, JPMorgan Chase hereby agrees to file with the Securities and Exchange Commission, upon request, the Guarantees and the Amended and Restated Trust Agreements for each Delaware business trust subsidiary that has issued Capital Securities. The provisions of such agreements differ from the documents constituting Exhibits 4.8(b) and (c) and 4.9(b) and (c) to this report only with respect to the pricing terms of each series of Capital Securities; these pricing terms are disclosed in Note 11 on page 81.
(B) Reports on Form 8-K
Pages 18-21 not used
17
financial table of contents
This section of the Annual Report provides management’s discussion and analysis (“MD&A”) of the financial condition and results of operations for JPMorgan Chase. See Glossary of terms on pages 100 and 101 for a definition of terms used throughout this Annual Report.
Certain forward-looking statements
The MD&A contains certain forward-looking statements. Those forward-looking statements are subject to risks and uncertainties, and JPMorgan Chase’s actual results may differ from those set forth in the forward-looking statements. See JPMorgan Chase’s reports filed with the Securities and Exchange Commission for a discussion of factors that could cause JPMorgan Chase’s actual results to differ materially from those described in the forward-looking statements.
22 JPMorgan Chase 2001 Annual Report
five-year summary of financial highlightsJ.P. Morgan Chase & Co.
(unaudited)
JPMorgan Chase 2001 Annual Report 23
management’s discussion and analysisJ.P. Morgan Chase & Co.
J.P. Morgan Chase & Co. (“JPMorgan Chase” or “the Firm”) is a leading global financial services firm with assets of nearly $700 billion and operations in more than 50 countries. JPMorgan Chase has relationships with over 99% of the Fortune 1000 companies and serves more than 30 million consumers. The Firm is comprised of five business segments: Investment Bank, Treasury & Securities Services, Investment Management & Private Banking, JPMorgan Partners, and Retail & Middle Market Financial Services.
Financial performance of JPMorgan Chase
In 2001, JPMorgan Chase’s reported net income, which includes merger and restructuring costs, was $1,694 million, or $0.80 per share. This compares with $5,727 million, or $2.86 per share, in 2000. Operating income was $3,409 million in 2001, compared with $5,927 million last year. Operating earnings per share were $1.65, compared with $2.96 in 2000.
These results reflect a challenging economic environment that, in varying degrees, negatively affected activity, spreads and values in each of the Firm’s major business segments. During 2001, the global economy was moving into a recession, as evidenced by significant reductions in asset values globally, lower liquidity in equity and equity-related markets, sharply reduced mergers and acquisitions (“M&A”) activity and related declines in overall capital markets activity. These factors also contributed to cyclical credit pressures on both consumer and commercial financing markets.
While these economic and market pressures negatively affected 2001 operating performance, the pace of merger integration was on or ahead of plan, and this progress was enhanced by the franchise- and brand-power of the newly merged company. Market share gains in investment banking were realized as clients embraced the JPMorgan Chase business model as one that contributes to their success and financial flexibility. The investment management and private banking business successfully completed its merger integration and expense initiatives in 2001. Operating services and consumer businesses continued to produce solid returns and to execute on efficiency plans. JPMorgan Chase is well-positioned to produce higher returns when the economy recovers.
Key events for full-year 2001
Summary results by segment
Though revenue and cash operating earnings in the Investment Bank(“IB”) were lower in 2001 than in 2000, expenses were significantly reduced. The IB’s overhead ratio in 2001 reached its target of 60% for the year. Leadership positions across product categories
24 JPMorgan Chase 2001 Annual Report
were improved or maintained, and equities, a strategic priority, made important strides towards reaching its goals. Higher credit costs, including additions to the loan loss allowance, more than offset these positives and contributed to lower earnings.
Three businesses make up the Treasury & Securities Services (“T&SS”) segment. Two of these, Treasury Services and Institutional Trust Services, posted revenue and earnings growth from 2000. Revenues and income in Investor Services, the largest of the three, decreased due to declining market transaction volumes and values. Treasury & Securities Services provides an important diversification benefit to the Firm and had a 24% ROCE for the year.
The Investment Management & Private Banking (“IMPB”) segment was hard hit by declines in asset values and shifts in asset mix from equities to fixed income and money market products. In addition, the disappearance of the domestic technology initial public offering (“IPO”) market and the downturn in the Japanese equity markets negatively impacted IMPB’s results. With assets under management of $605 billion, JPMorgan Chase is one of the top five active asset managers in the world. The private bank continued to win new clients and an increased share of existing clients’ assets. Expense discipline was strong in both businesses; however, with lower revenues, the unit saw its margin decline from last year.
Retail & Middle Market Financial Services (“RMMFS”) posted revenue growth of 7%, driven by strong production, with record originations in Cardmember Services, Home Finance and Auto Finance. Cardmember Services realized double-digit revenue and earnings growth despite higher credit costs. The deposit businesses were hurt by declining interest rates despite growth in the deposit base. Expenses grew at a lower rate than revenues. A 35% increase in RMMFS’s credit costs, including an addition to the loan loss allowance, resulted in cash operating earnings declining 5%.
JPMorgan Partners’ public and private portfolios were negatively affected by the market conditions in 2001. Unrealized losses of $1,857 million more than offset realized gains of $675 million for the year. Many of the losses were attributable to write-downs in the values of the telecommunications companies in the portfolio. At the same time, sluggish M&A and IPO market activity negatively affected JPMP’s ability to exit investments, significantly slowing the pace of realized gains. However, JPMorgan Chase continues to believe that JPMP’s unique approach to investing across industries, types of investments and regions will lead to positive shareholder value added (“SVA”) and improved returns in the future.
Expense management
The Firm aggressively reduced expenses in 2001 through both merger-related and right-sizing initiatives. Cash operating expenses in 2001 were reduced $1.9 billion from a pro forma 2000 base which assumes that the purchase of Robert Fleming Holdings Limited (“Flemings”) occurred at the beginning of 2000. Expense reductions exceeded the original management target to hold expenses flat. Expense reductions occurred in businesses that were merging and which also had to align their costs with lower revenues. Businesses of the Firm not directly affected by the merger also focused on efficiency gains through the use of tools like Six Sigma.
JPMorgan Chase 2001 Annual Report 25
The Firm enters 2002 with the momentum of declining expenses. The 2001 fourth quarter operating expense run rate of $19.6 billion (which is the annualized amount of fourth quarter expenses adjusted for full-year incentives) is almost $3 billion lower than the run rate in the fourth quarter of 2000. This reduction was driven by merger savings and other cost reductions as well as lower incentives resulting from the decline in revenues. In 2001, management increased the original target of merger expense savings and cost reductions related to right-sizing efforts from $2.0 billion to $3.8 billion; 100% of these savings are anticipated to be realized by the end of 2002. The merger and restructuring costs related to achieving these additional savings also increased. For a more detailed discussion, refer to page 44 and Note 6 on page 73.
Risk management
The Firm focuses on risk distribution and on diversification, with a significant weighting of its credit portfolios toward investment-grade companies. The Firm’s ability to assist its clients in risk management was affirmed this year by various industry publications’ awards.
The Firm is operating in a recessionary environment. For the first time in many years, the loan loss provision exceeded loan charge-offs, leading to a higher loan loss allowance. Nonperforming assets rose substantially in 2001. The Firm’s focus is on distribution of credit and on continuing the reduction of its commercial credit exposure, both on- and off-balance sheet. The capacity and willingness to extend JPMorgan Chase’s balance sheet to clients is an important competitive advantage.
Capital management
The Firm is committed to maintaining strong capital ratios, including a Tier 1 capital ratio in the range of 8% to 8.25%. At the end of 2001, the ratio was 8.3%.
SVA discipline is applied to all investments and remains a critical performance metric for evaluating transactions and segment results. In July 2001, the Board of Directors authorized the repurchase of up to $6 billion of JPMorgan Chase’s common stock, net of issuance for employee benefit plans. For a further discussion of the Firm’s repurchase program, refer to the Capital management section on page 46.
26 JPMorgan Chase 2001 Annual Report
The Firm prepares its financial statements using generally accepted accounting principles (“GAAP”) in the United States of America. The primary financial statements prepared in accordance with GAAP appear on pages 65-68 of this Annual Report. This presentation, which is referred to as “reported basis,” provides the reader with an understanding of the Firm’s results that can be consistently tracked from year to year and enables a comparison of the Firm’s performance with other companies’ GAAP financial statements.
In addition to analyzing the Firm’s results on a reported basis, management utilizes “operating basis” to assess each of its businesses and to measure overall Firm results against targeted goals. The definition of operating basis starts with the reported GAAP results and then excludes the impact of merger and restructuring costs and special items, which usually are significant nonrecurring gains or losses. Management generally defines “special items” as nonrecurring revenue or expense events of $50 million or more. Both restructuring charges and special items are viewed by management as transactions that are not part of the Firm’s normal daily business operations or are unusual in nature and are therefore not indicative of trends.
Operating results also exclude the impact of credit card securitizations. JPMorgan Chase periodically securitizes a portion of its credit card portfolio by selling a pool of credit card receivables to a trust, which issues securities to investors. When credit card receivables are securitized, the Firm ceases to accrue interest and credit costs on the receivables and, instead, receives net fee revenue for continuing to service those receivables. As a result, securitization does not affect JPMorgan Chase’s reported or operating net income; however, it does affect the classification of items in the Consolidated statement of income.
Management also utilizes the term “cash operating earnings,” defined as operating earnings excluding the impact of amortization of intangibles. Commencing January 1, 2002, the Firm adopted SFAS 142. Adoption of that accounting standard will eliminate the need for management, in assessing the Firm’s performance, to add back the amortization of intangibles, as GAAP reported results will become substantially closer to cash earnings. For a further discussion of the impact of SFAS 142, see the Accounting and reporting developments section on page 62.
Within the MD&A section of the Annual Report, particularly the Segment results on pages 28-41 and the consolidated Results of operations for the Firm on pages 42-45, management provides a discussion of the results for 2001 and 2000 as well as a comparative discussion of the results for 2000 pro forma. The 2000 pro forma results assume that the purchase of Flemings occurred at the beginning of 2000 rather than at the time of purchase in August 2000.
The following summary table provides a reconciliation between the Firm’s reported and its operating and cash operating results.
JPMorgan Chase 2001 Annual Report 27
Segment results
The wholesale commercial and private banking businesses are known globally as “JPMorgan” and encompass the Investment Bank, Treasury & Securities Services, Investment Management & Private Banking and JPMorgan Partners. The retail businesses of JPMorgan Chase are known as “Chase,” consisting of Retail & Middle Market Financial Services.
The table below provides summary financial information on a cash operating basis for the five major business segments. Management tracks the operating performance of the Firm both including and excluding the results of JPMP. Management believes that it is more informative to analyze separately the results of JPMP and the results of the Firm excluding JPMP as the basis for valuing the Firm.
For the businesses that were affected by the Flemings acquisition, all comparisons with 2000 are on a pro forma basis, which assumes that the purchase of Flemings occurred at the beginning of 2000. See Note 29 for further information about JPMorgan Chase’s five business segments.
28 JPMorgan Chase 2001 Annual Report
JPMorgan Chase’s segment results reflect the manner in which financial information currently is evaluated by the Firm’s management.
The Firm allocates equity to its business units utilizing a risk-adjusted methodology, which quantifies credit, market and operating risks within each business and, for JPMP, private equity risk. For a discussion of those risks, see the Risk management section on pages 45-62. The Firm also allocates equity to its businesses incorporating an “asset capital tax” on managed assets and some off-balance sheet instruments. In addition, businesses are allocated equity equal to 100% of goodwill and certain intangibles generated through acquisitions.
For the Firm, the SVA framework applies a 12% cost of equity. To derive SVA for businesses, JPMorgan Chase applies a 12% cost of equity for all businesses except JPMorgan Partners. This business is charged a 15% cost of equity. All prior periods have been restated to conform with the current presentation.
The capital elements and resultant capital charges provide the businesses with the financial framework to evaluate the trade-off between the use of capital by the business unit versus its return to the shareholders. The capital charges are an integral part of the SVA measurement for each business. See Glossary of terms on page 101 for a definition of SVA.
Restatements of segment results may occur in future periods to reflect further alignment of management accounting policies or changes in organizational structure among businesses.
Contribution of businesses (2000 results are on a pro forma basis where applicable)
Segment results (continued)
JPMorgan Chase 2001 Annual Report 29
Investment Bank
Combining the best of investment and commercial banking, the Investment Bank serves the financial needs of corporations, financial institutions, governments and institutional investors. It uses an integrated delivery model that leverages scale, global presence and broad leadership positions. The Investment Bank advises on corporate strategy, raises capital and designs risk management solutions. It also provides market making and distribution of a broad range of financial instruments.
Financial results overviewIn a challenging market environment in 2001, the Investment Bank’s cash operating margin declined 2% from last year’s pro forma results. Operating revenue declined 11%, driven by the substantial reduction in market activity for M&A and equity underwriting. This was largely offset by a 16% decline in cash expenses from the prior year. The Investment Bank met its 2001 overhead ratio target of 60%, which was down from 64% a year ago. Results included approximately $800 million in pre-tax charges related to Enron and Argentina as well as higher loan charge-offs and additions to the loan loss allowance. As a result of these factors, cash operating earnings declined 18%.
In a challenging market environment in 2001, the Investment Bank’s cash operating margin declined 2% from last year’s pro forma results. Operating revenue declined 11%, driven by the substantial reduction in market activity for M&A and equity underwriting. This was largely offset by a 16% decline in cash expenses from the prior year. The Investment Bank met its 2001 overhead ratio target of 60%, which was down from 64% a year ago. Results included approximately $800 million in pre-tax charges related to Enron and Argentina as well as higher loan charge-offs and additions to the loan loss allowance. As a result of these factors, cash operating earnings declined 18%.
Financial line-item discussionTrading-related revenues, which include trading-related net interest income, were lower by 10%. The decline was primarily attributable to lower equity-related trading results, driven by lower margins in equity securities and reduced demand for equity derivatives. Also contributing to the decline was $359 million of losses related to exposure to Enron and Argentina infixed income trading. Excluding the effects of Enron and Argentina, fixed income and other trading was up 3%, as weaker performance in emerging markets was more than offset by strong results in interest rate trading products.
Investment banking fees were 20% lower than last year, driven by the overall market decline in equity underwriting and M&A activities. These declines were partially offset by record investment-grade bond underwriting fees. Advisory revenues declined 34%, while overall market volume was down 50%. The Investment Bank increased its market share in global announced M&A transactions during 2001.
Underwriting and other fees declined 10%, reflecting significantly lower equity underwriting activity, partially offset by higher bond underwriting fees. Record bond issuance for the market was driven by the favorable interest rate market environment.
2001 highlights
30 JPMorgan Chase 2001 Annual Report
Dimensions of revenue diversification
Important leadership positions were maintained in leveraged and syndicated lending (ranked No.1) and U.S. investment-grade debt underwriting (No. 2). The Investment Bank’s equity underwriting business lost market share relative to the prior year, but increased market share in each of the quarters of 2001, culminating with a market share of 8% (ranked No. 6) in the 2001 fourth quarter. In addition, the Investment Bank was named “Bank of the Year” by International Financing Review and “Derivatives House of the Year” byRisk magazine.
The increase in net interest income of 14% from last year was primarily due to the Firm’s interest rate risk management in a declining rate environment.
Fees and commissions declined 21% from the prior year, reflecting lower equity brokerage commissions.
The decrease in all other revenue was attributable to negative valuation adjustments taken against syndicated loans that are held for sale. Partly offsetting the decrease were higher gains on sales of available-for-sale securities as part of the Firm’s interest rate risk management activity.
Cash operating expense declined 16% from 2000. Included in the decline was the impact of reduced headcount and lower incentive compensation expense. Compensation as a percentage of revenue decreased from 42% in 2000 to 39% in 2001 despite lower revenues. Since the merger announcement date, the Investment Bank has reduced staff levels by approximately 6,700, or 23% of total headcount, contributing to the Investment Bank’s ability to meet its 2001 overhead ratio target of 60%.
Credit costs increased 328%, reflecting the impact, in general, of the recession on the Firm’s credit portfolio and, in particular, charge-offs for Enron of $221 million and a provision for Argentina of $140 million.
Average total assets were $511 billion, an increase of 7%, reflecting growth in fixed income trading assets, partially offset by a decline in commercial loans and investment securities. Average common equity declined by 4% from last year as a result of lower operating risk capital, associated with the Investment Bank’s lower expense base.
The economic outlook remains uncertain, and revenue levels for the Investment Bank in 2002 will be heavily influenced by the speed and extent of the economic recovery.
Market shares and rankings (a)
JPMorgan Chase 2001 Annual Report 31
Treasury & Securities Services
Treasury & Securities Services is composed of three businesses: Institutional Trust Services provides a range of fiduciary services to debt and equity issuers and various intermediaries, from traditional trustee and paying agent to global securities and other administrative services; Investor Servicesprovides securities custody and related services, such as securities lending and investment analytics and reporting for mutual funds, investment managers, pension funds, insurance companies and banks worldwide; Treasury Servicesprovides treasury and cash management, as well as payment, liquidity management and trade finance services for a diversified client base of corporations, financial institutions and governments worldwide.
Selected financial data
Financial results overview
Treasury & Securities Services’ cash operating earnings remained virtually flat, compared with 2000, with growth in Institutional Trust Services of 22% and Treasury Services of 11% offset by a decline in Investor Services of 17%. These results reflected the impact of weaknesses in the economy and financial markets. Significant declines in interest rates and reduced equity market prices depressed many revenue sources. Partially offsetting these declines were the positive effects, especially in Institutional Trust Services, of greater volumes of debt issuance and market share gains in several key product lines. The net result was revenue growth of 15% in Institutional Trust Services and of 3% in Treasury Services—in line with historical growth rates—and a revenue decline of 4% in Investor Services, which had realized high growth rates in previous years due to more favorable market conditions.
Financial line-item discussionFees and commissions increased 6%, primarily due to higher fees in Institutional Trust Services. Institutional Trust Services earns fees from the issuance and payment of debt securities, servicing secondary market loan programs for governmental entities, and maintaining American depositary receipt programs for foreign issuers. The increase in fees in 2001 was attributable to successful sales in the expanding collateralized debt obligation market and the acquisition of Colson Services Corp. (“Colson”), a recordkeeper and loan servicer providing outsourcing support to government agencies. Treasury Services’ clients shifted their payment method to fees rather than maintain compensating balances in a low interest rate environment. These increases were offset by lower revenues at Investor Services, as fees based on equity values and the volume of transactions declined.
32 JPMorgan Chase 2001 Annual Report
Investor Services 43%Treasury Services 37%Institutional Trust Services 20%
Non-bank financial institutions 41%Banks 19%Corporations 19%Middle Market 11%Governments 10%
The Americas 63%Europe, Middle East & Africa 28%Asia 9%
Net interest income decreased slightly, reflecting compressed spreads on deposits as a result of lower interest rates and the impact of lower compensating balances. This was partially offset by higher deposit levels at Institutional Trust Services associated with new clients processing their debt payments.
The events of September 11th caused Treasury &Securities Services’ demand deposits and noninterest-bearing deposits to grow significantly as customers looked to depository institutions to hold their cash funds. By the end of 2001, these cash balances had returned to pre-September 11th levels.
The decline in all other revenue of 19% was attributable to lower foreign exchange revenue, driven by the decrease in clients’ global trading activities at Investor Services. Also contributing to the decline was the effect of the divestiture by Institutional Trust Services of a company involved in stock transfer.
Cash operating expense grew modestly from 2000, reflecting strategic investments in all three businesses, partly offset by tighter expense control, primarily in Treasury Services and Investor Services. The 3% expense growth, coupled with 2% revenue growth, slightly increased the cash overhead ratio to 71%. Treasury & Securities Services’ long-term cash overhead ratio target is 65%.
JPMorgan Chase 2001 Annual Report 33
Investment Management & Private Banking
Assets under management were $605 billion. Investment Management delivers expertise and advice across all asset classes and global markets to private and public sector institutional investors, high net worth individuals, and retail customers. The Private Bank delivers personalized advice and solutions to wealthy individuals and families.
Investment Management & Private Banking’s cash operating earnings were 30% lower than last year. Lower revenues were only partially offset by lower expenses. Revenues decreased due to declines in the value of assets under management, lower international retail fund flows and a reduction in brokerage account volumes. Investment Management revenues of $1.37 billion decreased 23%, and Private Banking revenues of $1.72 billion declined 16% from 2000. For the year, the percentage of cash operating earnings before taxes to total operating revenue declined to 19% from 25% in 2000; the business’s long-term target is 30%.
Financial line-item discussion
Fees and commissions were 12% lower than the prior year, reflecting the lower value of assets under management and lower associated investment management fees, and the shift from higher-margin equities to fixed income and money market products. In addition, brokerage commissions declined as private banking clients executed fewer transactions in 2001. Partially offsetting these factors were gains realized from new inflows to money market funds.
The decline in net interest income of 16% reflected the impact of lower short-term interest rates on the spread on client deposits.
Private Banking 55%Investment Management 45%
All other revenue was lower by 58%, primarily as a result of the decline in trading volumes. Earnings from the Firm’s 45% investment in American Century Companies, Inc. (“American Century”) also declined.
Cash operating expense decreased 13% as a result of merger synergies and the elimination of approximately 1,500 positions since the merger announcement date. With the merger integration essentially completed in IMPB, the business is positioned to benefit from future improvement in market conditions.
The increase in amortization of intangibles to $289 million reflected the full-year impact of the Flemings acquisition.
Average assets for the year were $34 billion, a decline of 4% from the prior year, primarily reflecting lower equity-related lending. For 2001, average common equity decreased 7%.
34 JPMorgan Chase 2001 Annual Report
Diversification of IMPB’s $605 billion of assets under management at December 31, 2001
Assets under management at December 31, 2001 declined 5% from the prior year-end, primarily as a result of market depreciation. However, during 2001, inflows into assets under management were driven by a significant increase in money market assets, as investors shifted toward lower-risk assets. The result was approximately $45 billion in new flows into global money market funds. The accompanying table demonstrates the diversification across asset classes and geographic regions, which has helped mitigate market volatility.
Assets under management (a)
JPMorgan Chase 2001 Annual Report 35
JPMorgan Partners
JPMorgan Partners, the global private equity organization of JPMorgan Chase, provides equity and mezzanine capital financing to private and public companies. It invests throughout the entire life cycle of the business development process, with the objective of creating long-term value for the Firm and its third-party investors.
JPMorgan Partners recognized a cash operating loss of $1.1 billion in 2001. The portfolio was negatively affected by a decline in valuations of private securities and the downturn in the public equity markets, particularly securities in the telecommunications, media and technology (“TMT”) sector.
Financial line-item discussionPrivate equity gains (losses)JPMP’s portfolio recorded a loss of $1.2 billion in 2001 consisting of losses in direct investments ($0.9 billion), private funds ($0.2 billion) and from hedging transactions ($0.1 billion). During the year, unrealized losses from portfolio revaluations more than offset income from realization activities. Despite limited exit opportunities, JPMP generated realized cash gains of over $1.0 billion from sales of investments, including approximately $0.9 billion from public and private direct investments and $0.1 billion from fund investments. Realized cash gains were recognized across all industries, with significant gains harvested from investments in the energy sector. During the fourth quarter of 2001, JPMP completed significant selldowns of two public TMT holdings, generating realized cash gains of over $125 million.
JPMP’s realized gains were more than offset by valuation actions taken across the private portfolio and mark-to-market losses recorded in the public portfolio. Valuation actions included net write-downs and write-offs of $1.4 billion on private direct securities and $0.3 billion on private fund investments. JPMP’s private direct TMT investments from 1999 and 2000 currently are valued at 50% of initial cost. In 2001, JPMP also recorded unrealized losses of $0.5 billion from mark-to-market losses on its public portfolio.
Other revenue includes third-party management fees and net revenue allocated to or from other JPMorgan Chase businesses. While management fee revenue was stable year over year, net intersegment revenue in 2001 included fees paid to other areas of the Firm for services associated with the raising of third-party funding and asset sale activities.
JPMorgan Partners’ cash operating expenses in 2001 decreased 20%, driven by a decline in compensation expenses.
Investment pace, portfolio diversification and capital under managementFor 2001, JPMorgan Partners’ investment pace declined 65% from last year to $0.9 billion as JPMP adopted a more cautious approach to new investments in light of the depressed market conditions.
36 JPMorgan Chase 2001 Annual Report
JPMP investment portfolio
Public securities investments at December 31, 2001(a)(dollars and shares in millions)
At December 31, 2001, JPMP’s investment portfolio was $9.2 billion, a decline of $2.6 billion from year-end 2000. The decline from last year was primarily the result of reductions in carrying values due to valuation adjustments and sales activities. The decline in JPMP’s assets resulted in a 15% decline in common equity allocated to JPMP.
At December 31, 2001, TMT investments were $2.5 billion, down 40% from December 31, 2000; they represented 27% of JPMP’s holdings. Management’s goal is to decrease TMT investments while increasing the industrial and consumer sectors.
The Firm believes that JPMorgan Partners will continue to create value over time. Given the volatile nature of the markets, and the NASDAQ market in particular, JPMP’s reported results for any period may include significant public securities unrealized gains or losses. The Firm makes no assumptions about the unrealized gains or losses that may be experienced by the JPMP portfolio.
Telecommunications,media & technology2000 $4.12001 $2.5
Life Sciences2000 $0.82001 $0.7
Industrial growth2000 $2.32001 $2.0
Consumer retail2000 $1.02001 $1.1
Real estate2000 $0.52001 $0.4
Financial services2000 $0.72001 $0.6
Funds2000 $2.42001 $1.9
JPMorgan Chase 2001 Annual Report 37
Retail & Middle Market Financial Services
Retail & Middle Market Financial Services, through branch networks (in the New York tri-state area and Texas) and national product companies, offers a complete range of financial products and services to consumers, small businesses and middle market clients. These products and services include banking, credit cards, loans (home, auto and education finance), investment and insurance offerings.
Retail & Middle Market Financial Services’ 2001 results were marked by solid revenue growth and disciplined expense management. Record originations drove revenues, while restructuring, Six Sigma and other productivity efforts moderated expenses. These actions were unable to offset the negative impact of higher credit costs. As a result, RMMFS realized a 5% decline in cash operating earnings from last year.
Net interest income grew 10% from a year ago, driven by higher levels of consumer loans resulting from record origination volumes across all credit businesses (CCS, CHF and CAF), partially offset by the lower spreads earned on customer deposits due to the decline in interest rates experienced in 2001.
Fees and commissions declined 9%, reflecting the negative impact of the increased level of mortgage loan prepayments that occurred because of lower interest rates. Prepayments resulted in accelerated amortization and impairment of mortgage servicing rights. In CHF, this was substantially offset by increased securities gains and other revenues. The decline in fees and commissions was partially offset by growth in credit card, mortgage and auto loans outstanding, as well as by a higher utilization of consumer banking and insurance products and services, all of which generated higher fees.
The increase in securities gains of 50% was attributable to sales of U.S. government securities used as economic hedges of mortgage servicing rights.
All other revenue increased by 60%, primarily as a result of record residential mortgage sales activity to government sponsored enterprises such as Fannie Mae, Ginnie Mae and Freddie Mac.
Cash expense rose 4%, reflecting the costs associated with the growth in origination volumes. The expense increase also included the impact of the acquisition in 2001 of the mortgage business of Advanta Corp. (“Advanta”) and higher credit card marketing expenditures that helped generate a record number of new accounts. Partially offsetting these increases were $145 million in savings achieved through restructuring, productivity and quality programs, including an organization-wide Six Sigma effort. This disciplined expense management approach helped reduce the cash overhead ratio to 50% from 52% one year ago.
Amortization of intangibles decreased 8% as a result of the sale of the Hong Kong credit card business in 2000.
Credit costs increased by 35% due to significant growth in credit card customer bankruptcies, increased levels of delinquencies resulting from the economic slowdown in the U.S. and a higher level of consumer-related receivables outstanding. RMMFS added $310 million to its allowance for loan losses in 2001 in response to the deteriorating credit conditions. For a further discussion of the consumer credit portfolio, see pages 52-53. The impact of these events was partially mitigated by more intense collection efforts in all of the credit businesses. In 2002, credit costs will be dependent upon the conditions in the domestic economy. RMMFS will continue to pursue collection and risk management actions to mitigate future credit losses.
38 JPMorgan Chase 2001 Annual Report
Retail & Middle Market Financial Services’ businesses
Cardmember Services
Cardmember Services is the fifth largest credit card issuer in the U.S., servicing almost 24 million accounts. Cash operating earnings for 2001 were a record $595 million, 16% greater than 2000. Operating revenue increased $630 million, or 17%, driven by the increase in the number of cardholders, growth in receivables and stronger customer purchase volume. Also contributing to the increase was the decline in the costs to fund receivables. Cash expense increased 9% when compared with last year due to higher marketing expenditures that resulted in record originations of over 4 million new accounts, and higher business volume-related expenses. Credit costs rose 21% due to the impact of the increase in receivables outstanding combined with the slowdown in the economy that affected the level of consumer bankruptcies. The managed credit card-related net charge-off ratio was 5.49%, an increase of 36 basis points from 2000. Managed credit card-related receivables at December 31, 2001 increased 12% to over $41 billion and total purchase volume, cash advances and balance transfers increased 19% to over $72 billion. The cash overhead ratio in 2001 improved 200 basis points to 33%.
In the first quarter of 2002, Cardmember Services acquired Providian National Bank’s interest in the Providian Master Trust, which includes a credit card portfolio of approximately $8.0 billion. The acquired portfolio is comprised mainly of Providian’s higher quality or “platinum” assets and consists of approximately 3.3 million credit card accounts.
Business-related metrics
Regional Banking Group
The Regional Banking Group is the No. 1 full-service bank based on deposits for consumers and small businesses in the New York tri-state area and is one of the leading providers of financial services to the consumer and small business sectors in the Firm’s Texas market. RBG provides banking, investment, credit and insurance services to 2.9 million consumers and 300,000 small businesses. RBG also offers discount brokerage services through Brown & Company, the 8th largest online brokerage firm in the U.S.
RBG had cash operating earnings of $504 million in 2001, down 8% from 2000, driven by the declining interest rates and lower customer trading volumes in the equities markets, which negatively affected deposit spreads and discount brokerage transactions revenue, respectively. Partially offsetting these unfavorable items was the growth in insurance sales, particularly annuities. The lower interest rate environment also negatively affected the cash overhead ratio increasing it 100 basis points to 68%.
Total client assets under management of $100 billion, including $67 billion in deposits and $33 billion of investment assets, grew 4% over 2000.
Cash expense declined $60 million, or 3%, from 2000. This decline reflected the results of initiatives to realize continued productivity improvement and provide high-quality service to the Firm’s customers.
JPMorgan Chase 2001 Annual Report 39
Home Finance
Chase Home Finance is the mortgage industry’s second largest mortgage originator and third largest mortgage servicer in the United States with over 4 million customers. CHF experienced a record year in 2001, with total revenue increasing 22%, cash operating earnings increasing 20% and mortgage originations increasing 142% to $184 billion. CHF’s 2001 performance demonstrated the effectiveness of its balanced business model of being both a leading originator and servicer of mortgage loans. The significant reduction in interest rates contributed to higher origination revenue as record loan originations were packaged and sold as securities. Low interest rates also improved net interest margins by reducing funding costs. However, the lower interest rates led to high prepayment levels and reduced mortgage servicing revenue due to the accelerated amortization and impairment of mortgage servicing rights (“MSR”). To mitigate the effect of reduced revenue from MSR impairment and prepayments, CHF used both interest rate derivatives and available-for-sale (“AFS”) securities that increased in value when interest rates declined.
Interest rate derivatives that qualify as fair value hedges under SFAS 133 and the related hedged MSRs were accounted for at fair value. For 2001, the decrease in revenue resulting from SFAS 133 valuation adjustments and MSR impairment totaled $1,951 million. These losses were substantially offset by total gains of $1,773 million relating to a combination of derivative gains, including those that qualify as SFAS 133 hedges, and realized gains from sales of AFS securities.
The increase in cash expense of 22% was related to the growth of business volume and the acquisition in 2001 of Advanta’s mortgage business. The cash overhead ratio remained flat compared with last year at 60%. Charge-offs of 0.18% were slightly higher in 2001 reflecting weak domestic economic conditions.
Middle Markets
JPMorgan Middle Market Banking is a premier national provider of commercial banking and corporate financial services to companies with annual sales of $3 million to $500 million, as well as to not-for-profit, real estate and public sector entities. Middle Markets enjoys a leadership position in the lucrative New York tri-state market and select Texas markets, and is leveraging its expertise in select markets across the country. Product offerings include corporate finance, cash management, credit and international finance capabilities. Cash operating earnings declined 7% when compared with the prior year. Declining interest rates affected earnings as well as revenue. Revenue declined 3% despite a 7% increase in deposit levels. A 24% increase in deposit fees offset some of the impact of lower rates. Cash expense rose 1% due to the increase in volume-related expenses.
Auto Finance
Auto Finance is the largest bank originator of auto loans and leases in the U.S., with over 2 million accounts. In 2001, the business unit had a record number of auto loan originations, which grew 63% over 2000 to $19.9 billion. Loan and lease receivables grew 26% to $28.4 billion, and Auto Finance’s market share among auto finance companies improved from 2.6% in 2000 to 4.1% in 2001 as a result of strong organic growth and an origination strategy that allies the business with car manufacturers and dealers nationwide.
Auto Finance’s operating revenues and cash operating earnings grew 63% and 215%, respectively, from 2000. The cash overhead ratio decreased to 37%. These results reflected the increase in origination volume, the impact of lower rates, and the effect of a $100 million charge in 2000 from an estimated decrease in auto lease residual value. The risk of future charges for residual values was substantially mitigated in the first quarter of 2001 through the purchase of a residual value insurance policy to cover previously uninsured auto leases in the portfolio. New auto lease originations continue to be insured under an existing policy. The moderately higher charge-off rate in 2001 reflects consumer defaults in a weaker business environment.
The results of Auto Finance also include Chase Education Finance, which is a top provider of government guaranteed and private loans for higher education through its joint venture with Sallie Mae.
40 JPMorgan Chase 2001 Annual Report
Support Units and Corporate
The Support Units and Corporate include Enterprise Technology Services (“ETS”), Corporate Business Services (“CBS”), legal, audit and finance.
ETS is an internal technology service organization, and CBS manages the Firm’s support services, including real estate management, human resources, finance operations and procurement. CBS and ETS seek to provide services to the Firm’s businesses that are competitive with comparable third-party providers in terms of price and service quality. These units leverage the Firm’s global scale and technology to gain efficiencies through consolidation, standardization, vendor management and outsourcing.
Corporate reflects the accounting effects remaining at the Corporate level after the application of management accounting policies of the Firm. These policies include the allocation of costs associated with technology, operational and staff support services with the respective revenue generating businesses and allow management to evaluate business performance on an allocated basis.
For 2001, Corporate had a cash operating loss of $507 million, compared with a loss of $334 million in 2000. In 2001, there were $251 million of credit costs in excess of net charge-offs not allocated to the segments. Also included in the 2001 net loss was a pre-tax loss of $152 million at LabMorgan resulting from the write-downs of investments and equity accounting losses. LabMorgan has been restructured and, going forward, its remaining investment portfolio of $52 million at December 31, 2001 will be managed by JPMorgan Partners.
Critical accounting policies used by the Firm
The Firm’s accounting policies are integral to understanding the results reported. Accounting policies are described in detail in the Notes to the consolidated financial statements. The Firm’s most complex accounting policies require management’s judgment to ascertain the valuation of assets and liabilities. The Firm has established detailed policies and control procedures that are intended to ensure valuation methods are well controlled and applied consistently from period to period. In addition, the policies and procedures are intended to ensure that the process for changing methodologies occurs in an appropriate manner. The following is a brief description of the Firm’s current accounting policies involving significant management valuation judgments.
Allowance for loan lossesJPMorgan Chase’s allowance for loan losses is intended to adjust the value of the Firm’s loan assets for probable credit losses. Management also computes an allowance for lending-related commitments using a methodology similar to that used for the loan portfolio. The methodology for calculating both allowances involves judgments at many levels. First and foremost, it involves the early identification of credits that are deteriorating. Second, management applies its judgment to derive loss factors. Wherever possible, the Firm uses independent, verifiable data or the Firm’s own historical loss experience in its models for estimating loan losses. Many factors can affect management’s estimates of specific loss and expected loss, including volatility of default probabilities, rating migrations and loss severity. For example, judgment is required to determine how many years of data to include when estimating loss severity. If a full credit cycle is not captured in the data, loss estimates may be inaccurate. Similarly, there are judgments as to which external data on default probabilities should be used, and when they should be used. Choosing data that are not reflective of the Firm’s specific loan portfolio characteristics could affect loss estimates. Management’s judgments also are applied when considering uncertainties that relate to current macroeconomic and political conditions, the impact of currency devaluations on cross-border exposures, changes in underwriting standards, unexpected correlations within the portfolio or other factors. For a further discussion of the methodologies used in establishing the Firm’s Allowance for loan losses, see Credit risk management and Note 8 – Loans on pages 54 and 75, respectively.
Fair value of financial instrumentsA portion of JPMorgan Chase’s assets and liabilities are carried at fair value, including trading assets and liabilities, available-for-sale securities and loans held for sale. At December 31, 2001, approximately $315 billion of the Firm’s assets were recorded at fair value.
Fair value is defined as the value at which positions could be closed out or sold in a transaction with a willing and knowledgeable counterparty over a period of time consistent with JPMorgan Chase’s trading or investment strategy. A majority of assets carried at fair value are determined based on quoted market prices. If listed prices or quotes are not available, then fair value is based on internally developed cash flow models. These models use as their basis independently sourced market parameters including, for example, interest rate yield curves, option volatilities and currency rates. The valuation process then takes into consideration factors such as counterparty credit quality, liquidity and concentration concerns. Management applies judgment in the determination of these factors. For example, there is often limited market data to rely on when estimating the impact of holding a large or aged position. Similarly, judgment must be applied in estimating prices where no external parameters exist. Finally, other factors can affect estimates of fair value including market dislocations, incorrect model assumptions, and unexpected correlations. Imprecision in estimating these factors can impact the amount of revenue or loss recorded for a particular position. The largest valuation adjustment relates to credit risk associated with derivatives in the Firm’s derivatives portfolio. The credit valuation adjustment, or CVA, represents the estimated credit component of the Firm’s derivative counterparty exposures. The CVA is recalculated on a daily basis, taking into account market and
JPMorgan Chase 2001 Annual Report 41
counterparty-related activity, such as changes in credit ratings and market prices, master netting agreements and collateral. CVA also includes additional adjustments for name-specific credit risk not reflected in credit spreads.
Notwithstanding the judgment required in fair valuing JPMorgan Chase’s assets and liabilities, the Firm believes its estimates of fair value are reasonable given the Firm’s process for obtaining external prices and parameters, internal model review and approval, consistent application of approach from period to period and the validation of estimates through the actual settlement of contracts.
Specific details on fair values by type of instrument, including the valuation policy for private equity investments and mortgage servicing rights, are included in Note 27 – Fair value of financial instruments and Note 10 – Mortgage servicing rights, respectively.
Results of operations
The following section provides a discussion of JPMorgan Chase’s results of operations both on a reported and operating basis. The differences between reported and operating basis are the treatment of revenues from credit card securitizations, the exclusion of special items and the reclassification of trading-related net interest income (“NII”) to trading revenue. See page 27 for a further discussion.Revenues
Revenues
Revenues both on a reported and operating basis were down from 2000 due to private equity losses and, to a lesser degree, lower investment banking fees and trading revenue. These were partially offset by higher net interest income and securities gains.
Investment banking fees
Investment banking fees declined due to lower merger and acquisition advisory and equity underwriting fees. The decline was partially offset by a record year for investment-grade bond underwriting fees. For a further discussion of these fees, see the Investment Bank’s results on page 30 and Note 4 on page 72.
Trading-related revenue
The decline was primarily attributable to lower margins in equity securities and reduced demand for equity derivatives. Also contributing to the decline was $359 million of losses related to the exposure to Enron and Argentina. Excluding these two, the weaker performance in emerging markets was more than offset by the strong results within the interest rate trading products as a result of the declining interest rate environment.
Fees and commissions
Fees and commissions both on a reported and operating basis for 2001 were essentially flat from last year, reflecting:
42 JPMorgan Chase 2001 Annual Report
partly offset by:
For a table that breaks out fees and commissions, see Note 4 on page 73.
Private equity gains (losses)
Both realized gains and unrealized losses on private equity investments deteriorated from last year’s levels due to the limited opportunities to sell investments and depressed valuations, particularly in the TMT sector. For a further discussion of private equity gains (losses), see JPMorgan Partners’ results on page 36.
Securities gains
The Firm’s available-for-sale securities portfolio was positioned for interest rate reductions in the U.S. and Europe, and thus, the Firm was able to realize large gains on the sales of those securities in 2001. There were also higher gains on the sales of debt securities used as economic hedges of the value of mortgage servicing rights at Home Finance. For a further discussion of securities gains, see both the Investment Bank and Home Finance discussions on pages 30 and 40, respectively.
Other revenue
The decrease in other revenue of $288 million included:
Reported other revenue reflected the following special items, all in 2000:
For a table that breaks out other revenue, see Note 4 on page 73.
Net interest income
Net interest income benefited from the lower interest rate environment in 2001, resulting in a higher volume of average interest-earning assets (in particular, credit card receivables and residential mortgages), and slightly wider spreads on assets (the short-term funding costs to support interest-earning assets declined faster than the interest earned on them). Also contributing to the increase in NII was an aggregate of $84 million of interest refunds in 2001 (related to several tax settlements) for prior years’ federal tax overpayments.
The spread on interest-earning assets was 1.99% in 2001, compared with 1.87% in the prior year. Excluding the impact of the interest refunds, the spread would have been 1.97% in 2001.
Expenses
On a reported basis, total noninterest expense increased slightly from 2000, reflecting higher merger and restructuring costs. On an operating basis, expenses declined from the prior year due to savings from merger and right-sizing initiatives and lower incentives. On a pro forma basis, operating expenses in 2001 decreased 8%.
JPMorgan Chase 2001 Annual Report 43
Compensation expense
Compensation expense declined 6% in 2001, primarily as a result of headcount reductions, particularly in areas affected by the merger such as the Investment Bank and Investment Management & Private Banking. Also contributing to the decline were lower incentives as a result of a lower level of earnings. These items were partially offset by higher compensation expense, reflecting the full-year impact of Flemings in 2001, the addition of the mortgage business of Advanta, and new hiring at Home Finance and Cardmember Services related to the growth in their business volume.
The total number of full-time equivalent employees at December 31, 2001 was 95,812, a decrease of 3,945 employees from the prior year-end, reflecting headcount reductions at businesses that were impacted by the merger, particularly IB and IMPB, partly offset by an increase in RMMFS.
Occupancy, technology and communications
The increase of $54 million in occupancy expense was primarily attributable to the Flemings acquisition, additional space requirements of several business segments, and the moderate increase in utility, maintenance and building administration costs. These were partially offset by the savings derived from the consolidation of offices and the relocations of certain functions from the New York metropolitan area to the South and Southwest regions of the United States.
Technology and communications expense reflected the increase in depreciation expense associated with upgrades to the Firm’s hardware systems and software applications. Also contributing to the increase were the costs of more sophisticated telecommunications systems, including greater requirements for market data used in trading activities and research at the Investment Bank, as well as the leasing and maintenance of more advanced computer and other equipment.
Other expense
Other operating expense decreased $245 million from 2000 due to the following (for the table on other expense, see page 74):
Expenses related to the attacks on the World Trade Center were immaterial. The branch located at the World Trade Center was destroyed and the Firm experienced some temporary dislocations in its downtown Manhattan offices, but there were no significant operational losses.
Amortization of intangibles
The increase was largely attributable to the full-year impact of goodwill associated with the acquisitions of Flemings and The Beacon Group, LLC in mid-2000. For a discussion on the impact of SFAS 142 on the Firm’s amortization of intangibles expense in 2002, see page 62.
Merger and restructuring costs
Management initially estimated that the Firm would incur one-time costs of $3.2 billion in connection with the merger of J.P. Morgan and Chase. These costs consisted of a $1.25 billion merger charge that was recorded on the December 31, 2000 merger date and $1.95 billion of other costs to be incurred in 2001 and 2002 that were not accruable under existing accounting pronouncements.
In September 2001, management estimated that $1.05 billion of additional merger costs (consisting primarily of systems integration costs, facilities costs and retention payments) and severance costs for the right-sizing of employee levels in certain businesses (2,000 employee reductions) beyond that planned at the time of the merger would be incurred in the remainder of 2001 and 2002. At that time, management also increased its estimate of related expense savings from the $2.0 billion originally estimated at the time of the merger to $3.6 billion. During 2001, the Firm incurred total merger and right-sizing costs of $2.3 billion. At December 31, 2001, cumulative merger-related and right-sizing employee reductions, including attrition, since the merger announcement date, have been approximately 8,200.
In December 2001, management again revised its estimate of total merger and right-sizing costs to be incurred in 2002 to be approximately $1 billion, representing an increase of approximately $250 million from the total costs previously estimated. At the same time, management increased its estimate of expense savings to be realized from $3.6 billion to $3.8 billion.
For the past few years, the Firm has been relocating several businesses to Florida, Texas and Massachusetts. Management continues to estimate that $200 million of relocation costs will be incurred in 2002, resulting in cumulative relocation costs of $585 million and related expense savings of $80 million in 2003 increasing to $140 million in 2007.
Credit costs
Credit costs on an operating basis are composed of the provision for loan losses related to loans on the Consolidated balance sheet and the provision for credit card receivables that have been securitized.
Credit costs increased 79% in 2001 due to the impact of the economic slowdown on both the commercial and consumer credit portfolios. In 2001, the Firm increased the loan loss allowance by $850 million. For a further discussion of these costs, see page 54.
44 JPMorgan Chase 2001 Annual Report
Income taxes
JPMorgan Chase recognized income tax expense on a reported basis of $847 million in 2001, compared with $3.01 billion in 2000. The effective tax rate was 33.0% in 2001 compared with 34.4% in 2000. The decrease in the effective tax rate in 2001 as compared with 2000 was principally a result of the decrease in reported income before income tax expense. JPMorgan Chase’s effective tax rate in 2002 will likewise be affected by the overall level of reported pre-tax earnings.
The major risks to which the Firm is exposed are:
Risk management at JPMorgan Chase is guided by several principles, including:
Risk management and oversight begins with the Risk Policy Committee of the Board of Directors, which reviews the governance of these activities, delegating the formulation of policy and day-to-day risk oversight and management to the Executive Committee and to the two corporate risk committees:
The Executive Committee provides guidance regarding strategies and risk appetite and is responsible for an integrated view of risk exposures, including the interdependencies among JPMorgan Chase’s various risk categories.
The Capital Committee focuses on firm-wide capital planning, internal capital allocation and liquidity risk. The Risk Management Committee focuses on credit risk, market risk, operational and business risks, private equity risk and fiduciary risk. Both risk committees have decision-making authority, with major policy decisions and risk exposures subject to review by the Executive Committee.
In addition to the Risk Policy Committee, the Audit Committee of the Board of Directors reviews with management the system of internal controls and financial reporting that is relied upon to assure compliance with the Firm’s operational risk management processes.
The Firm’s use of SVA, which incorporates a risk-adjusted capital methodology as its primary performance measure, has strengthened its risk management discipline by charging the businesses the cost of capital linked to the risks associated with their respective activities. The result of this discipline has been controlled growth in, and a lower risk profile for, the assets on the Firm’s balance sheet.
JPMorgan Chase 2001 Annual Report45
JPMorgan Chase’s capital management framework helps to optimize the use of capital by:
Available versus required capital
Economic risk capital: JPMorgan Chase assesses capital adequacy by measuring risk utilizing internal risk assessment methodologies. The Firm assigns economic capital based primarily on four risk factors. The methodology quantifies credit, market and operating risk for each business and, for JPMP, private equity risk, and assigns capital accordingly. These methodologies are discussed in the risk management sections of this Annual Report.
Capital also is assessed against business units for certain nonrisk factors. Businesses are assessed capital equal to 100% of any goodwill or certain other intangibles generated through acquisitions. Additionally, JPMorgan Chase assesses an “asset capital tax” against managed assets and some off-balance sheet instruments. These assessments recognize that certain minimum regulatory capital ratios must be maintained by the Firm. JPMorgan Chase also estimates the portfolio effect on required economic capital based on correlation of risk in stress scenarios across risk categories. This estimated diversification benefit leads to a reduction in required economic capital for the Firm.
The total required economic capital for JPMorgan Chase as determined by its models and after considering the Firm’s estimated diversification benefits is then compared with available common stockholders’ equity to evaluate overall capital utilization. The Firm’s policy is to maintain an appropriate level of excess capital to provide for growth and additional protection against losses.
Regulatory capital: JPMorgan Chase’s primary federal banking regulator, the Federal Reserve Board, establishes capital requirements, including well-capitalized standards and leverage ratios, for the consolidated financial holding company and its state-chartered banks, including JPMorgan Chase Bank. The Office of the Comptroller of the Currency establishes similar capital requirements and standards for the Firm’s national bank subsidiaries, including Chase Manhattan Bank USA, National Association. As of December 31, 2001, the financial holding company and its banking subsidiaries maintained capital levels well in excess of the minimum capital requirements and in excess of well-capitalized standards.
Additional information regarding the Firm’s capital ratios as well as a more detailed discussion of federal regulatory capital standards are presented in Note 21 on pages 88-89 of this Annual Report.
Currently, the Firm’s most important regulatory capital target is to maintain a Tier 1 capital ratio in the range of 8% to 8.25%. The Capital Committee reviews the Firm’s capital targets and policies regularly in light of changing economic conditions and business needs. Capital generated in excess of the Tier 1 capital target and the Firm’s assessment of necessary excess capital could be used for purchases of JPMorgan Chase common stock or for future investment opportunities. The components of the Firm’s Tier 1 and total capital are reflected in Note 21 on pages 88-89 of this Annual Report.
Stock repurchases: In July 2001, JPMorgan Chase’s Board of Directors authorized the repurchase of up to $6 billion of the Firm’s common stock, net of any issuance for employee benefit plans. In the latter half of 2001, the Firm repurchased approximately 21.9 million shares worth $871 million. These repurchases were offset by the net issuance of 5.7 million shares during the same period under JPMorgan Chase’s various stock-based employee benefit plans. Management anticipates significant repurchases only when the operating income of the Firm improves and generation of internal excess capital accelerates.
Dividends: In the first quarter of 2001, JPMorgan Chase raised the quarterly cash dividend on its common stock to $0.34 per share from $0.32 per share. In recent years, JPMorgan Chase has had a policy of paying common stock dividends at a level that over time would be in the range of 25%-35% of an amount equal to operating earnings less preferred stock dividends. The Firm continues to consider this range an appropriate target over the medium- and long-term. However, dividends above this range may be declared for a period if the Firm’s results for the relevant period are below what the Firm considers its medium- or long-term operating earnings capacity, as has been the case for the past several quarters. Dividends declared in any quarter will be determined by JPMorgan Chase’s Board of Directors after taking into consideration factors such as the Firm’s current earnings, expected medium- and long-term operating earnings, financial condition, regulatory capital position and applicable governmental regulations and policies.
46 JPMorgan Chase 2001 Annual Report
Credit risk management
Credit risk is the risk of loss due to borrower or counterparty default. This risk is managed at both the transaction and portfolio levels. Credit risk management processes are designed to preserve the independence and integrity of the risk assessment process.
Credit risk management begins with an assessment of the risk of loss resulting from the default by a borrower or counterparty. All credit exposures are assessed, whether on- or off-balance sheet. These exposures include loans, receivables under derivative and foreign exchange contracts, and lending-related commitments (e.g., letters of credit and undrawn commitments to extend credit).
Using statistical techniques, estimates are made of both expected losses (average losses over a cycle) and unexpected losses for each segment of the portfolio. Unexpected losses represent the potential volatility of actual losses relative to the expected level of loss. Expected losses are used to set risk-adjusted loss provisions, whereas unexpected losses drive the allocation of credit risk capital by portfolio segment. Within the consumer businesses, capital allocations are differentiated by product and product segment. In the commercial portfolio, capital allocations are differentiated by risk rating and maturity. Off-balance sheet exposures are converted to loan equivalent amounts, based on their probability of being drawn, before applying the expected loss and capital factors. The credit risk profile of each business unit is an important factor in assessing its financial performance.
Expected credit losses alone are not key indicators of risk. For commercial assets, if losses were entirely predictable, then the expected loss rate could be factored into pricing and covered as a normal and recurring cost of doing business. Unexpected losses (i.e., the uncertainty of loss rates relative to expected levels) are what create risk and represent the primary focus of credit risk management.
The risks of the consumer and commercial portfolios are markedly different. Broadly speaking, losses on consumer exposures are more predictable, less volatile and less cyclical than losses on commercial exposures. For the latter, the loss volatility can be much greater over the course of an economic cycle.
JPMorgan Chase’s managed credit-related assets totaled $310 billion at December 31, 2001, essentially flat from year-end 2000. The portfolio continues to be well-balanced between commercial and consumer assets. At December 31, 2001, consumer assets represented 43% of the total managed credit-related portfolio, compared with 37% at December 31, 2000.
Credit risk management processes
The credit risk management process is guided by policies and procedures established by the Credit Risk Policy group. At both the business unit and corporate level, processes are in place that are designed to ensure that risks are accurately assessed, properly approved and continuously monitored.
Credit Risk Policy also has primary responsibility for the credit risk measurement framework, allocating the cost of credit, evaluating the portfolio risk profile and assessing concentration risks, setting limits to provide for adequate portfolio diversification, validating internal risk grades and managing problem assets.
Within each major business unit, there is an independent credit risk management function that reports jointly to the relevant business executive and to the Vice Chairman for Finance, Risk Management and Administration. These functions are responsible for managing credit decisions on a day-to-day basis. They approve significant new transactions and product offerings, have the final authority over credit risk assessments and monitor the credit risk profile of the business unit’s portfolio.
Credit risk management of commercial assetsWithin the commercial sector, credit risk management begins with the client selection process. A global industry approach allows the Firm to monitor and evaluate a given industry’s risk profile; exposures thus can be managed in industries deemed to have increasing risk profiles. The Firm’s international strategy, particularly in emerging markets, is to focus on the largest, leading firms with cross-border financing needs.
Despite a difficult economic environment in 2001, the overall quality of both the commercial and consumer credit portfolios remained sound
JPMorgan Chase 2001 Annual Report 47
Concentration management continues to be a key tool in managing commercial credit risk. The Firm manages concentrations by obligor, risk grade, industry, product and geographic location. From the perspective of portfolio risk management in the aggregate, concentration management is enhanced by the Firm’s established strategy of loan origination for distribution as well as the purchase of credit protection.
Credit risk management of consumer assets
Consumer credit risk management uses sophisticated portfolio modeling, credit scoring and decision support tools to project credit risks and establish underwriting standards. Risk parameters are established in the early stages of product development, and the cost of credit risk is an integral part of the pricing and evaluation of a product’s profit dynamics. Consumer portfolios are monitored to identify deviations from expected performance and shifts in consumers’ patterns of behavior.
2002 view
The Firm continues to view credit as a lagging economic indicator. The economic and associated credit environments are expected to remain challenging in 2002.
In the consumer sector, the Firm currently anticipates higher loan losses and charge-off rates in 2002, reflecting both ongoing portfolio growth and a continuation of the difficult economic environment.
Credit-related portfolio
The following table presents a summary of managed credit-related information for the dates indicated:
48 JPMorgan Chase 2001 Annual Report
Commercial portfolio
The following table presents commercial credit-related information for the dates indicated:
Loan origination for distributionThe Firm’s business strategy remains one of origination for distribution. The majority of the Firm’s wholesale loan originations continue to be distributed into the marketplace. The commercial loan portfolio declined 12% in 2001 reflecting, in part, the results of the Firm’s strategy to originate for distribution as well as the Firm’s ongoing goal of reducing its exposure to commercial credit. In addition, the Firm’s SVA discipline continues to discourage the retention of loan assets that do not generate a positive return above the cost of risk-adjusted capital. SVA remains a critical discipline in selecting loan assets to add to the Firm’s balance sheet, particularly when combined with other credit and capital management disciplines (e.g., credit derivatives).
Purchase of credit protectionThe Firm uses credit derivatives, as well as cash and synthetic collateralized loan obligations (“CLOs”), to reduce the credit risk of, and the internal economic capital allocated to loans, loan commitments, and derivatives. The use of credit derivatives to hedge exposures does not reduce the reported level of assets on the balance sheet or the level of reported off-balance sheet commitments. The notional amounts outstanding relating to single name credit default swaps and CLOs were approximately $19.0 billion and approximately $18.7 billion, respectively, at December 31, 2001.
Commercial credit qualityAt December 31, 2001, 65% of the Firm’s commercial credit-related assets were considered investment-grade equivalent, while approximately 35% were considered non-investment-grade equivalent, of which 1% was nonperforming.
Total commercial nonperforming assets were $3.297 billion at December 31, 2001. Excluding the $1.130 billion of nonperforming Enron-related other receivables, commercial nonperforming assets were $2.167 billion, an increase of $696 million from year-end 2000, which equaled approximately 1% of the total commercial credit-related assets.
JPMorgan Chase 2001 Annual Report 49
Unfunded commercial lending commitmentsThe Firm’s unfunded commercial lending-related commitments at December 31, 2001 totaled $248 billion, down from $263 billion at the year-end 2000; 85% of these unfunded commitments were considered investment grade equivalent and 15% were considered non-investment grade equivalent, which were essentially unchanged from the prior year. For a breakdown of the unfunded commitments outstanding at December 31, 2001, by remaining maturity, see page 60.
The risk profile of the Firm’s total commercial credit exposure at December 31, 2001 (loans, derivatives and unfunded commitments) was considered 77% investment grade equivalent and 23% non-investment grade equivalent.
Commercial credit exposure
Net charge-offsIn 2001, commercial net charge-offs increased by $582 million, or 146%, compared with 2000. The increase was primarily the result of higher domestic commercial net charge-offs, including increased net charge-offs in the telecommunications sector and for Enron. The annual commercial loan net charge-off rate for 2001 had been expected to be in the range of 60 basis points (0.60%) of the total commercial loan portfolio. In 2001, the actual net charge-off rate on average commercial loans was 0.87%. In 2000, the net charge-off rate was 0.33%.
DiversificationThe Firm remains highly focused on diversifying its commercial credit-related assets. The graph below displays the Firm’s 10 largest credit-related industry groups.
50 JPMorgan Chase 2001 Annual Report
Commercial loans
Commercial and industrial: The commercial and industrial (“C&I”) portfolio consists primarily of loans made to large corporate and middle market customers. The domestic C&I portfolio declined $7.4 billion from 2000 year-end. Nonperforming domestic C&I loans increased over 2000, while net charge-offs in 2001 were $796 million, or 1.13% of the average portfolio, higher in both absolute dollar and percentage terms relative to 2000.
The foreign C&I portfolio totaled $33.5 billion at December 31, 2001, representing a $3.5 billion decline in outstandings from 2000 year-end levels. Nonperforming foreign C&I loans increased by $123 million, or 22%, due primarily to an increase in nonperforming loans in Latin America (largely Argentina), offset in part by declines in Asia. Net charge-off levels for 2001 increased from the prior year by $44 million, or 37%, reflecting higher charge-offs in Europe and Latin America in 2001, partly offset by lower charge-offs in Asia.
Commercial real estate: The commercial real estate portfolio represents loans secured primarily by real property (other than loans secured by mortgages on 1-4 family residential properties, which are included in the consumer loan portfolio). Domestic commercial real estate loans decreased $686 million from year-end 2000, principally as a result of sales and repayments.
Financial institutions: The financial institutions portfolio includes loans to commercial banks and companies whose businesses primarily involve lending, financing, investing, underwriting or insurance. Loans to financial institutions decreased $2.1 billion in 2001 from 2000 levels, primarily in the domestic portion of the portfolio. Nonperforming financial institution loans increased by $14 million in 2001, primarily in the foreign portfolio. The total portfolio experienced net charge-offs of $17 million in 2001, compared with $18 million in 2000.
Enron-related exposureThe Firm’s exposure to Enron at the time it declared bankruptcy was approximately $2.6 billion. At year-end 2001, after giving effect to net charge-offs, write-downs and payments of $0.5 billion, Enron-related exposure was $2.1 billion. The following table provides details of Enron-related exposure at year end:
Nonperforming Enron-related assets at December 31, 2001 were comprised of $98 million of nonperforming loans, $45 million of nonperforming derivatives, and the $1,130 million of nonperforming other receivables, which represent surety receivables and a letter of credit that are the subject of litigation with insurance companies and a foreign bank.
Derivative and foreign exchange contracts
In the normal course of business, the Firm utilizes derivative and foreign exchange financial instruments to meet the financial needs of its customers, to generate revenues through its trading activities, to manage its exposure to fluctuations in interest and currency rates, and to manage the Firm’s own credit risk.
The Firm uses the same credit risk management procedures when entering into derivative and foreign exchange transactions as those used for traditional lending products. In addition, the Firm actively manages the credit risk of the derivative counterparties with credit, interest rate, foreign exchange, equities and commodity derivatives.
In terms of credit risk outstanding exposure, the true measure of risk from derivative and foreign exchange contracts is the mark-to-market value of the contracts at a point in time (i.e., the cost to replace the contract at the current market rates should the counterparty default prior to the settlement date). For most derivative transactions, the notional principal amount does not change hands; it is simply an amount that is used as a reference upon which to calculate payments. While notional principal is the most commonly used volume measure in the derivative and foreign exchange markets, it is not a measure of credit risk. The $24 trillion of notional principal of the Firm’s derivative and foreign exchange contracts outstanding at December 31, 2001, does not represent a proxy for, and significantly exceeds the possible credit losses that could arise from such transactions. At December 31, 2001, the associated mark-to-market value of the contracts, or the amount owed to the Firm, was $71 billion after taking into consideration the benefit of legally enforceable master netting agreements. Further, after taking into account $20 billion of collateral held by the Firm at year-end, the net credit exposure owed to the Firm relating to derivative and foreign exchange contracts was $51 billion.
The Firm’s primary counterparties in derivative and foreign exchange transactions are investment-grade financial institutions, most of which are dealers in these products. The investment-grade equivalent portion of the derivative and foreign exchange contracts portfolio was 83% at December 31, 2001.
Many of the Firm’s derivative and foreign exchange contracts are short term, which also mitigates credit risk, since these transactions settle quickly. The table on the next page provides the remaining maturities of derivative and foreign exchange contracts outstanding at December 31, 2001 and 2000. The maturity profile remained relatively consistent with the prior year.
At December 31, 2001, the Firm had approximately $41 billion in notional value related to energy trading commodity contracts with unrealized gains of $4.3 billion and unrealized losses of $2.8 billion.
At December 31, 2001, nonperforming derivative contracts were $170 million, compared with $37 million at December 31, 2000.
JPMorgan Chase 2001 Annual Report 51
Maturity profile
Country exposure
The Firm has a process for measuring and managing its country exposures and risk. Exposures to a country include all credit-related lending, trading and investment activities.
The table below presents JPMorgan Chase’s exposure to selected countries. This disclosure is based on management’s view of country exposure. Amounts as of December 31, 2000 have been restated to conform to the current presentation.
The Firm has been closely managing its exposure to Argentina over the last several quarters and, in particular, in the months leading up to the government’s announcement of a restructuring of its bond obligations. Since March of 2001, the Firm reduced its exposure to Argentina from $1.8 billion to $0.6 billion (before loan loss allowances). The latter number includes the effect of fair value adjustments on the derivatives portfolio ($0.2 billion) and write-downs of market positions ($0.1 billion) taken by the end of December 2001.
In addition, the Firm took a $140 million provision against its loans to Argentina. The increase in the Firm’s exposure to Brazil was largely concentrated in short-term lending and trading activity.
Selected country exposure
Consumer portfolio
The following table presents managed consumer credit-related information for the dates indicated:
52 JPMorgan Chase 2001 Annual Report
JPMorgan Chase’s consumer portfolio consists primarily of mortgages, credit cards and auto financings. This portfolio is predominately domestic and continues to be geographically well-diversified.
The Firm’s managed consumer portfolio totaled $134 billion at December 31, 2001, an increase of $20 billion, or 17%, from 2000. The following pie graph provides a summary of the consumer portfolio by loan type at 2001 year-end and each loan type’s respective charge-off rate. The Firm’s largest component, residential mortgage loans, comprised 44% of the total consumer portfolio and is primarily secured by first mortgages.
Consumer loans
Residential mortgage loans: 1-4 family residential mortgage loans increased 18% during 2001. While net charge-offs for 2001 increased $14 million, or 39%, over the prior year, the 2001 net charge-off rate remained low at 0.09%, reflecting the continued strong credit quality of the portfolio.
Credit card loans: The Firm analyzes its credit card portfolio on a “managed basis,” which includes credit card receivables on the balance sheet as well as credit card receivables that have been securitized.
Managed credit card receivables increased 12% during 2001. The increase in the net charge-off rate was a result of higher consumer bankruptcy levels as well as higher contractual losses (i.e., losses on accounts not bankrupt).
A new collection system for Cardmember Services was installed in the fourth quarter of 2000, the benefits of which were evidenced in 2001. This system significantly improved the productivity of collections and the accuracy and sophistication of risk prediction models, as well as enabling the Firm to move more quickly to decrease credit card lines for high-risk accounts.
Auto financings: Auto financings increased 30% from year-end 2000, reflecting strong consumer demand during the second half of 2001 as a result of favorable pricing programs. The moderately higher charge-off rate in 2001 reflected consumer defaults in a weaker economic environment.
Consumer loans by geographic region
JPMorgan Chase 2001 Annual Report 53
Allowance for credit losses
LoansJPMorgan Chase’s Allowance for loan losses is intended to cover probable credit losses for which either the asset is not specifically identified or the size of the loss has not been fully determined. Within the allowance, there are specific and expected loss components and a residual component.
The specific loss component covers those commercial loans deemed by the Firm to be criticized. The Firm internally categorizes its criticized commercial loans into three groups: doubtful, substandard and special mention.
Nonperforming commercial loans (excluding leases) are considered to be impaired loans. The allowance for impaired loans is computed using the methodology under SFAS 114. An allowance is established when the discounted cash flows (or collateral value or observable market price) of an impaired loan is lower than the carrying value of that loan. For purposes of computing the specific loss component of the allowance, larger impaired loans are evaluated individually, and smaller impaired loans are evaluated as a pool using historical loss experience for the respective class of assets. The criticized but still performing loans also are evaluated as a pool using historical loss rates.
The expected loss component covers performing commercial loans (except criticized loans) and consumer loans.
Expected losses are the product of default probability and loss severity. The computation of the expected loss component of the allowance is based on estimates of these factors in JPMorgan Chase’s credit risk capital model. These estimates are differentiated by risk rating and maturity for commercial loans.
The expected loss estimates for each consumer loan portfolio are based primarily on the Firm’s historical loss experience for the applicable product portfolio.
Finally, a residual component is maintained to cover uncertainties that could affect management’s estimate of probable losses. The residual component of the allowance reflects the margin of imprecision inherent in the underlying assumptions used in the methodologies for estimating specific losses and expected losses in both the commercial and consumer portfolios. It is anticipated that the residual component of the allowance will range between 10% and 20% of the total allowance for loan losses.
Factors affecting the uncertainty of specific loss and expected loss estimates include the volatility of default probabilities, rating migrations and loss severity. These uncertainties also could relate to current macroeconomic and political conditions, the impact of currency devaluations on cross-border exposures, changes in underwriting standards, unexpected correlations within the portfolio or other factors.
The Firm’s Risk Management Committee reviews, at least quarterly, the allowance for loan losses relative to the risk profile of the Firm’s credit portfolio and current economic conditions. The allowance is adjusted based on that review if, in management’s judgment, changes are warranted.
The total specific and expected allowance for commercial loan losses was $1,724 million at December 31, 2001, an increase of 13% from the prior year-end. The specific loss component was approximately $1 billion, up significantly from year-end 2000 reflecting an increase in commercial loans deemed by the Firm to be criticized. The expected loss component of the commercial allowance was approximately $700 million at year-end 2001, a decrease of approximately 20% from the prior year-end as a result of a lower level of commercial loans outstanding.
The consumer expected loss component of approximately $2.1 billion increased 46% from the prior year-end reflecting the growth in consumer portfolios and a challenging credit environment.
The residual component at December 31, 2001 was $695 million, approximately the same at year-end 2000. The residual component represented approximately 15% of the total allowance for loan losses.
The Firm’s concerns with respect to the continuing challenging credit environment are reflected in the allowance for credit losses, which was increased by $850 million over the third and fourth quarters of 2001. The allowance represented 2.08% of loans at December 31, 2001, compared with 1.70% at December 31, 2000.
As of December 31, 2001, management deemed the allowance to be adequate (i.e., sufficient to absorb losses that currently may exist but are not yet identifiable).
Lending-related commitmentsTo provide for risk of losses inherent in the credit extension process, management also computes specific and expected loss components as well as a residual component for lending-related commitments, using a methodology similar to that used for the loan portfolio.
Allowance components
54 JPMorgan Chase 2001 Annual Report
Market risk management
JPMorgan Chase employs comprehensive, rigorous processes to measure, monitor and control market risk.
Market risk represents the potential loss in value of portfolios and financial instruments caused by movements in market variables, such as interest and foreign-exchange rates, credit spreads, and equity and commodity prices.
The Firm employs a comprehensive approach to market-risk management for its trading, investment and asset/liability management (“A/L”) portfolios. Responsible for maintaining a sound market-risk control environment, the Firm’s Market Risk Management Group operates independently of the business units it monitors, and comprises professionals in major markets around the globe.
Limits
JPMorgan Chase controls market risk primarily through a series of limits. Approved by the Firm’s Risk Management Committee, these limits align specific risk-taking activities with the overall risk appetite of the Firm and of the individual business units.
Limits are set based on analyses of both the market environment and business strategy. The analyses encompass criteria such as market volatility, liquidity of the products involved, business track record, and management experience and depth. JPMorgan Chase reviews risk limits regularly and the Firm’s Market Risk Management Group updates the risk limits at least twice a year. The Market Risk Management Group further limits the Firm’s exposure by specifically designating which financial instruments each business unit may trade.
Types of limits and where they apply:
At the corporate level:
At the segment and line of business levels:
The Firm establishes VAR limits at the aggregate corporate and top-level business, or unit levels. The Firm complements VAR with restrictions on overall portfolio size, and the amount of value a portfolio can lose as measured by hypothetical stress test scenarios. Additional types of limits may apply to business sub-units. As a rule, all businesses are expected to maintain exposures within their limits. If a limit is exceeded, the business is responsible for immediately reducing exposure to a level within the limit. When this is not possible within an acceptable timeframe, senior management is consulted on the appropriate method of reducing exposure. Together, these techniques reduce the likelihood that trading losses will exceed the risk appetite of the Firm as a whole, or that of a single business.
Risk measurement
Because no single measure can reflect all aspects of market risk, the Firm uses several risk measures, both statistical and nonstatistical. This combined approach gives JPMorgan Chase a more comprehensive view of its exposure, and enhances the stability of the Firm’s revenues from market-risk-taking activities.
Risk measures:
Value-at-riskJPMorgan Chase’s statistical risk measure, VAR, gauges the dollar amount of potential loss from adverse market moves in an ordinary market environment. Each business day, the Firm undertakes a comprehensive VAR calculation that includes the trading and investment portfolios, plus all JPMorgan Chase market-risk-related A/L activities.
JPMorgan Chase’s VAR calculation is highly granular, comprising more than 500,000 positions and 220,000 market prices, e.g., securities prices, interest rates, and foreign-exchange rates. For a large portion of the Firm’s exposure, JPMorgan Chase has implemented full-revaluation VAR, which management believes tends to generate more accurate results.
To calculate VAR, the Firm uses historical simulation, which measures risk across instruments and portfolios in a consistent, comparable way. This approach assumes that actual historical changes in market prices are representative of possible future changes. The simulation is based on data for the previous 12-month period.
Key terms:
JPMorgan Chase 2001 Annual Report 55
All statistical models involve a degree of uncertainty, depending on the assumptions they employ. The Firm prefers historical simulation because it involves fewer assumptions about the distribution of portfolio losses than parameter-based methodologies.
To evaluate the soundness of the Firm’s VAR model, JPMorgan Chase conducts daily back-testing of VAR against actual financial results. In addition, the Firm rigorously assesses the quality of the market data, since their accuracy is critical to computing VAR.
JPMorgan Chase calculated the VAR numbers reported to the right using a one-day time horizon and a 99% confidence level. This means the Firm would expect to incur losses greater than predicted by VAR estimates only once in every 100 trading days, or about 2.5 times a year. For the year 2001, actual Firm-wide trading losses exceeded the VAR on one day, a result which does not differ significantly from the 99% confidence level.
Although no single risk statistic can reflect all aspects of market risk, the table below provides a meaningful overview of the Firm’s market risk exposure arising from trading activities and the investment and A/L portfolio. The investment and A/L activities are accounted for on an accrual basis; therefore, changes in value do not impact income results in the same manner as trading positions.
Aggregate portfolio
As the chart at the top of the next page shows for 2001, JPMorgan Chase posted positive daily market risk-related revenue for 220 out of 251 days, with 89 days exceeding positive $50 million. No daily trading losses were incurred in excess of $125 million.
The inset examines the 31 days on which JPMorgan Chase posted trading losses, and depicts the amount by which the VAR was greater than the actual loss on each day. The inset shows that a loss exceeded the VAR on only one day (when the Firm recognized trading losses related to its exposure to Enron), a performance statistically consistent with the Firm’s VAR’s 99% confidence level.
Stress testingWhile VAR reflects the risk of loss due to unlikely events in normal markets, stress testing captures the Firm’s exposure to unlikely but plausible events in abnormal markets. Stress testing is equally important as VAR to the Firm in measuring and controlling its risk. The Firm stress tests its portfolios at least once a month, at both the corporate and line-of-business levels, using multiple scenarios. Scenarios are continually reviewed and updated to reflect changes in the Firm’s risk profile and economic events.
The Firm’s stress testing methodology assumes that, during an actual stress event, no action would be taken to change the risk profile of the Firm’s portfolios. This lets the Firm capture the decreased liquidity that often occurs with abnormal markets, and results, in the Firm’s view, in a conservative stress test result.
The Firm’s Risk Management Committee has established stress test loss advisories for the Firm. Should a stress test loss exceed a designated threshold, responsible business managers and senior management discuss how best to reduce the relevant risk exposure.
JPMorgan Chase conducts both economic-value and NII stress tests. Applying economic-value stress tests to the Firm’s trading portfolio, investment portfolio and A/L activities helps the Firm understand how the economic value of its balance sheet (not the amounts reported under GAAP) would be likely to change under certain scenarios.
56 JPMorgan Chase 2001 Annual Report
The following table represents the potential economic value stress test loss (pre-tax) in JPMorgan Chase’s trading portfolio predicted by JPMorgan Chase’s stress test scenarios:
Largest monthly stress test loss — pre-tax
The more conventional NII stress test reveals the potential change in JPMorgan Chase’s net interest income over the next year. NII stress tests highlight exposures to various interest-rate-sensitive factors, such as rates (e.g., the prime-lending rate), pricing strategies on deposits, and changes in product mix. NII stress tests also take into account forecasted balance sheet changes, such as asset sales and securitizations, as well as prepayment and reinvestment behavior.
Other nonstatistical risk measuresNonstatistical risk measures other than stress testing include net open positions, basis point values, option sensitivities, position concentrations and position turnover. These risk measures provide additional information on an exposure’s size and the direction in which it is moving.
Some material risks may escape detection through VAR, stress testing and the nonstatistical risk measures described above. JPMorgan Chase identifies these potential earnings vulnerabilities through the RIFLE system. Individuals who manage risk positions use this system to identify potential “worst-case” losses and estimate the probability of loss. Through RIFLE, this information flows to the appropriate level of management.
Capital allocationJPMorgan Chase allocates market risk capital to each major business division according to a formula that weights the division’s VAR and stress test exposures.
The VAR measure captures a large number of one-day price moves, while stress tests capture a smaller number of very large price moves. Under the capital allocation formula, capital is allocated to VAR exposure and stress test exposure equally.
JPMorgan Chase 2001 Annual Report 57
Operational risk management
Operational risk is the risk of loss resulting from inadequate or failed processes or systems, human factors, or external events.
Operational risk is an inherent risk element in each of the Firm’s businesses and key support activities. Such risk can manifest itself in various ways, including breakdowns, errors, business interruptions, and inappropriate behavior of employees, and can potentially result in financial losses and other damage to the Firm.
To monitor and control such risk, the Firm maintains a system of comprehensive policies and a control framework designed to provide a sound and well-controlled operational environment. The goal is to keep operational risk at appropriate levels in view of the Firm’s financial strength, the characteristics of its businesses and the markets in which it operates, and the competitive and regulatory environment to which it is subject.
Notwithstanding its control environment, the Firm has incurred operational risk losses from time to time, and there can be no assurance that such losses will not be incurred in the future.
Components of the JPMorgan Chase operational risk management practice
The Firm’s operational risk practice is comprised of several integrated components:
Governance structure: The governance structure provides the framework for, and sets the direction of, the Firm’s operational risk management activities.
Primary responsibility for managing operational risk rests with business managers. These individuals, with the support of their staffs, are responsible for establishing and maintaining internal control procedures that are appropriate for their particular operating environments.
The Corporate Operational Risk (“COR”) team, reporting to the Firm’s Productivity and Quality Executive under the overall responsibility of the Vice Chairman for Finance, Risk Management and Administration, has oversight responsibility for the Firm’s operational risk management initiatives. The COR team is currently executing a multi-year plan to develop a new integrated operational risk approach that emphasizes active management of operational risk throughout the Firm.
In 2001, the COR team created the Operational Risk Committee (“ORC”), comprised of senior operational risk and finance managers from each of the businesses. The ORC meets quarterly to discuss key operational risk issues of importance to the Firm. In addition, each of the businesses is required by COR policy to maintain business control committees which are responsible for overseeing the operational risk management practices within their respective businesses.
Self-assessment process: In 2001, a revised, firm-wide self-assessment process was designed and implemented. The focus of the process is to identify the key risks specific to each business’ operating environment, and for each business to assess the degree to which it is maintaining internal control procedures appropriate for its operating environment.
Components of the Firm’s operational risk management practice
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Year-end self-assessments were completed by the businesses in 2001 utilizing Horizon, an automated software application developed by the Firm. With the aid of Horizon, the Firm expects to move in 2002 from an annual, year-end self-assessment process to one that will be used by the businesses as an ongoing, dynamic risk management tool.
Risk event database: This database was extended firm-wide in 2001. The database enables the collection of operational event data thereby permitting analysis of errors and losses incurred (including analysis of trends and patterns), leading to a better understanding of the risk events faced by the businesses. Where available, the internal data can be supplemented with external data for comparative analysis with industry patterns. The data collected in the risk event database will also enable the Firm to back-test against self-assessment results.
Key risk indicators: Many of the businesses have incorporated “key risk indicators” for use as leading indicators in their operational risk management practices. This risk management tool will be further developed in 2002.
Audit alignment: Close collaboration between the COR team and the Firm’s internal audit function has helped further the firm-wide implementation of the operational risk approach, which in turn has led to a stronger overall control environment.
Capital allocation methodology
A combined capital amount for operational risk and business risk is derived through top-down benchmarking, by business, against comparable financial institutions. Capital is allocated to each business based on its complexity, expense base and control quality.
2002 initiatives
Specific 2002 initiatives include:
Impact of the events of September 11 on the operational risk practices of the Firm
The events of September 11th strongly tested the Firm’s operational risk practices, and demonstrated the importance of its disaster recovery contingency planning. While the Firm’s businesses were able successfully to implement their disaster recovery plans, and to avoid serious operational losses, there were nevertheless important lessons learned by the entire financial community. These lessons are currently under review for incorporation, as appropriate, into the Firm’s ongoing contingency planning.
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Liquidity risk management
Liquidity risk management policy
Liquidity risk arises from the general funding needs of the Firm’s activities and in the management of its assets. Liquidity risk management focuses on the risk that the Firm will be unable to replace maturing obligations when due or fund its assets at appropriate maturities and rates.
JPMorgan Chase recognizes the importance of sound liquidity management and has developed a liquidity framework intended to maximize liquidity access and minimize funding costs.
Liquidity risk management responsibilities
The Capital Committee sets the overall liquidity policy and oversees the contingency funding plan. The Capital Committee also reviews the Firm’s exposure to special purpose entities (“SPE”), with particular focus on potential liquidity support requirements the Firm may have to such SPEs.
The Liquidity Risk Committee is responsible for policy adherence, developing contingency planning, and monitoring internal and external liquidity warning signals, such as unusual widening of spreads, to permit timely detection of liquidity issues.
Liquidity risk management framework
The contingency funding plan considers temporary and long-term stress scenarios, where access to unsecured funding is severely limited or nonexistent.
The plan forecasts potential funding needs, taking into account both on- and off-balance sheet exposures, evaluating separately access to funds by the parent holding company and JPMorgan Chase Bank.
The goals of the plan are intended to ensure:
The Firm’s liquidity risk framework also incorporates tools to monitor three primary measures of liquidity. Each liquidity position is managed to provide sufficient surplus liquidity:
All three measures involve estimates and rely on management’s judgment about the Firm’s ability to liquidate assets or use them as collateral for borrowings.
Each of the Firm’s liquidity surplus positions, as of December 31, 2001, indicate that JPMorgan Chase’s long-dated funding, including core deposits, exceeds illiquid assets and that the Firm’s obligations can be met if access to funding is impaired.
The following table summarizes JPMorgan Chase’s contractual cash obligations and off-balance sheet lending-related financial instruments by remaining maturity at December 31, 2001:
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Sources of funds
JPMorgan Chase has access to diverse global funding sources. Liquidity is provided by a variety of both short-term and long-term instruments, including deposits, federal funds purchased, repurchase agreements, commercial paper, bank notes, medium- and long-term debt, capital securities, and stockholders’ equity.
A major source of liquidity for the Firm’s bank subsidiaries arises from their ability to generate core deposits. Core deposits include all domestic deposits, except noninterest-bearing time deposits and certificates of deposit of $100,000 or more. In addition to core deposits, the Firm generates substantial deposits from its Treasury & Securities Services business.
The ability to sell assets quickly is an important additional source of liquidity for the Firm. JPMorgan Chase holds marketable securities and other short-term investments that can be readily converted to cash. Loan syndication networks also are utilized to facilitate the disposition of assets when deemed desirable.
The Firm uses asset securitization programs as alternative funding sources, to provide liquidity and for asset/liability management purposes. In particular, securitization activities provide financing for credit cards, residential mortgages, auto loans, and commercial loans originated by JPMorgan Chase. SPEs are an integral part of securitization structures. Transactions between the Firm and these entities are reflected in JPMorgan Chase’s financial statements; these relationships include retained interests in securitization trusts, derivative transactions, and liquidity facilities. For further details, see Notes 1, 9, and 25.
The diversity of the Firm’s funding sources enhances funding flexibility, limits dependence on any one source of funds, and generally lowers the cost of funds. In making funding decisions, management considers market conditions, prevailing interest rates, liquidity needs, and the desired maturity profile of its liabilities.
Credit ratings
The cost and availability of unsecured financing are influenced by credit ratings. A reduction in these ratings could increase cost and limit market access.
JPMorgan Chase’s parent holding company credit ratings as of December 31, 2001 were as follows:
The ratings of the senior obligations of JPMorgan Chase Bank are generally one notch higher than the parent holding company. At February 28, 2002, the ratings outlook for the parent holding company by Standard & Poor’s and Fitch were negative, while the rating outlook from Moody’s was stable.
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Private equity risk management
JPMorgan Partners employs processes for risk measurement and control that are similar to those employed for other businesses within the Firm. Risk is initially monitored through limits calculated on original investment cost for the privately-held securities in JPMP’s portfolio through risk-based measures such as VAR and stress tests for the publicly-held securities in the portfolio.
JPMP’s limits are also structured to monitor potential industry sector and regional concentration issues. Industry limits have been set limiting the portfolio’s cost basis not to exceed 20% to any single sector. Regional limits have been set limiting the portfolio’s cost basis in international investments not to exceed 40%. In addition, to manage the pace of new investment activity, a ceiling on the amount of annual direct private equity investment activity has been set.
JPMorgan Partners’ holdings in public equities creates a significant exposure to general declines in the equity markets. To gauge that risk, VAR and stress test exposures are calculated in the same way as they are for the Firm’s trading and investment and asset/liability portfolios. See the Market risk management section of the MD&A on pages 55-57. In addition, to reduce the revenue volatility that results from this exposure, the Firm entered into hedging transactions that were intended to partially offset public equity market movements. These hedges were initially entered into during the third quarter of 2001. At the end of 2001, cumulative losses from these hedges were $71 million, primarily as a result of a rise in equity market price levels while the hedges were in place. The Firm may change the nature and type of hedges it enters into, as well as close a hedging position altogether, at any point in time.
Capital allocation
Internal capital is allocated to JPMP’s public equities portfolio based on stress scenarios that are similar to those applied to other businesses, and which reflect potential loss in the event of a large equity market decline. Capital is also allocated against illiquidity risk, which results from the trading restrictions to which some holdings are subject. For private equities, capital is allocated based on a long-term equity market stress scenario that is consistent with the investment horizons associated with these holdings. For these investments, additional capital is allocated against the risk of an unexpectedly large number of write-offs or write-downs.
For both public and private equities, the overall internal capital allocation exceeds 50% of the investments’ carrying value. This is a significantly higher allocation than the amount that is currently required for regulatory capital.
Accounting and reporting developments
Business combinations and intangible assets
In June 2001, the FASB issued SFAS 141, which revises the financial accounting and reporting for business combinations, and SFAS 142, which revises the financial accounting and reporting for goodwill and other intangible assets. SFAS 141 requires that all business combinations be accounted for using the purchase method. Accounting for business combinations using the pooling of interests method no longer is allowed. SFAS 141 also requires that intangible assets acquired in a business combination be recognized apart from goodwill if the intangible assets meet one of two criteria — the contractual-legal criterion or the separability criterion. The provisions of SFAS 141 apply to all business combinations initiated after June 30, 2001 as well as business combinations accounted for by the purchase method for which the date of acquisition is July 1, 2001 or later.
SFAS 142 establishes how intangible assets (other than those acquired in a business combination) should be accounted for upon acquisition. It also addresses how goodwill and other intangible assets should be accounted for subsequent to their acquisition. Goodwill and intangible assets that have indefinite useful lives no longer will be amortized but will be tested at least annually for impairment. Intangible assets with finite lives will continue to be amortized over their useful lives. The provisions of SFAS 142 are required to be adopted January 1, 2002. Impairment losses that arise due to the initial application of SFAS 142 are required to be reported as a change in accounting principle.
The Firm has determined that the adoption of SFAS 142 will not result in an impairment of goodwill. Based on current levels of amortization expense, the Firm estimates that the elimination of goodwill amortization expense will reduce total noninterest expense by approximately $580 million during 2002 and that ongoing amortization expense will be approximately $150 million per year (prior to the Providian card acquisition in the first quarter of 2002).
Derivatives
JPMorgan Chase adopted SFAS 133, which establishes accounting and reporting standards for all derivative instruments, at January 1, 2001. For a further discussion on the adoption of SFAS 133, see Note 24.
Allowance for loan losses
In 1999, the Accounting Standards Executive Committee of the American Institute of Certified Public Accountants formed the Allowance for Loan Losses Task Force (“Task Force”) to research current accounting guidance and practices as they relate to loan losses. It is currently expected that the Task Force will issue an exposure draft of a statement of position in the second half of 2002 that will provide additional accounting and reporting guidance and clarification of the factors to consider in determining the allowance for loan losses.
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Comparison between 2000 and 1999
JPMorgan Chase’s reported net income was $5.73 billion in 2000 compared with $7.50 billion in 1999. Diluted net income per share was $2.86 in 2000 compared with $3.69 in 1999.
Operating results Including JPMP
Operating earnings, including JPMorgan Partners, were $5.93 billion in 2000, a decrease of 20% from 1999. Diluted operating earnings per share decreased 19% when compared with the prior year.
Operating revenues in 2000 rose 3% to $32.8 billion reflecting the impact of the Hambrecht & Quist (“H&Q”), Flemings and The Beacon Group, LLC (“Beacon”) acquisitions, which resulted in higher investment banking fees, trading-related revenue and fees and commissions. The increases in revenues were partially offset by lower private equity gains, which were significantly affected by the sharp decline in the NASDAQ during 2000 compared with 1999. Net interest income, on an operating basis, was $10.0 billion in 2000, remaining relatively stable with 1999.
Operating expenses were $21.4 billion in 2000, an increase of 20% from the prior year. The growth in expenses reflected, in particular, the investments in talent and infrastructure of the Investment Bank to deepen its product capabilities, and at Investment Management & Private Banking to broaden its geographic reach.
Credit costs during 2000 were $2.37 billion compared with $2.44 billion in 1999. The slight decrease was due to the impact of lower net charge-offs in both the commercial and consumer loan portfolios.
Income tax expense in 2000 on a reported basis was $3.01 billion compared with $3.99 billion in 1999. The effective tax rate was 34.4% for 2000 compared with 34.7% for 1999.
Operating results excluding JPMP
JPMorgan Chase’s cash operating earnings, excluding JPMorgan Partners, were $6.2 billion in 2000, an increase of 4% from 1999. Diluted cash operating earnings per share increased 6%, when compared with 1999.
Investment Bank cash operating earnings of $3.49 billion for 2000 were up 3% when compared with 1999. Revenue growth was driven by higher investment banking fees, trading-related revenue and fees and commissions attributable to the acquisitions of Flemings, H&Q, and Beacon. These acquisitions contributed to the advisory and securities underwriting business, in particular, within the media, telecommunications, healthcare and technology-related industries. Also an effect of the acquisitions was the significant increase in brokerage commissions associated with the strong market making volume.
Cash operating expenses rose during 2000 primarily due to the build up of the investment banking platform and the inclusion of Flemings and H&Q. In addition, incentive costs increased as a result of the growth in revenue and acquisition-related compensation commitments to retain key executives.
Treasury & Securities Services cash operating earnings in 2000 increased 28% when compared with 1999 reflecting revenue growth of 13% for the year. Broad-based growth in Investor Services and Institutional Trust Services revenues fueled the growth in revenue, with only a slight increase reflected at Treasury Services. Expenses rose more slowly than revenues primarily due to expense reduction efforts at Treasury Services. Total cash operating expense rose only 8% from 1999, and combined with the higher rate of revenue growth, operating margin improved significantly from last year.
Investment Management & Private Banking cash operating earnings in 2000 increased 67% from 1999 due to the acquisitions of Flemings and H&Q. IMPB’s revenues increased 35% from 1999 due to the acquisitions. Pro forma for Flemings and H&Q, revenues increased primarily due to higher Private Banking revenues as a result of strong commission revenues and structuring fees during the first half of 2000. Cash operating expenses of $2.52 billion in 2000 rose 28% from the prior year primarily reflecting the aforementioned acquisitions.
Assets under management within Investment Management & Private Banking stood at $638 billion as of December 31, 2000, up from $543 billion at the end of 1999, primarily due to the acquisition of Flemings. This excludes assets attributable to JPMorgan Chase’s 45% stake in American Century.
JPMorgan Partners cash operating earnings decreased by 86% when compared with the prior year primarily as a result of unrealized losses associated with the downward movement in the public equity markets in 2000. These losses were mostly for listed companies at the NASDAQ, and particularly those that belonged to the telecommunications and technology sectors. Many of these same investments contributed to the significant unrealized gains recognized in 1999. These were partially offset by record realized gains reflecting the sales of direct investments in companies that JPMorgan Partners had financed in prior years.
Retail & Middle Market Financial Services cash operating earnings rose 5% to $1.79 billion. The increase in 2000 reflected the improvement in credit quality from 1999. In addition, the solid growth in deposit volumes helped produce strong results at RBG and Middle Markets. Partially offsetting these favorable items were the impact of increased funding costs as a result of higher interest rates on the credit-related businesses, namely, Cardmember Services, Home Finance and Auto Finance, as well as the impact of a $100 million decrease in the estimated auto lease residual value recognized in the first quarter of 2000.
During 2000, Retail & Middle Market Financial Services initiated a number of business reorganizations that included the sale of the retail operations in Hong Kong and Panama.
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management’s report on responsibility for financial reporting and report of independent accountantsJ.P. Morgan Chase & Co.
To our stockholders:
The management of J.P. Morgan Chase & Co. has the responsibility for preparing the accompanying consolidated financial statements and for their integrity and objectivity. The statements were prepared in accordance with accounting principles generally accepted in the United States of America. The consolidated financial statements include amounts that are based on management’s best estimates and judgments. Management also prepared the other information in the Annual Report and is responsible for its accuracy and consistency with the consolidated financial statements.
Management maintains a comprehensive system of internal control to assure the proper authorization of transactions, the safeguarding of assets and the reliability of the financial records. The system of internal control provides for appropriate division of responsibility and is documented by written policies and procedures that are communicated to employees. J.P. Morgan Chase & Co. maintains a strong internal auditing program that independently assesses the effectiveness of the system of internal control and recommends possible improvements. Management believes that as of December 31, 2001, J.P. Morgan Chase & Co. maintained an effective system of internal control.
The Audit Committee of the Board of Directors reviews the systems of internal control and financial reporting. The Committee, which is comprised of directors who are independent from J.P. Morgan Chase & Co., meets and consults regularly with management, the internal auditors and the independent accountants to review the scope and results of their work.
The accounting firm of PricewaterhouseCoopers LLP has performed an independent audit of J.P. Morgan Chase & Co.’s financial statements. Management has made available to PricewaterhouseCoopers LLP all of J.P. Morgan Chase & Co.’s financial records and related data, as well as the minutes of stockholders’ and directors’ meetings. Furthermore, management believes that all representations made to PricewaterhouseCoopers LLP during its audit were valid and appropriate. The accounting firm’s report appears below.
William B. Harrison, Jr.
Chairman and Chief Executive Officer
Marc J. Shapiro
Vice ChairmanFinance, Risk Management and Administration
Dina Dublon
Executive Vice President and Chief Financial Officer
January 15, 2002
PRICEWATERHOUSECOOPERS LLP • 1177 AVENUE OF THE AMERICAS • NEW YORK, NY 10036
To the Board of Directors and stockholders of J.P. Morgan Chase & Co.:
In our opinion, the accompanying consolidated balance sheets and the related consolidated statements of income, of changes in stockholders’ equity and of cash flows present fairly, in all material respects, the financial position of J.P. Morgan Chase & Co. and its subsidiaries at December 31, 2001 and 2000, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2001, in conformity with accounting principles generally accepted in the United States of America. These financial statements are the responsibility of J.P. Morgan Chase & Co.’s management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with auditing standards generally accepted in the United States of America, which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
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consolidated statement of incomeJ.P. Morgan Chase & Co.
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consolidated balance sheetJ.P. Morgan Chase & Co.
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consolidated statement of changes in stockholders’ equityJ.P. Morgan Chase & Co.
JPMorgan Chase 2001 Annual Report 67
consolidated statement of cash flowsJ.P. Morgan Chase & Co.
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notes to consolidated financial statementsJ.P. Morgan Chase & Co.
1 Basis of presentation
ConsolidationOn December 31, 2000, J.P. Morgan & Co. Incorporated (“J.P. Morgan”) merged with and into The Chase Manhattan Corporation (“Chase”). Upon consummation of the merger, Chase changed its name to J.P. Morgan Chase & Co. (“JPMorgan Chase” or “the Firm”). The merger was accounted for as a pooling of interests and, accordingly, the information included in the financial statements and consolidated notes of JPMorgan Chase reflects the combined results of Chase and J.P. Morgan as if the merger had been in effect for all periods presented. In addition, certain amounts have been reclassified to conform to the current presentation.
JPMorgan Chase is a financial holding company for a group of subsidiaries that provide a wide range of services to a global client base that includes corporations, governments, institutions and individuals. For a discussion of JPMorgan Chase’s business segment information, see Note 29.
The accounting and financial reporting policies of JPMorgan Chase and its subsidiaries conform to U.S. generally accepted accounting principles and prevailing industry practices. Additionally, where applicable, the policies conform to the accounting and reporting guidelines prescribed by bank regulatory authorities.
The consolidated financial statements include the accounts of JPMorgan Chase and its majority-owned subsidiaries after eliminating intercompany balances and transactions.
Investments in companies in which JPMorgan Chase has significant influence over operating and financing decisions (generally defined as owning a voting or economic interest of 20% to 50%) are accounted for in accordance with the equity method of accounting. These investments are generally included in Other assets and the Firm’s share of income or loss is included in Other revenue.
Assets held in an agency or fiduciary capacity by JPMorgan Chase are not assets of JPMorgan Chase and are not included in the Consolidated balance sheet.
Special-purpose entities(The terms special-purpose entity (“SPE”) and special-purpose vehicle (“SPV”) are used interchangeably in practice.)
Special-purpose entities are an important part of the financial markets, providing market liquidity by facilitating investors’ access to specific portfolios of assets and risks. SPEs are typically set up for a single, discrete purpose. SPEs are not operating entities and usually have no employees and a limited life. The basic SPE structure involves a company selling assets to the SPE. The SPE funds the purchase of those assets by issuing securities to investors. The legal documents that govern the SPE transaction describe how the cash earned on the assets held in the SPE must be allocated to the investors and other parties that have rights to these cash flows.
SPEs can be structured to be bankruptcy remote, thereby insulating investors from the impact of the creditors of other entities, including the seller of the assets. They are critical to the functioning of several significant investor markets, including, for example, the mortgage-backed securities, asset-backed securities and commercial paper markets.
Where JPMorgan Chase is a transferor of assets to an SPE, the assets sold to the SPE are derecognized and the SPE is not consolidated on the balance sheet when the assets are legally isolated from the Firm’s creditors and the SPE is a qualifying special-purpose entity (“QSPE”). SFAS 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities, provides specific criteria for determining when an SPE meets the definition of a QSPE. When an SPE does not meet the formal definition of a QSPE, the decision whether or not to consolidate depends on the applicable accounting principles for non-QSPEs, including a determination regarding the nature and amount of investment made by third parties to the SPE. Consideration is given to, for example, whether a third party has made a substantive equity investment in the SPE; which party has voting rights, if any; who makes decisions about the assets in the SPE; and who is at risk for loss. The SPE is consolidated if JPMorgan Chase retains or acquires control over the risks and rewards of the assets in the SPE.
JPMorgan Chase is involved with SPEs in three broad categories of transactions: securitizations, conduits, and client intermediation. As part of JPMorgan Chase’s securitization activity, consumer or commercial loans are sold to an SPE from the Firm’s balance sheet (see Note 9, Loan securitizations). Consumer securitizations involve the sale of consumer receivables originated primarily in the Firm’s residential mortgage, credit card, and auto loan businesses; for commercial securitizations, the Firm securitizes both Firm-originated and purchased commercial mortgages to facilitate the issuance of commercial mortgage-backed securities to investors. Assets sold to the SPEs as part of the securitization process are not reflected in JPMorgan Chase’s balance sheet (except for retained interests as described below), but are included on the balance sheet of the SPE purchasing the assets. Assets held by securitization-related SPEs as of December 31, 2001 were as follows:
In credit card securitizations, the Firm retains some risk of loss with respect to the receivables held by the SPE to the extent of its subordinated retained interest as well as its undivided interest in the credit card master trust. This risk of loss is reflected as “managed” losses in the Firm’s discussion of operating income. At December 31, 2001, the Firm’s undivided interest in the credit card master trust totaled $3.9 billion and is accounted for as set
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forth in Note 9. Interest-only strips of $38 million are also retained and carried on the Firm’s balance sheet at fair value. In home mortgage securitizations and in auto securitizations, JPMorgan Chase retains an interest-only strip (equal to $1.0 billion and $0.1 billion, respectively), which reflects first loss risk and is carried on the Firm’s balance sheet at fair value. In commercial mortgage securitizations, JPMorgan Chase retains a subordinated interest (equal to $10 million), which is also carried at fair value. With respect to securitization transactions involving other Firm assets, the Firm holds retained interests ($56 million, which are fully hedged), and may be obligated to fund an additional $31.8 million of senior notes. JPMorgan Chase does not provide any other liquidity commitments to the SPEs utilized in its commercial or consumer securitization business. All amounts above are as of December 31, 2001.
For conduit transactions, JPMorgan Chase serves as the administrator and provides contingency liquidity support for several commercial paper conduits. Conduits provide clients with a way to access liquidity in the commercial paper markets by allowing clients to sell assets to the conduit, which then issues commercial paper to fund the purchases. Issuance of commercial paper by conduits aggregated $20.2 billion at December 31, 2001. The commercial paper issued by the conduits is supported with sufficient asset collateral, other credit enhancement, and liquidity support to receive at least an A-1 or P-1 rating. JPMorgan Chase Bank has commitments to provide liquidity to these conduits up to $26.2 billion of commercial paper issuances. JPMorgan Chase applies the same underwriting standards in making liquidity commitments to the conduits as the Firm would with other extensions of credit.
As a financial intermediary, JPMorgan Chase is involved in structuring SPE transactions to meet investor and client needs. In this capacity, JPMorgan Chase has created structured commercial loan vehicles managed by third parties in which loans are purchased from third parties or through the Firm’s syndication and trading functions. Investors in these vehicles provide cash collateral and have a first risk of loss up to the amount of collateral committed. JPMorgan Chase retains a second risk of loss or has the option to sell loans from the vehicles if assets deteriorate below specified levels. Issuance of commercial paper by these vehicles as of December 31, 2001 was $9.1 billion. JPMorgan Chase Bank has a commitment to provide liquidity to these vehicles for up to $12.0 billion of commercial paper issuances.
As a financial intermediary, JPMorgan Chase also structures SPEs to modify the cash flows of third-party assets to create investments with specific risk profiles, or to assist clients in the efficient management of other risks. JPMorgan Chase may enter into derivative contracts with these SPEs to accomplish these ends. These derivative contracts are captured on the Firm’s balance sheet in Trading assets or Trading liabilities in the same manner as other derivative contracts and are marked-to-market through Trading revenue. Fees received from any administrative functions related to SPEs (underwriter, trustee, custodian, etc.) are included when earned in Fees and commissions. Note 4 provides details on JPMorgan Chase’s Noninterest revenue.
JPMorgan Chase’s maximum liquidity commitment to the structured commercial loan vehicles, the commercial paper conduits and to other client transactions ($3.7 billion) totaled $41.9 billion at December 31, 2001. These commitments are included in the Firm’s total of $248 billion in commitments to lend described in more detail in Note 25 and the Liquidity discussion on page 60 of the MD&A. The Firm would be required to fund these commitments in the event the commercial paper market were unavailable to these vehicles. In addition, if JPMorgan Chase Bank were downgraded below A-1 or P-1, the SPEs could draw on the commitments since asset-backed commercial paper rated below A-1 or P-1 would generally not be issuable by the vehicle. Under these circumstances, JPMorgan Chase Bank would have the option to replace itself as liquidity provider or the assets in the SPE could be sold or refinanced in other markets. In no circumstances is the Firm committed to issue its own stock to support an SPE transaction.
As noted above, all transactions and retained interests between the Firm and the SPEs are reflected in JPMorgan Chase’s balance sheet or Notes to the financial statements. Internal economic capital is held against all residual exposures, derivative transactions and lending commitments, as appropriate. The Firm’s policies require that transactions with SPEs be conducted at arms’ length and reflect market pricing. Consistent with this policy, no JPMorgan Chase employee is permitted to invest in the SPEs with which JPMorgan Chase are involved.
Use of estimates in the preparation of consolidated financial statementsThe preparation of consolidated financial statements requires management to make estimates and assumptions that affect reported revenues, expenses, assets, liabilities, and disclosure of contingent assets and liabilities. Actual results could be different from these estimates.
Foreign currency translationAssets and liabilities denominated in foreign currencies are translated into U.S. dollars using applicable rates of exchange. JPMorgan Chase translates revenues and expenses using exchange rates at the transaction date.
Gains and losses from translating the financial statements of a foreign operation where the functional currency is not the U.S. dollar are included in Accumulated other comprehensive income (loss) within Stockholders’ equity. For foreign operations where the functional currency is the U.S. dollar, which include operations in highly inflationary environments, transaction gains and losses are reported in the Consolidated statement of income.
Statement of cash flowsFor JPMorgan Chase’s Consolidated statement of cash flows, cash and cash equivalents is defined as those amounts included in Cash and due from banks.
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Significant accounting policiesThe following table identifies JPMorgan Chase’s significant accounting policies and the Note and page where a detailed description of each policy can be found:
2 Business changes and developments
Merger with J.P. Morgan on December 31, 2000Under the terms of the merger agreement, 617 million shares of JPMorgan Chase’s common stock were issued in exchange for all of the outstanding shares of J.P. Morgan’s common stock (based on an exchange ratio of 3.7 shares of JPMorgan Chase’s common stock for each share of J.P. Morgan’s common stock). All of J.P. Morgan’s series of preferred stock were exchanged on a one-for-one basis for a corresponding series of JPMorgan Chase’s preferred stock having substantially the same terms.
Acquisition of the mortgage business of Advanta Corp.In the first quarter of 2001, Chase Manhattan Mortgage Corporation, an indirect subsidiary of JPMorgan Chase, acquired all of the mortgage business of Advanta Corp. The acquisition included Advanta’s origination capability, loan servicing and subservicing portfolio, and related securitization residual interests.
Sale of Hong Kong retail banking businessDuring the fourth quarter of 2000, Chase completed the sale of its Hong Kong-based retail banking business, including Chase Manhattan Card Company Limited, to Standard Chartered PLC for $1.3 billion in cash. The sale resulted in a pre-tax gain of $827 million ($537 million after-tax).
Transfer of Euroclear-related businessOn December 31, 2000, J.P. Morgan and the Boards of Euroclear Clearance System PLC and Euroclear Clearance System Société Cooperative consummated their agreement and created a European-based bank in Brussels, known as Euroclear Bank, which assumed the operations of the Euroclear System from J.P. Morgan. The transfer resulted in a gain of $399 million ($267 million after-tax) in 2000, which reflected the impact of the minimum proceeds to be received from the Euroclear Bank over the next two years. In addition, under the agreement, the Firm could receive additional proceeds of up to $100 million per year for each of 2001 and 2002 based on the financial performance of the Euroclear Bank during those periods. The Firm received $16 million of additional proceeds in 2001.
Sale of ChaseMellon shareholder servicesOn October 16, 2000, Chase agreed to sell its interest in ChaseMellon Shareholder Services, then a 50-50 joint venture between Chase and Mellon Financial Corporation. The sale was completed during November 2000 and did not have a material impact on JPMorgan Chase’s earnings.
Acquisition of FlemingsOn August 1, 2000, Chase acquired Robert Fleming Holdings Limited (“Flemings”). The consideration issued to Flemings’ shareholders consisted of £2.6 billion in cash and notes and 65.3 million shares of Chase common stock. Chase also established retention arrangements for key Flemings employees that aggregated approximately $220 million (after-tax) and are generally being expensed over the two years following the acquisition. The transaction was accounted for under the purchase method.
Acquisition of BeaconChase acquired The Beacon Group, LLC (“Beacon”), a privately held investment banking firm, on July 6, 2000. The acquisition was accounted for under the purchase method.
Acquisition of Hambrecht & QuistChase acquired Hambrecht & Quist (“H&Q”) for $1.46 billion on December 9, 1999. The acquisition was accounted for under the purchase method.
3 Trading activities
Trading assets include debt and equity securities held for trading purposes that JPMorgan Chase owns (“long” positions). Trading liabilities include debt and equity securities that JPMorgan Chase has sold to other parties but does not own. These securities are “short” positions, and JPMorgan Chase is obligated to purchase these securities at a future date. Also included in Trading liabilities are structured notes that JPMorgan Chase transacts as part of its trading activity. Trading positions, as well as derivatives used for trading purposes, are carried at fair value on the Consolidated balance sheet, with changes in the fair value recorded in Trading revenue. Trading positions are recorded on a trade date basis. The reported receivables (unrealized gains) and payables (unrealized losses) related to derivatives include the effect of master netting agreements as permitted under FASB Interpretation No. 39.
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Trading revenueThe following table sets forth the components of total trading-related revenue:
Trading assets and liabilitiesThe following table presents the fair value of Trading assets and Trading liabilities for the dates indicated:
Debt and equity instruments pledged as collateral that can be sold or repledged by the secured party amounted to $48.6 billion and $53.6 billion at December 31, 2001 and 2000, respectively.
Average Trading assets and liabilities were as follows for the periods indicated:
4 Noninterest revenue
Investment banking feesInvestment banking fees include advisory, equity and debt underwriting and other fees. Advisory fees are recognized as revenue when the related services are performed. Underwriting fees are presented net of syndicate expenses. In addition, JPMorgan Chase recognizes credit arrangement and syndication fees as revenue after satisfying certain retention, timing and yield criteria.
The following table presents the components of investment banking fees:
Fees and commissionsFees and commissions primarily include fees from investment management, custody and processing services, deposit accounts, brokerage services, mortgage servicing, loan commitments, standby letters of credit, compensating balances, insurance products and other financial service-related products. All of these fees are generally recognized over the period that the related service is provided. Also included are credit card revenues which primarily include interchange income, late fees, cash advance, and annual and overlimit fees, as well as servicing fees earned in connection with securitization activities. Credit card revenues are generally recognized as billed, except for annual fees, which are recognized over a 12-month period.
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Details of Fees and commissions were as follows:
Other revenueDetails of Other revenue were as follows:
5 Interest income and interest expense
Details of interest income and expense were as follows:
6 Noninterest expense
Merger and restructuring costsThe following table shows the components of these costs during 2001 and 2000:
The following table shows the utilization of the $1.25 billion merger liability during 2001 and 2000:
In September 2001, management estimated that $650 million of additional nonaccruable merger costs would be incurred in 2001 and 2002. These costs consisted primarily of systems integration costs, facilities costs and retention payments. In September 2001, management estimated that the Firm would also incur one-time costs of $400 million in connection with the right-sizing of employee levels of certain businesses (2,000 employee reductions) beyond that planned at the time of the merger. These severance costs consisted of a $300 million charge that was recorded on September 30, 2001 and $100 million of costs to be incurred in 2001 and 2002 that were not accruable under existing accounting pronouncements. In 2001, $259 million of the right-sizing liability was utilized resulting in a remaining balance of $41 million at December 31, 2001.
In connection with several strategic restructuring initiatives in the fourth quarter of 1999, JPMorgan Chase incurred a charge of $175 million for planned consolidation actions in certain businesses, planned staff reductions, and the disposition of premises and equipment resulting from the relocation of several businesses to Florida, Texas and Massachusetts. At December 31, 2001, the related restructuring liability was fully utilized. Additionally, in December 1999, $152 million of costs were reversed, primarily relating to occupancy costs not fully utilized under a restructuring charge incurred in 1998.
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Other expenseDetails of Other expense were as follows:
7 Securities
Securities are classified as Available-for-sale (“AFS”), Held-to-maturity (“HTM”), or trading. Securities are classified as AFS when, in management’s judgment, they may be sold in response to or in anticipation of changes in market conditions. AFS securities are carried at fair value on the Consolidated balance sheet. Unrealized gains and losses after application of hedge accounting are reported net as increases or decreases to Accumulated other comprehensive income (loss). The specific identification method is used to determine realized gains and losses on AFS securities, which are included in Securities gains (losses) on the Consolidated statement of income. Securities that JPMorgan Chase has the positive intent and ability to hold to maturity are classified as HTM and are carried at amortized cost on the Consolidated balance sheet.
The following table presents realized gains and losses from AFS securities:
AFS securities pledged as collateral that can be sold or repledged by the secured party amounted to $30.2 billion and $28.7 billion at December 31, 2001 and 2000, respectively.
In the calculation of effective yield for mortgage-backed securities (“MBS”) and collateralized mortgage obligations (“CMO”), JPMorgan Chase actively monitors the likelihood of prepayment of principal through its portfolio management function. Management regularly performs simulation testing to determine the impact that market conditions would have on its MBS and CMO portfolios. MBSs and CMOs that management believes have high prepayment risk are included in the AFS portfolio and reported at fair value.
The amortized cost and estimated fair value of AFS and HTM securities were as follows for the dates indicated:
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The following table presents the amortized cost, estimated fair value and average yield at December 31, 2001 of JPMorgan Chase’s AFS and HTM securities by contractual maturity range:
Securities purchased under resale agreements (“resale agreements”) and securities sold under repurchase agreements (“repurchase agreements”) are generally treated as collateralized financing transactions and are carried on the Consolidated balance sheet at the amounts the securities will be subsequently sold or repurchased, plus accrued interest. Similar transactions that do not meet the SFAS 140 definition of a repurchase agreement are accounted for as “buys” and “sells” rather than financing transactions. Where appropriate, resale and repurchase agreements with the same counterparty are reported on a net basis. JPMorgan Chase takes possession of securities purchased under resale agreements. On a daily basis, JPMorgan Chase monitors the market value of the underlying collateral, which consists primarily of U.S. government and agency securities, and requests additional collateral from its counterparties when necessary.
Securities borrowed and securities lent (recorded in Other borrowed funds) are recorded at the amount of cash collateral advanced or received. Securities borrowed consist primarily of government and equity securities. JPMorgan Chase monitors the market value of the securities borrowed and lent on a daily basis and calls for additional collateral when appropriate. Fees received or paid are recorded in Interest income or Interest expense.
8 Loans
Loans are generally reported at the principal amount outstanding, net of the allowance for loan losses, unearned income and any net deferred loan fees (nonrefundable yield-related loan fees, net of related direct origination costs). Loans held for sale are carried at the lower of aggregate cost or fair value. Loans held for trading purposes are included in Trading assets and are carried at fair value, with the gains and losses included in Trading revenue. Interest income is recognized using the interest method or on a basis approximating a level rate of return over the term of the loan.
Nonaccrual loans are those loans on which the accrual of interest is discontinued. Loans (other than certain consumer loans discussed below) are placed on nonaccrual status immediately if, in the opinion of management, full payment of principal or interest is in doubt or when principal or interest is past due 90 days or more and collateral, if any, is insufficient to cover principal and interest. Interest accrued but not collected at the date a loan is placed on nonaccrual status is reversed against Interest income. In addition, the amortization of net deferred loan fees is suspended when a loan is placed on nonaccrual status. Interest income on nonaccrual loans is recognized only to the extent it is received in cash. However, where there is doubt regarding the ultimate collectibility of the loan principal, all cash receipts thereafter are applied to reduce the carrying value of the loan. Loans are restored to accrual status only when interest and principal payments are brought current and future payments are reasonably assured.
Consumer loans are generally charged to the allowance for loan losses upon reaching specified stages of delinquency in accordance with the Federal Financial Institutions Examination Council’s (“FFIEC”) policy. For example, credit card loans are charged off at the earlier of 180 days past due or within 60 days from receiving notification of the filing of bankruptcy. Residential mortgage products are generally charged off to net realizable value at 180 days past due. Other consumer products are generally charged off (to net realizable value if collateralized) at 120 days past due. Accrued interest on residential mortgage products, auto financings and certain other consumer loans are accounted for in accordance with the nonaccrual loan policy discussed above. Accrued interest on all other loans is generally reversed against interest income when the consumer loan is charged off.
A collateralized loan is considered an in-substance foreclosure and is reclassified to assets acquired as loan satisfactions, within Other assets, only when JPMorgan Chase has taken physical possession of the collateral, regardless of whether formal foreclosure proceedings have taken place.
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The composition of the loan portfolio at each of the dates indicated was as follows:
Impaired loansJPMorgan Chase accounts for and discloses nonaccrual commercial loans as impaired loans. JPMorgan Chase recognizes interest income on impaired loans as discussed previously for nonaccrual loans. JPMorgan Chase excludes from impaired loans its small-balance homogeneous consumer loans, loans carried at fair value or the lower of cost or fair value, debt securities and leases.
The table below sets forth information about JPMorgan Chase’s impaired loans. JPMorgan Chase uses the discounted cash flow method as its primary method for valuing its impaired loans:
Allowance for credit lossesJPMorgan Chase’s Allowance for loan losses is intended to cover probable credit losses for which either the asset is not specifically identified or the size of the loss has not been fully determined. Within the allowance, there are specific and expected loss components and a residual component.
The specific loss component covers those commercial loans deemed by JPMorgan Chase to be criticized. JPMorgan Chase internally categorizes its criticized commercial loans into three groups: doubtful, substandard and special mention.
Nonperforming commercial loans (excluding leases) are considered to be impaired loans. The allowance for impaired loans is computed using the methodology under SFAS 114. An allowance is established when the discounted cash flows (or collateral value or observable market price) of an impaired loan is lower than the carrying value of that loan. For the purposes of computing the specific loss component of the allowance, larger impaired loans are evaluated individually, and smaller impaired loans are evaluated as a pool using historical loss experience for the respective class of assets. The criticized but still performing loans also are evaluated as a pool using historical loss rates.
The expected loss estimates for each consumer loan portfolio are based primarily on JPMorgan Chase’s historical loss experience for the applicable product portfolio.
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Finally, a residual component is maintained to cover uncertainties that could affect management’s estimate of probable losses. The residual component of the allowance reflects the margin of imprecision inherent in the underlying assumptions used in the methodologies for estimating specific losses and expected losses in both the commercial and consumer portfolios. It is anticipated that the residual component of the allowance will range between 10% and 20% of the total Allowance for loan losses.
JPMorgan Chase’s Risk Management Committee reviews, at least quarterly, the Allowance for loan losses relative to the risk profile of the Firm’s credit portfolio and current economic conditions. The allowance is adjusted based on that review if, in management’s judgment, changes are warranted. As of December 31, 2001, JPMorgan Chase deemed the allowance to be adequate (i.e., sufficient to absorb losses that currently may exist but are not yet identifiable).
To provide for risk of losses inherent in the credit extension process, management also computes specific and expected loss components as well as a residual component for lending-related commitments, using a methodology similar to that used for the loan portfolio.
JPMorgan Chase maintains an allowance for credit losses as follows:
The table below summarizes the changes in the Allowance for loan losses:
9 Loan securitizations
JPMorgan Chase securitizes, sells and services residential mortgage, credit card, automobile and commercial loans. Interests in the securitized and sold loans are generally retained in the form of senior or subordinated interest-only strips, subordinated tranches, escrow accounts and servicing rights. JPMorgan Chase’s undivided interest in its credit card master trust is recorded in and accounted for as Loans. This undivided interest represents credit card receivables owned by JPMorgan Chase within the master trust that have not been sold. JPMorgan Chase’s interest in these receivables rank pari-passu with the investors’ interests in the master trust. Other retained interests are primarily recorded in Other assets.
JPMorgan Chase retains the servicing responsibilities for all of its residential mortgage, credit card and automobile loan securitizations and for certain of its commercial loan securitizations and receives annual servicing fees based on the securitized loan balance plus certain ancillary fees. JPMorgan Chase also retains the right to service the residential mortgage loans sold as a result of mortgage-backed security transactions with the Government National Mortgage Association (“GNMA”), Federal National Mortgage Association (“FNMA”) and Federal Home Loan Mortgage Corporation (“Freddie Mac”). For a discussion of mortgage servicing rights, see Note 10.
Gains or losses on securitizations and sales depend, in part, on the previous carrying amount of the loans involved in the transfer and are allocated between the loans sold and the retained interests based on their relative fair values at the date of sale. Since quoted market prices are generally not available, JPMorgan Chase usually estimates fair value of these retained interests by determining the present value of future expected cash flows using modeling techniques that incorporate management’s best estimates of key variables, including credit losses, prepayment speeds and discount rates commensurate with the risks involved. Gains on securitizations and sales are reported in Other revenue. Retained interests that are subject to prepayment risk such that JPMorgan Chase may not recover substantially all of its investment are recorded at fair value with subsequent adjustments reflected in Other comprehensive income or in earnings if the fair value of the retained interest has declined below its carrying amount and such decline has been determined to be other-than-temporary.
During 2001, JPMorgan Chase securitized approximately $7.9 billion of residential mortgage loans, $6.0 billion of credit card loans, $2.5 billion of automobile loans and $5.5 billion of commercial loans, resulting in pre-tax gains on securitizations of $242 million, $42 million, $17 million and $40 million, respectively. During 2000, JPMorgan Chase securitized approximately $2.7 billion of residential mortgage loans, $2.9 billion of credit card loans, $1.3 billion of automobile loans and $4.7 billion of commercial loans, resulting in pre-tax gains (losses) on securitizations of $46 million, $7 million, $(1) million and $53 million, respectively. In addition, JPMorgan Chase sold residential mortgage
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loans totaling $45.8 billion and $21.5 billion during 2001 and 2000, respectively, primarily as GNMA, FNMA and Freddie Mac mortgage-backed securities, which sales resulted in gains of $262 million in 2001 and $106 million in 2000.
The following table summarizes certain cash flows received from securitization trusts for sales that were completed during 2001 and 2000 and the key economic assumptions used in measuring the retained interests as of the dates of such sales:
At December 31, 2001 and 2000, JPMorgan Chase had $3.9 billion and $6.7 billion, respectively, related to its undivided interest in its credit card master trusts. JPMorgan Chase also maintains escrow accounts up to predetermined limits for some of its residential mortgage, credit card and automobile securitizations in the unlikely event that deficiencies in cash flows owed to investors occur. The amounts available in such escrow accounts are recorded in Other assets and totaled $1 million, $341 million and $79 million as of December 31, 2001 for residential mortgage, credit card and automobile securitizations, respectively, and $7 million, $297 million and $81 million as of December 31, 2000, respectively. In addition, the Firm had other retained interests as of December 31, 2001 and 2000 totaling $1.0 billion and $363 million from its residential mortgage, $38 million and $2 million from its credit card, $141 million and $87 million from its automobile securitizations, and $66 million and $138 million from its commercial securitizations, respectively. These retained interests are primarily subordinated or residual interests.
The table below outlines the key economic assumptions and the sensitivity of the fair value at December 31, 2001 of the remaining retained interests to immediate 10% and 20% adverse changes in those assumptions:
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The sensitivity analysis in the preceding table is hypothetical and should be used with caution. As the figures indicate, changes in fair value based on a 10% variation in assumptions generally cannot easily be extrapolated because the relationship of the change in the assumptions to the change in fair value may not be linear. Also, in this table, the effect that a change in a particular assumption may have on the fair value is calculated without changing any other assumption. In reality, changes in one factor may result in changes in another, which might magnify or counteract the sensitivities.
Expected static pool net credit losses include actual incurred losses plus projected net credit losses divided by the original balance of the outstandings comprising the securitization pool. The table below displays the expected static pool net credit losses for 2001 and 2000 based on securitizations occurring in that year.
The table below presents information about delinquencies, net credit losses, and components of reported and securitized financial assets at December 31, 2001:
10 Mortgage servicing rights
JPMorgan Chase capitalizes the value that is expected to be realized from performing specified residential mortgage servicing activities for others as Mortgage servicing rights (“MSRs”). Such capitalized servicing rights are purchased or retained upon sales or securitization of mortgages. These rights are amortized in proportion to, and over the period of, the estimated future net servicing income stream of the underlying mortgage loans as a reduction of the actual servicing income received. MSRs are periodically evaluated for impairment based on their current fair values, which are estimated using a discounted future cash flow model that considers portfolio characteristics and assumptions regarding prepayment speeds, delinquency rates, ancillary revenues and other economic factors. For purposes of evaluating and measuring impairment of MSRs, the Firm stratifies its portfolio on the basis of the predominant risk characteristics: loan type and interest rate. Any indicated impairment is recognized as a reduction in revenue through a valuation allowance to the extent that the carrying value of an individual stratum exceeds its estimated fair value. Management has used its best judgment in estimating fair value. Since many economic factors can affect the estimate of the fair value of MSRs, the Firm closely assesses the major assumptions and modeling techniques used in its estimate of the fair value of its MSRs and reviews such assumptions against market comparables, if available. To mitigate the effect of changes in revenue from the interest rate risk inherent in the MSRs, the Firm uses both interest rate derivatives and AFS securities.
The following table summarizes mortgage servicing rights activity and related amortization. It also includes the key assumptions and the sensitivity of the fair value of MSRs at December 31, 2001 to immediate 10% and 20% adverse changes in each of those assumptions:
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The sensitivity analysis in the preceding table is hypothetical and should be used with caution. As the figures indicate, changes in fair value based on a 10% and 20% variation in assumptions generally cannot be easily extrapolated because the relationship of the change in the assumptions to the change in fair value may not be linear. Also, in this table, the effect that a change in a particular assumption may have on the fair value is calculated without changing any other assumption. In reality, changes in one factor may result in changes in another, which might magnify or counteract the sensitivities.
As of January 1, 2001, certain interest rate derivatives that qualify as fair value hedges under SFAS 133 and the related hedged MSRs are accounted for at fair value in accordance with SFAS 133.
For the year ended December 31, 2001, the decrease in revenue resulting from SFAS 133 valuation adjustments and the change in the valuation allowance due to impairment totaled $1,951 million. These losses were substantially offset by total gains of $1,773 million relating to a combination of derivative gains, including those that qualify as SFAS 133 hedges, and realized gains from sales of AFS securities. Prior to January 1, 2001, realized gains and losses from the settlement or termination of derivative contracts that qualified as hedges were deferred as adjustments to the carrying value and amortized over the remaining life of the MSRs. At December 31, 2000 and 1999, net deferred hedge gains of $152 million and $193 million, respectively, were included as an adjustment to the carrying value of the MSRs.
11 Long-term debt
The following table is a summary of long-term debt (net of unamortized original issue debt discount):
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JPMorgan Chase issues long-term debt denominated in various currencies, although predominately U.S. dollars, with both fixed and variable interest rates.
The weighted-average contractual interest rate for total long-term debt was 5.12% and 6.52% as of December 31, 2001 and 2000, respectively. In order to modify exposure to interest rate and currency exchange rate movements, JPMorgan Chase utilizes derivative instruments, primarily interest rate and currency swaps, in conjunction with some of its debt issues. The use of these instruments modifies the Firm’s interest expense on the associated debt. The modified weighted average interest rate for total long-term debt, including the effects of related derivative instruments, was 4.64% and 6.70% as of December 31, 2001 and 2000, respectively.
JPMorgan Chase has guaranteed several long-term debt issues of its subsidiaries. Guaranteed debt totaled $180 million and $195 million at December 31, 2001 and 2000, respectively.
Guaranteed preferred beneficial interests in the Firm’s junior subordinated deferrable interest debenturesAt December 31, 2001, 11 wholly owned Delaware statutory business trusts established by JPMorgan Chase had issued an aggregate $4,439 million in capital securities, net of discount. The capital securities qualify as Tier 1 capital of the Firm. The proceeds from each issuance were invested in a corresponding series of junior subordinated deferrable interest debentures of JPMorgan Chase. The sole asset of each statutory business trust is the relevant debenture. The Firm has fully and unconditionally guaranteed each of the business trust’s obligations under each trust’s capital securities to the extent set forth in the guarantee. Each trust’s capital securities are subject to mandatory redemption, in whole or in part, upon repayment of the debentures at their stated maturity or earlier redemption.
The following is a summary of the outstanding capital securities, net of discount, issued by each trust and the junior subordinated deferrable interest debenture issued by JPMorgan Chase to each trust as of December 31, 2001:
12 Preferred stock of subsidiary
Chase Preferred Capital Corporation (“Chase Preferred Capital”), a wholly owned subsidiary of JPMorgan Chase Bank, a bank subsidiary of JPMorgan Chase, is a real estate investment trust (“REIT”) established for the purpose of acquiring, holding and managing real estate mortgage assets. At December 31, 2001, there were 22 million shares of 8.10% cumulative preferred stock, Series A (“Series A preferred shares”) issued and outstanding (liquidation preference, $25 per share). Dividends on the Series A preferred shares are cumulative and are payable quarterly. The dividends are recorded as minority interest expense by JPMorgan Chase. The Series A preferred shares are treated as Tier 1 capital of JPMorgan Chase and Tier 2 capital of JPMorgan Chase Bank. The total amount of Series A preferred shares outstanding at both December 31, 2001 and 2000 was $550 million.
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13 Preferred stock
JPMorgan Chase is authorized to issue 200 million shares of preferred stock, in one or more series, with a par value of $1 per share. Outstanding shares of preferred stock at December 31, 2001 and 2000 were 17.8 million and 26.2 million, respectively. During 2001, the Firm redeemed its 10.84% cumulative preferred stock, its variable cumulative preferred stock, Series B, C, D, E and F and repurchased 0.12 million shares of its 6.63% Series H cumulative preferred stock.
Dividends on shares of each outstanding series of preferred stock are payable quarterly. All the preferred stock outstanding have preference over JPMorgan Chase’s common stock for the payment of dividends and the distribution of assets in the event of a liquidation or dissolution of JPMorgan Chase.
The following is a summary of JPMorgan Chase’s preferred stock outstanding:
14 Common stock
JPMorgan Chase is authorized to issue 4.5 billion shares of common stock, with a $1 par value per share. The number of shares of common stock issued and outstanding were as follows:
On July 19, 2001, JPMorgan Chase’s Board of Directors authorized the repurchase of up to $6 billion of the Firm’s common stock, net of issuance for employee benefit plans. As of December 31, 2001, the Firm had repurchased 21.9 million shares of common stock under this authorization. During 2001, approximately 65.0 million shares were issued, under various employee stock option and other stock-based plans, and approximately 1.8 million shares were issued in connection with purchase accounting acquisitions.
During 2000, approximately 20.3 million shares of outstanding common stock were repurchased by JPMorgan Chase under a stock repurchase plan which began on January 19, 2000 and was formally terminated on October 17, 2000.
JPMorgan Chase shareholders approved a three-for-two stock split at their annual meeting on May 16, 2000. The record date for the split was May 17, 2000, and the additional shares of the Firm’s common stock issued as a result of the split were distributed on June 9, 2000.
As of December 31, 2001, approximately 399 million unissued shares of common stock were reserved for issuance under various employee incentive, option and stock purchase plans.
Common shares issued (newly issued or distributed from treasury) by JPMorgan Chase during 2001, 2000 and 1999 were as follows:
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15 Earnings per share
SFAS 128 requires the presentation of basic and diluted earnings per share (“EPS”) in the income statement. Basic EPS is computed by dividing net income applicable to common stock by the weighted-average number of common shares outstanding for the period. Diluted EPS is computed using the same method as basic EPS, but, in the denominator, common shares outstanding reflect the potential dilution that could occur if convertible securities or other contracts to issue common stock were converted or exercised into common stock. Net income available for common stock is the same computation for basic EPS and diluted EPS as JPMorgan Chase had no convertible securities, and, therefore, no adjustments to net income available for common stock were necessary.
Basic and diluted earnings per share were as follows for the dates indicated:
16 Comprehensive income
Comprehensive income is composed of net income and other comprehensive income, which includes the after-tax change in unrealized gains and losses on AFS securities, cash flow hedging activities and foreign currency translation adjustments (including the impact of related derivatives).
The following table presents other comprehensive income balances:
The net change amount, in the following table, represents the sum of net unrealized holding gains (losses) and reclassification adjustments of AFS securities. Reclassification adjustments are amounts recognized in net income during the current year that had been part of other comprehensive income in previous years.
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17 Income taxes
JPMorgan Chase and its eligible subsidiaries file a consolidated U.S. federal income tax return. JPMorgan Chase uses the asset and liability method required by SFAS 109 to provide income taxes on all transactions recorded in the consolidated financial statements. This requires that income taxes reflect the expected future tax consequences of temporary differences between the carrying amounts of assets or liabilities for book purposes and for tax purposes. Accordingly, a deferred tax liability or asset for each temporary difference is determined based on the tax rates that JPMorgan Chase expects to be in effect when the underlying items of income and expense are to be realized. JPMorgan Chase’s expense for income taxes includes the current and deferred portions of that expense. A valuation allowance is established to reduce deferred tax assets to the amount JPMorgan Chase expects to be realized.
Deferred income tax expense (benefit) results from differences between assets and liabilities measured for financial reporting purposes and for income tax return purposes. The significant components of deferred tax assets and liabilities are reflected in the following table:
A valuation allowance has been recorded in accordance with SFAS 109, primarily relating to tax benefits associated with foreign operations and with state and local deferred tax assets. The components of income tax expense included in the Consolidated statement of income were as follows:
The preceding table does not reflect the tax effects of unrealized gains and losses on AFS securities, SFAS 133 transactions and certain tax benefits associated with JPMorgan Chase’s employee stock plans. The tax effect of these items is recorded directly in Stockholders’ equity. Stockholders’ equity increased by $541 million and $1,860 million in 2001 and 1999, respectively, and decreased by $281 million in 2000 as a result of these tax effects.
Federal income taxes have not been provided on the undistributed earnings of certain foreign subsidiaries, to the extent such earnings have been reinvested abroad for an indefinite period of time. For 2001, such earnings approximated $263 million on a pre-tax basis. At December 31, 2001, the cumulative amount of undistributed earnings in these subsidiaries approximated $1,667 million. It is not practicable at this time to determine the income tax liability that would result upon repatriation of these earnings.
The tax expense (benefit) applicable to securities gains and losses for the years 2001, 2000 and 1999 was $286 million, $78 million and $(84) million, respectively.
A reconciliation of the applicable statutory U.S. income tax rate to the effective tax rate for the past three years is shown in the following table:
The following table presents the domestic and foreign components of income before income tax expense:
84 JPMorgan Chase 2001 Annual Report
18 Postretirement employee benefit plans
New domestic postretirement plans were approved in 2001, and the prior plans of Chase and J.P. Morgan were merged as of December 31, 2001.
Pension plansJPMorgan Chase has a noncontributory domestic pension plan that provides defined benefits to substantially all domestic employees. The domestic plan employs a cash balance defined benefit formula that provides for benefits based on salary and service. For J.P. Morgan employees who were earning benefits under a prior plan formula as of December 31, 1998, the plan also provides a minimum benefit based on eligible compensation and service through December 31, 2003. The following table presents the funded status and actuarial assumptions for the domestic plan.
Domestic pension plan
The periodic domestic pension plan expense (reported in Compensation expense) totaled $113 million in 2001, $76 million in 2000 and $75 million in 1999.
JPMorgan Chase also has a number of other defined benefit pension plans (i.e., domestic plans not subject to Title IV of the Employee Retirement Income Security Act) and several foreign pension plans. Compensation expense related to these plans totaled $50 million in 2001, $45 million in 2000 and $48 million in 1999. At December 31, 2001 and 2000, JPMorgan Chase’s liability (included in Accrued expenses) related to plans that JPMorgan Chase elected not to prefund fully totaled $249 million and $234 million, respectively. A prepaid asset of $184 million was included in Other assets at December 31, 2001, as the Firm elected to fund certain plans during the year.
Compensation expense related to defined contribution plans totaled $208 million in 2001, $213 million in 2000 and $195 million in 1999.
Postretirement medical and life insuranceJPMorgan Chase provides postretirement medical and life insurance benefits to qualifying domestic and foreign employees. These benefits vary with length of service and date of hire and provide for limits on JPMorgan Chase’s share of covered medical benefits. The medical benefits are contributory, while the life insurance benefits are noncontributory.
JPMorgan Chase’s postretirement benefit obligations are funded with corporate-owned life insurance (“COLI”) purchased on the lives of eligible employees and retirees. Assets of the COLI policies are held in a separate account with the insurance company. The insurance company invests the cash value of the policies in equities, bonds and other debt securities. While JPMorgan Chase owns the COLI policies, COLI proceeds (death benefits, withdrawals and other distributions) may be used only to reimburse the Firm for its net postretirement benefit claim payments and related administrative expenses.
Postretirement medical and life insurance liability
Postretirement medical and life insurance expense (reported in Compensation expense) totaled $27 million in 2001, $32 million in 2000 and $44 million in 1999.
The discount rates and rates of increase for future compensation used to determine the actuarial values for postretirement medical and life insurance benefits are generally consistent with those used for the domestic pension plan. At December 31, 2001, JPMorgan Chase’s assumed weighted-average medical benefits cost trend rate used to measure the expected cost of benefits covered was 8.75% for 2001, declining gradually over seven years to a floor of 5.0%. The effect of a 1% change in the assumed medical cost trend rate would result in a corresponding change in the December 31, 2001 benefit obligation and 2001 periodic expense by up to 5.2%.
JPMorgan Chase 2001 Annual Report 85
19 Employee stock-based incentives
Key employee stock-based awardsJPMorgan Chase has long-term stock-based incentive plans (the “LTI Plans”) that provide for grants of common stock-based awards, including stock options, restricted stock and restricted stock units (“RSU”) to certain key employees.
Under the LTI Plans, stock options are granted with exercise prices equal to JPMorgan Chase’s common stock price on the grant date. Generally, options cannot be exercised until at least one year after the grant date and become exercisable over various periods as determined at the time of the grant. Options generally expire ten years after the grant date.
In January 2001, JPMorgan Chase granted 82.2 million options under the LTI Plans pursuant to a growth performance incentive program (“GPIP”). The exercise price of all GPIP awards is $51.22, the price of JPMorgan Chase’s common stock on the grant date. One half of the GPIP options are exercisable after two years if a firm-wide performance target (“corporate performance goal”) is achieved, with the remaining 50% exercisable after two years if certain business specific performance targets are achieved. The corporate performance goal will be achieved if cumulative diluted cash operating earnings per share for 2001 and 2002, excluding JPMorgan Partners, equals or exceeds $8.50. Business specific performance targets are based primarily on SVA. If the targets are not achieved, options will be exercisable after six years. As of December 31, 2001, 4.8 million GPIP options had been forfeited. All GPIP options expire ten years after the grant date.
The following table presents a summary of JPMorgan Chase’s option activity under the LTI Plans, excluding GPIP, during the last three years.
(a) Includes 5,124,000 options at a weighted-average exercise price of $15.61 related to the acquisition of H&Q.
The following table details the distribution of options outstanding under the LTI Plans, excluding GPIP, at December 31, 2001.
Restricted stock and RSUs are granted by JPMorgan Chase under the LTI Plans at no cost to the recipient. Restricted stock/units are subject to forfeiture until certain restrictions have lapsed, including continued employment for a specified period. The recipient of a share of restricted stock is entitled to voting rights and dividends on the common stock. An RSU entitles the recipient to receive a share of common stock after the applicable restrictions lapse; the recipient is entitled to receive cash payments equivalent to dividends on the underlying common stock during the period the RSU is outstanding.
During 2001, 25.9 million restricted stock/unit awards (all payable solely in stock) were granted by JPMorgan Chase. Of the 25.9 million restricted stock/unit awards granted, vesting of 1.3 million of such awards also is conditioned upon certain vesting periods being met and JPMorgan Chase’s stock price reaching and sustaining target prices (the “targets”) during the service period. The awards are forfeited in their entirety if the targets are not achieved (“forfeitable awards”). Half of the 2001 forfeitable awards have a target price of $75, which exceeded the stock price on the grant date by 46%. The other half have a target price of $85, which exceeded the stock price on the grant date by 66%.
86 JPMorgan Chase 2001 Annual Report
Under the LTI Plans, in 2000 and 1999, 36.1 million and 26.2 million awards (all payable solely in stock), respectively, were granted by JPMorgan Chase. In both years, 1.3 million of the restricted stock/unit awards that were granted are forfeitable if target prices are not achieved. None of the 2000 and 1999 forfeitable awards have vested as the target prices have not been achieved.
A portion of certain employees’ incentive compensation that exceeds specified levels is awarded in restricted stock or RSUs (the “required deferral plan”) that are issued under the LTI Plans. These restricted stock/units vest solely based on continued employment. During 2001, 2000 and 1999, 137,500, 160,000 and 149,000, respectively, of such awards were granted.
Broad-based employee stock optionsIn January 2001, JPMorgan Chase granted Value Sharing Plan awards, under which 26.0 million options to purchase common stock were granted to all eligible full-time (375 options each) and part-time (188 options each) employees. This award is the second of three equal annual grants to eligible active employees. The exercise price for each annual grant is equal to JPMorgan Chase’s common stock price on the grant date. The options become exercisable after five years, or earlier if JPMorgan Chase’s stock price reaches and sustains a target price for a minimum period. The 2000 and 2001 grants have not achieved their price targets.
Under the Value Sharing Plan adopted by JPMorgan Chase in December 1996, annual awards were granted in December of 1996, 1997 and 1998. The 1996, 1997 and 1998 awards became exercisable in 1997, 1998 and 1999, respectively, as a result of the target prices having been achieved. All outstanding options expire ten years after their respective grant dates.
The following table presents a summary of JPMorgan Chase’s broad-based employee stock option plan activity during the past three years:
The following table details the distribution of broad-based employee stock options outstanding at December 31, 2001.
Comparison of the fair and intrinsic value based measurement methodsJPMorgan Chase accounts for its employee stock-based compensation plans under the intrinsic value based method in accordance with Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees.” There is no expense recognized for stock options, as they have no intrinsic value on the grant date. Forfeitable restricted stock and RSUs are expensed based upon the target prices. The expense for restricted stock and RSUs other than forfeitable awards is measured by the grant-date stock price. Pre-tax stock compensation expense recognized in reported earnings totaled $0.8 billion in 2001, $1.1 billion in 2000 and $1.0 billion in 1999.
If JPMorgan Chase had adopted the fair value based method pursuant to SFAS 123, options would be valued using a Black-Scholes model. The following table presents net income and basic and diluted earnings per share as reported and after the impact of applying SFAS 123. The higher impact from applying SFAS 123 in 2001 reflects the lower level of net income and increased options granted during 2001.
JPMorgan Chase 2001 Annual Report 87
The following table presents JPMorgan Chase’s weighted-average grant-date fair value and assumptions used to value the options using a Black-Scholes model for equity awards granted:
20 Restrictions on cash and intercompany funds transfers
The Federal Reserve Board requires depository institutions to maintain cash reserves with a Federal Reserve Bank. The average amount of reserve balances deposited by JPMorgan Chase’s bank subsidiaries with various Federal Reserve Banks was approximately $1.1 billion in 2001 and $0.6 billion in 2000.
Restrictions imposed by federal law prohibit JPMorgan Chase and certain other affiliates from borrowing from banking subsidiaries unless the loans are secured in specified amounts. Such secured loans to JPMorgan Chase or to other affiliates generally are limited to 10% of the banking subsidiary’s total capital, as determined by the risk-based capital guidelines; the aggregate amount of all such loans is limited to 20% of the banking subsidiary’s total capital. JPMorgan Chase and its affiliates were well within these limits throughout the year.
The principal sources of JPMorgan Chase’s income (on a parent company-only basis) are dividends and interest from JPMorgan Chase Bank and the other banking and nonbanking subsidiaries of JPMorgan Chase. In addition to dividend restrictions set forth in statutes and regulations, the Federal Reserve Board, the Office of the Comptroller of the Currency (“OCC”) and the Federal Deposit Insurance Corporation (“FDIC”) have authority under the Financial Institutions Supervisory Act to prohibit or to limit the payment of dividends by the banking organizations they supervise, including JPMorgan Chase and its subsidiaries that are banks or bank holding companies, if, in the banking regulator’s opinion, payment of a dividend would constitute an unsafe or unsound practice in light of the financial condition of the banking organization.
At December 31, 2001 and 2000, JPMorgan Chase’s bank subsidiaries could pay, in the aggregate, $2.2 billion and $2.1 billion, respectively, in dividends to their respective bank holding companies without prior approval of their relevant banking regulators.
In compliance with rules and regulations established by domestic and foreign regulators, cash of $2.0 billion and $1.6 billion and securities with a market value of $4.4 billion and $6.2 billion were segregated in special bank accounts for the benefit of securities and futures brokerage customers as of December 31, 2001 and 2000, respectively.
21 Capital
There are two categories of risk-based capital: core capital (referred to as Tier 1 capital) and supplementary capital (referred to as Tier 2 capital). Tier 1 capital includes common stockholders’ equity, qualifying preferred stock and minority interest less goodwill and other adjustments. Tier 2 capital consists of preferred stock not qualifying as Tier 1, long-term debt and other instruments qualifying as Tier 2, the aggregate allowance for credit losses up to a certain percentage of risk-weighted assets, less investments in certain subsidiaries. Under the risk-based capital guidelines of the Federal Reserve Board, JPMorgan Chase is required to maintain minimum ratios of Tier 1 and total (Tier 1 plus Tier 2) capital to risk-weighted assets. Failure to meet these minimum requirements could result in actions taken by the Federal Reserve Board. Bank subsidiaries also are subject to these capital requirements by their respective primary regulators. Management believes that as of December 31, 2001, JPMorgan Chase met all capital requirements to which it was subject and is not aware of any subsequent events that would alter this classification.
88 JPMorgan Chase 2001 Annual Report
The following table presents the risk-based capital ratios for JPMorgan Chase and its significant banking subsidiaries:
The following table shows the components of the Firm’s Tier 1 and total capital.
22 Premises and equipment, goodwill and other intangibles
Premises and equipment, including leasehold improvements, are carried at cost less accumulated depreciation and amortization. JPMorgan Chase generally computes depreciation using the straight-line method over the estimated useful life of an asset. For leasehold improvements, the Firm uses the straight-line method over the lesser of the remaining term of the leased facility or the estimated economic life of the improvement. JPMorgan Chase capitalizes certain costs associated with the acquisition or development of internal-use software. Once the software is ready for its intended use, these costs are amortized on a straight-line basis over the software’s expected useful life.
Goodwill and other acquired intangibles, such as core deposits and credit card relationships, are amortized over the estimated periods to be benefited, generally ranging from 7 to 25 years. An impairment review is performed periodically on these assets.
Capitalized mortgage servicing assets consist of purchased and originated servicing rights. These rights are amortized in proportion to, and over the period of, the estimated future net servicing income stream of the underlying mortgage loans. Mortgage servicing rights are periodically evaluated for impairment based on their current fair values. For purposes of evaluating and measuring impairment of MSRs, the Firm stratifies its portfolio on the basis of the predominant risk characteristics: loan type and interest rate.
JPMorgan Chase 2001 Annual Report 89
23 Commitments and contingencies
At December 31, 2001, JPMorgan Chase and its subsidiaries were obligated under a number of noncancelable operating leases for premises and equipment used primarily for banking purposes. Certain leases contain rent escalation clauses for real estate taxes and other operating expenses and renewal option clauses calling for increased rents. No lease agreement imposes any restrictions on JPMorgan Chase’s ability to pay dividends, engage in debt or equity financing transactions, or enter into further lease agreements. Future minimum rental payments required under operating leases with noncancelable lease terms that expire after December 31, 2001 were as follows:
Total rental expense was as follows:
At December 31, 2001, assets were pledged to secure public deposits and for other purposes. The significant components of the assets pledged were as follows:
Collateral that can be sold or repledged was composed as follows:
JPMorgan Chase and its subsidiaries are defendants in a number of legal proceedings. After reviewing with counsel all such actions and proceedings pending against or involving JPMorgan Chase and its subsidiaries, management does not expect the aggregate liability or loss, if any, resulting from such proceedings to have a material adverse effect on the consolidated financial condition of JPMorgan Chase although the outcome of a particular proceeding may be material to JPMorgan Chase’s results of operations for any particular period depending on the size of the loss or liability relative to JPMorgan Chase’s income for that period.
The Firm has $1,130 million of nonperforming Enron-related other receivables, which represent surety receivables and a letter of credit that are the subject of litigation with insurance companies and a foreign bank.
JPMorgan Chase may guarantee the obligations of its subsidiaries. These guarantees rank on a parity with all other unsecured and unsubordinated indebtedness of JPMorgan Chase. See Note 11 for a discussion of JPMorgan Chase’s guarantees of long-term debt-related instruments of its subsidiaries.
24 Accounting for derivative instruments and hedging activities
On January 1, 2001, JPMorgan Chase adopted SFAS 133, which establishes accounting and reporting standards for derivative instruments, including derivative instruments embedded in other contracts used for trading and hedging activities. All derivatives, whether designated for hedging relationships or not, are required to be recorded on the balance sheet at fair value. If the derivative is designated as a fair value hedge, all changes in the fair value of the derivative and changes in the fair value of the hedged item attributable to the hedged risk are recognized in earnings. If the derivative is designated as a cash flow hedge, the effective portion of the change in the fair value of the derivative is recorded in other comprehensive income (“OCI”) and recognized in the income statement when the hedged item affects earnings. The ineffective portions of cash flow hedges are immediately recognized in earnings.
The majority of JPMorgan Chase’s derivatives are entered into for trading purposes and were not affected by the adoption of SFAS 133. The Firm also uses derivatives as an end user to hedge market exposures, modify the interest rate characteristics of related balance sheet instruments or meet longer-term investment objectives. Both trading and end-user derivatives are recorded at fair value in Trading assets and Trading liabilities.
The adoption of SFAS 133 resulted in an after-tax reduction to net income of $25 million and an after-tax reduction to OCI of $36 million. The impact of reclassifying certain SFAS 115 securities from AFS to trading was not material at the adoption date.
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Due to SFAS 133, JPMorgan Chase changed certain hedging strategies and elected not to designate some derivatives utilized to manage economic exposure as accounting hedges. For example, to moderate its use of derivatives, the mortgage business began using AFS securities as economic hedges of mortgage servicing rights.
Certain interest rate derivatives are recorded in Trading revenue due to operational and cost constraints of applying hedge accounting. Changes in the fair value of credit derivatives used to manage the Firm’s credit risk are recorded in Trading revenue because of the difficulties in qualifying such contracts as hedges of loans and commitments. Because of hedge ineffectiveness and management’s decision to no longer apply hedge accounting but to continue to enter into economic hedges to support certain business strategies, the application of SFAS 133 may cause volatility in quarterly earnings and equity.
Prior to the adoption of SFAS133, derivatives used for hedging purposes generally were not recorded on the Consolidated balance sheet and the unrealized gains and losses were deferred on those contracts.
Derivatives used as hedges must be considered to be highly effective at reducing the risk associated with the exposure being hedged. Each derivative must be designated as a hedge, with documentation of the risk management objective and strategy for the hedge, including identification of the hedging instrument, the hedged item and the risk exposure, and how effectiveness is assessed prospectively and retrospectively.
JPMorgan Chase’s fair value hedges primarily include hedges of fixed rate long-term debt, loans, AFS securities and mortgage servicing rights. Interest rate swaps are the most common type of derivative contract used to modify exposure to interest rate risk by converting fixed rate assets and liabilities to a floating rate. All amounts have been included in earnings consistent with the hedged transaction, primarily net interest income, Fees and commissions and Other revenue. JPMorgan Chase did not recognize any gains or losses during 2001 on firm commitments that no longer qualify as fair value hedges.
JPMorgan Chase enters into derivative contracts to hedge exposure to variability in cash flows for floating rate financial instruments and forecasted transactions, that primarily include the rollover of short-term assets and liabilities, loan sales and anticipated securities transactions. Interest rate swaps, futures and options are the most common instruments used to reduce the impact of interest rate changes on future earnings. All amounts have been included in earnings consistent with the hedged transaction, primarily net interest income.
JPMorgan Chase primarily uses forward foreign exchange contracts and foreign currency denominated debt instruments to protect the value of its net investments in its foreign subsidiaries in foreign currencies. The portion of the hedging instruments excluded from the assessment of hedge effectiveness (forward points) is recorded in Net interest income.
The following table presents derivative instrument and hedging related activities for the period indicated.
25 Off-balance sheet lending-related financial instruments
JPMorgan Chase utilizes lending-related financial instruments as one method by which to meet the financing needs of its customers. JPMorgan Chase issues commitments to extend credit, standby letters of credit and guarantees and also provides securities-lending services. For lending-related financial instruments, the contractual amount of the financial instrument represents the maximum potential credit risk if the counterparty does not perform according to the terms of the contract. A large majority of these commitments expire without being drawn upon. As a result, total contractual amounts are not representative of the Firm’s actual future credit exposure or liquidity requirements for these commitments.
Additionally, to provide for risk of losses inherent in the credit extension process, management computes specific and expected loss components as well as a residual component for lending-related commitments. At December 31, 2001 and 2000, the Allowance for credit losses on lending-related commitments, which is reported in Other liabilities, was $282 million and $283 million, respectively.
The following table summarizes the contract amounts relating to JPMorgan Chase’s lending-related financial instruments at December 31, 2001 and 2000:
Off-balance sheet lending-related financial instruments
JPMorgan Chase 2001 Annual Report 91
Unfunded commitments to extend credit are agreements to lend to a customer who has complied with predetermined contractual conditions. Commitments generally have fixed expiration dates. Unfunded commitments to extend credit include $41.9 billion of commitments to SPEs.
Standby letters of credit and guarantees are conditional commitments issued by JPMorgan Chase generally to guarantee the performance of a customer to a third party in borrowing arrangements, such as commercial paper issuances, bond financing, construction and similar transactions. The credit risk involved in issuing standby letters of credit is essentially the same as that involved in extending loan facilities to customers and may be reduced by participations to third parties. JPMorgan Chase holds collateral to support those standby letters of credit and guarantees when deemed necessary.
Customers’ securities lent are customers’ securities held by JPMorgan Chase, as custodian, which are lent to third parties. JPMorgan Chase obtains collateral, with a market value exceeding 100% of the contract amount, for customers’ securities lent, which is used to indemnify customers against possible losses resulting from third-party defaults.
26 Credit risk concentrations
Concentrations of credit risk arise when a number of customers are engaged in similar business activities, or activities in the same geographic region, or have similar economic features that would cause their ability to meet contractual obligations to be similarly affected by changes in economic conditions.
JPMorgan Chase regularly monitors various segments of its credit risk portfolio to assess potential concentration risks and to obtain collateral when deemed necessary.
JPMorgan Chase’s exposures within these major segments are diversified, and these diversification factors reduce concentration risk. More information about geographic and other concentrations can be found at the following tables in the MD&A:
The table below indicates major product and industry segments, including both on-balance sheet (principally loans) and off-balance sheet (principally unfunded commitments to extend credit) exposures:
27 Fair value of financial instruments
Fair value is defined as the value at which positions could be closed out or sold in a transaction with a willing and knowledgeable counterparty over a period of time consistent with JPMorgan Chase’s trading or investment strategy.
The accounting for an asset or liability may differ based on the type of instrument and/or its use in a trading or investing strategy. Generally, the measurement framework recorded in financial statements is one of the following:
92 JPMorgan Chase 2001 Annual Report
Fair value is based on quoted market prices, where available. If listed prices or quotes are not available, fair value is based on internally developed models that primarily use market-based or independent information as inputs. These methods may produce a fair value calculation that may not be indicative of net realizable value or reflective of future fair values. Valuation adjustments are made, at times, based on defined methodologies that are applied consistently over time and that are intended to ensure that positions are carried at the best estimate of fair value. Valuation adjustments include amounts to reflect counterparty credit quality, liquidity and concentration concerns, and ongoing servicing costs. JPMorgan Chase’s valuation process is continually subject to a rigorous review, which includes valuation model and methodology reviews and price testing with independent sources where appropriate.
Certain financial instruments and all nonfinancial instruments are excluded from the scope of SFAS 107. Accordingly, the fair value disclosures required by SFAS 107 provide only a partial estimate of the fair value of JPMorgan Chase. For example, JPMorgan Chase has developed long-term relationships with its customers through its deposit base and its credit card accounts, commonly referred to as core deposit intangibles and credit card relationships. In the opinion of management, these items in the aggregate add significant value to JPMorgan Chase, but their fair value is not disclosed in this Note.
The following captions describe the methodologies and assumptions used, by financial instrument, to determine fair value.
Financial assets
Assets for which fair value approximates carrying valueFair values of certain financial assets carried at cost, including cash and due from banks, deposits with banks, Federal funds sold and securities purchased under resale agreements, securities borrowed, short-term receivables and accrued interest receivable are considered to approximate their respective carrying values due to their short-term nature and generally negligible credit losses.
Assets where fair value differs from costJPMorgan Chase’s debt, equity and derivative instruments are carried at their estimated fair value. Quoted market prices, when available, are used to determine the fair value of trading instruments. If quoted market prices are not available, then fair values are estimated by using pricing models, quoted prices of instruments with similar characteristics or discounted cash flows.
SecuritiesFair values of actively-traded securities are determined by the secondary market, while the fair values for nonactively traded securities are based on independent broker quotations.
DerivativesFair value for derivatives is determined based on the following:
LoansFair value for loans is determined using methodologies suitable for each type of loan:
JPMorgan Chase 2001 Annual Report 93
Other assetsThis caption includes private equity investments and mortgage servicing rights.
The fair value of public securities held by JPMP are marked-to-market at the quoted public value. To determine the carrying value, JPMP’s valuation policy for public securities incorporates the use of liquidity discounts and price averaging methodologies in certain circumstances to take into account the fact that JPMP cannot immediately realize the quoted public values as a result of the regulatory, corporate, or other contractual sales restrictions generally imposed on these holdings. Private investments are initially carried at cost, which is viewed as an approximation of fair value. The carrying value of private investments is adjusted to reflect valuation changes resulting from unaffiliated party transactions and for evidence of a decline in value.
Fair value for mortgage servicing rights is estimated using a discounted future cash flow model that considers portfolio characteristics and assumptions regarding prepayment speeds, delinquency rates, ancillary revenues and other economic factors. The Firm reviews such assumptions against market comparables, if available.
Financial liabilities
Liabilities for which fair value approximates carrying valueSFAS 107 requires that the fair value disclosed for deposit liabilities with no stated maturity (i.e., demand, savings and certain money market deposits) be equal to the carrying value. SFAS 107 does not allow for the recognition of the inherent funding value of these instruments.
Fair value of federal funds purchased and securities sold under repurchase agreements, commercial paper, other borrowed funds, accounts payable and accrued liabilities is considered to approximate their respective carrying values due to their short-term nature.
Interest-bearing depositsFair value of interest-bearing deposits is estimated by discounting cash flows based on contractual maturities of funds having similar interest rates and similar maturities.
Long-term debt-related instrumentsFair value for long-term debt, including the guaranteed preferred beneficial interests in the Firm’s junior subordinated deferrable interest debentures, is based on current market rates and is adjusted for JPMorgan Chase’s credit quality.
Commitments to extend creditJPMorgan Chase has reviewed the unfunded portion of its commitments to extend credit as well as its standby and other letters of credit and, based on market prices observed at the point of origination to extend undrawn credit, has determined that the fair value of such financial instruments is not material.
The following table presents the carrying value and estimated fair value of financial assets and liabilities valued under SFAS 107. Accordingly, certain amounts which are not considered financial instruments are excluded from the table.
94 JPMorgan Chase 2001 Annual Report
28 International operations
The following table presents income statement information of JPMorgan Chase by major geographic areas. JPMorgan Chase defines international activities as business transactions that involve customers residing outside the U.S., and the information presented below is based primarily on the domicile of the customer. However, many of the Firm’s domestic operations service international businesses.
As these operations are highly integrated, estimates and subjective assumptions have been made to apportion revenue and expense between domestic and international operations. The estimates and assumptions used to apportion revenue and expense are consistent with the allocations used for JPMorgan Chase’s segment reporting as set forth in Note 29.
JPMorgan Chase’s long-lived assets for the periods presented are not considered by management to be significant in relation to total assets. The majority of its long-lived assets are located domestically.
JPMorgan Chase 2001 Annual Report 95
29 Segment information
JPMorgan Chase is organized into five major businesses. These businesses are segmented based on the products and services provided, or the type of customer serviced, and reflect the manner in which financial information is evaluated by management.
JPMorgan Chase uses SVA, operating earnings and cash operating earnings as its principal measures of segment profitability. For a definition of these measurements, see the Glossary of terms on pages 100 and 101.
Operating revenues and expenses directly associated with each segment are included in determining the segment’s operating earnings. Guidelines exist for assigning those remaining expenses that are not directly incurred by the segments, such as overhead and taxes. In addition, management has developed a risk-adjusted
Segment results and reconciliation (table continued on next page)
96 JPMorgan Chase 2001 Annual Report
capital methodology that quantifies different types of risk – credit, market, operational and private equity – within the various businesses and assigns capital accordingly. The provision for loan losses is allocated to the segments utilizing a credit risk methodology and a risk grading system appropriate for each segment’s portfolio.
A summary of the business segment results is shown in the following table. The Corporate/reconciling items column reflects revenues and expenses excluded from the determination of the segment’s operating earnings. This column includes the effects remaining at the corporate level after the application of management accounting policies, including income tax expenses (the difference between the amounts allocated to business units and JPMorgan Chase’s consolidated income tax expense).
For a further discussion concerning JPMorgan Chase’s business segments, see Segment results in the MD&A on pages 28 and 29. Additionally, financial information relating to JPMorgan Chase’s operations by geographic area is provided in Note 28.
(table continued from previous page)
[Additional columns below]
[Continued from above table, first column(s) repeated]
The tables below present reconciliations of the combined segment information included in the preceding table to JPMorgan Chase’s reported revenue and net income as included in the Consolidated statement of income.
JPMorgan Chase 2001 Annual Report 97
30 Parent company
Parent company – balance sheet
Parent company – statement of income
Parent company – statement of cash flows
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supplementary informationSelected quarterly financial data (unaudited)
JPMorgan Chase 2001 Annual Report 99
Glossary of terms
Asset capital tax: The tax which is included in each of the business unit’s capital charge, recognizing the need for the Firm to maintain certain capital ratios to meet bank regulatory definitions of “well capitalized.”
Basis point value (“BPV”): This measurement quantifies the change in the market value of JPMorgan Chase’s assets and liabilities (that are not part of its trading activities) that would result from a one basis point change in interest rates or one basis point widening of interest rate spreads. BPV shows whether an increase of 1/100 of 1% (or one basis point) in a market rate will yield a profit or loss, and of what magnitude.
CAGR: “Compound annual growth rate.”
Cash operating earnings: Operating earnings excluding the impact of the amortization of intangibles.
Cash overhead ratio: Noninterest expense, excluding amortization of intangibles, as a percentage of the total of net interest income and noninterest revenue (excluding merger and restructuring costs and special items).
Credit derivatives are contractual agreements that provide insurance against a credit event of one or more referenced credits. The nature of the credit event is established by the buyer and seller at the inception of the transaction, and such events include bankruptcy, insolvency and failure to meet payment obligations when due. The buyer of the credit derivative pays a periodic fee in return for a contingent payment by the seller (insurer) following a credit event.
Credit risk: The risk of loss due to borrower or counterparty default.
Cross-currency interest rate swaps are contracts that generally involve the exchange of both interest and principal amounts in two different currencies. Also see interest rate swaps in this glossary.
Debt, equity, commodity and other contracts include swaps and options and are similar to interest rate contracts except the underlying instrument is debt-, equity- or commodity-related.
FASB: Financial Accounting Standards Board.
Foreign currency options are similar to interest rate options except they are based on foreign exchange rates. Also see interest rate options in this glossary.
Foreign exchange contracts are contracts that provide for the future receipt or delivery of foreign currency at previously agreed-upon terms.
Forward rate agreements are contracts to exchange payments on a specified future date, based on a market change in interest rates from trade date to contract settlement date.
Interest rate futures and forwards are contracts for the delayed delivery of securities or money market instruments. The selling party agrees to deliver, on a specified future date, a specified instrument at a specified price or yield.
Interest rate options, including caps and floors, are contracts to modify interest rate risk in exchange for the payment of a premium when the contract is initiated. As a writer of interest rate options, JPMorgan Chase receives a premium in exchange for bearing the risk of unfavorable changes in interest rates. Conversely, as a purchaser of an option, JPMorgan Chase pays a premium for the right, but not the obligation, to buy or sell a financial instrument or currency at predetermined terms in the future.
Interest rate swaps are contracts in which a series of interest rate flows in a single currency is exchanged over a prescribed period. Interest rate swaps are the most common type of derivative contract that JPMorgan Chase uses in its A/L activities. An example of a situation in which JPMorgan Chase would utilize an interest rate swap would be to convert its fixed-rate debt to a variable rate. By entering into the swap, the principal amount of the debt would remain unchanged, but the interest streams would change.
Investment grade equivalent: JPMorgan Chase’s internal risk assessment which generally represents a risk profile similar to that of a BBB-/Baa3 or better rating as defined by independent rating agencies, such as Standard & Poor’s or Moody’s.
Liquidity risk: The risk of being unable to fund JPMorgan Chase’s portfolio of assets at appropriate maturities and rates, and the risk of being unable to liquidate a position in a timely manner at a reasonable price.
Managed credit card receivables or managed basis: JPMorgan Chase uses this terminology to refer to its credit card receivables on the balance sheet plus securitized credit card receivables.
Mark-to-market exposure: Mark-to-market exposure is a measure, at a point in time, of the value of a derivative or foreign exchange contract in the open market. When the mark-to-market is positive, it indicates the counterparty owes JPMorgan Chase and, therefore, creates a repayment risk for JPMorgan Chase. When the mark-to-market is negative, JPMorgan Chase owes the counterparty. In this situation, JPMorgan Chase does not have repayment risk.
Market risk: The potential loss in value of portfolios and financial instruments caused by movements in market variables, such as interest and foreign-exchange rates, credit spreads, and equity and commodity prices.
Merger: The term refers to the December 31, 2000 merger of The Chase Manhattan Corporation and J.P. Morgan & Co. Incorporated.
Net yield on interest-earning assets: The average rate for interest-earning assets less the average rate paid for all sources of funds.
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Operating basis or operating earnings: Reported results excluding the impact of merger and restructuring costs, special items and credit card securitizations.
Operational risk: The risk of loss resulting from inadequate or failed processes or systems, human factor, or external events.
SFAS: Statement of Financial Accounting Standards.
SFAS 107: “Disclosures about Fair Value of Financial Instruments.”
SFAS 109: “Accounting for Income Taxes.”
SFAS 114: “Accounting by Creditors for Impairment of a Loan.”
SFAS 115: “Accounting for Certain Investments in Debt and Equity Securities.”
SFAS 123: “Accounting for Stock-Based Compensation.”
SFAS 128: “Earnings per Share.”
SFAS 133: “Accounting for Derivative Instruments and Hedging Activities.”
SFAS 140: “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities – a replacement of FASB Statement No. 125.”
SFAS 141: “Business Combinations.”
SFAS 142: “Goodwill and Other Intangible Assets.”
Shareholder value added (“SVA”): Represents cash operating earnings minus preferred dividends and an explicit charge for capital.
Six sigma: Represents a business management approach that enables firms to improve the quality of products and services delivered to clients through understanding client priorities, and then eliminating process defects and failures. “Sigma’s” (or standard deviations) are statistical measures of the defects or failures generated by a business process.
Special items: All amounts are on a pre-tax basis. There were no special items in 2001. Special items in 2000 include a gain on the sale of the Hong Kong retail banking business ($827 million), a gain from the transfer of Euroclear-related business ($399 million), gain from the sale of the Panama operations ($81 million) and loss resulting from the economic hedge of the purchase price of Flemings prior to its acquisition ($176 million). The 1999 special items were interest income from prior-years’ tax refunds ($62 million), gains from sales of nonstrategic assets ($166 million) and a special contribution to The Chase Manhattan Foundation ($100 million). In 1998, special items were interest income from prior-years’ tax refunds ($191 million), sale of a global trust and agency services business ($131 million), sale of an investment management business in Australia ($56 million) and costs incurred for accelerated vesting of stock-based incentive awards ($37 million). In 1997, special items were gains on the sales of JPMorgan Chase’s remaining interests in The CIT Group Holdings, Inc. ($58 million) and a partially owned foreign investment ($44 million), as well as costs incurred for accelerated vesting of stock-based incentive awards ($135 million).
Stress testing: Discloses market risk under plausible events in abnormal markets.
Value-at-risk (“VAR”): A measure of the dollar amount of potential loss from adverse market moves in an everyday market environment.
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Distribution of assets, liabilities and stockholders’ equity;interest rates and interest differentials
Consolidated average balance sheet, interest and rates
A summary of JPMorgan Chase’s consolidated average balances, interest rates and interest differentials on a taxable-equivalent basis for the years 1999 through 2001 is provided below. Income computed on a taxable-equivalent basis is the income reported in the Consolidated statement of income adjusted to make income and interest-earning yields on assets exempt from income taxes (primarily federal taxes) comparable with other taxable income. The incremental tax rate used for calculating the taxable-equivalent adjustment was approximately 41% in the year 2001 and
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approximately 42% in each of the years 1999 and 2000. A substantial portion of JPMorgan Chase’s securities is taxable.
Within the Consolidated average balance sheet, interest and rates summary, the amounts of nonaccrual and renegotiated loans have been included in the average loan balances used to determine the average interest rate earned on loans. For additional information on nonaccrual loans, including interest accrued, see Note 8 on pages 75 and 76.
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Interest rates and interest differential analysis of net interest income –domestic and foreign
A summary of interest rates and interest differentials segregated between domestic and foreign operations for the years 1999 through 2001 is presented below. The segregation between the domestic and foreign components is based on the location of the office recording the transaction. Intra-company funding transactions are generally dollar-denominated deposits originated in various foreign and domestic locations that are centrally managed by JPMorgan Chase’s treasury units. Domestic net interest income
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was $8,432 million in 2001, an increase of $1,437 million from the prior year. The increase in 2001 primarily was attributable to improved spreads. Net interest income from foreign operations was $2,454 million for 2001, compared with $2,601 million in 2000. The decrease reflected a shift from higher-yielding interest-earning assets (primarily loans) to lower-yielding assets (primarily trading assets and securities) and lower net yields.
For further discussion, see the section entitled “Net interest income” in the MD&A on page 43.
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Changes in net interest income, volume and rate analysis
The table below presents an analysis of the effect on net interest income of volume and rate changes for the periods 2001 versus 2000 and 2000 versus 1999. In this analysis, the change due to the volume/rate variance has been allocated to volume.
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Securities portfolio
The amortized cost, estimated fair value and average yield (including the impact of related derivatives) of JPMorgan Chase’s securities by contractual maturity range and type of security are presented in the table that follows:
The U.S. government and certain of its agencies were the only issuers whose securities exceeded 10% of JPMorgan Chase’s total stockholders’ equity at December 31, 2001.
For a further discussion of JPMorgan Chase’s securities portfolios, see Note 7 on page 74.
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Loan portfolio
The table below sets forth the amounts of loans outstanding by type:
Maturities and sensitivity to changes in interest rates
The following table shows, at December 31, 2001, commercial loan maturity and distribution between fixed and floating interest rates based upon the stated terms of the commercial loan agreements. The table below does not include the impact of derivative instruments.
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Cross-border outstandings
Cross-border disclosure is based upon the Federal Financial Institutions Examination Council’s (“FFIEC”) guidelines governing the determination of cross-border risk. In accordance with FFIEC revised guidelines, credit derivatives were included in the determination of cross-border exposure beginning in 2000. Prior-year amounts do not include these instruments.
The following table lists all countries in which JPMorgan Chase’s cross-border outstandings exceed 0.75% of consolidated assets as of any of the dates specified. The disclosure includes certain exposures that are not required under the disclosure requirements of the SEC. The most significant differences between the FFIEC and SEC methodologies relate to the treatments of local country exposure and to foreign exchange and derivatives.
For a further discussion of JPMorgan Chase’s cross-border exposure based on management’s view of this exposure, see page 52.
Cross-border outstandings exceeding 0.75% of total assets
JPMorgan Chase’s cross-border outstandings tend to fluctuate greatly, and the amount of outstandings at year-end tends to be a function of timing rather than representing a consistent trend.
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Risk elements
The following table sets forth nonperforming assets and contractually past-due assets at the dates indicated:
For a discussion of nonperforming loan and past-due loan policies, see Note 8 on page 75. Renegotiated loans are those for which concessions, such as the reduction of interest rates or the deferral of interest or principal payments, have been granted as a result of a deterioration in the borrowers’ financial condition.
Impact of nonperforming loans on interest income
The negative impact on interest income from nonperforming loans represents the difference between the amount of interest income that would have been recorded on nonperforming loans according to their contractual terms and the amount of interest that actually was recognized on a cash basis. The following table sets forth this data for the years specified. The increases in both 2001 and 2000 in total negative impact on interest income reflect a higher level of interest that was not recognized in income due to the increased levels of nonperforming loans.
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Summary of loan loss experience
For a further discussion, see Note 8 on pages 75 through 77.
The table below summarizes the changes in the allowance for loan losses during the periods indicated.
Loan loss analysis
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Derivative and FX contracts
The following table summarizes the risk profile, as of December 31, 2001, of the Firm’s derivative and foreign exchange contract balance sheet exposure, both before and after taking into account cash and other highly liquid collateral held by the Firm. The Firm's internal risk ratings generally represent a risk profile similar to that of the independent rating agencies; the following table is presented on a Standard & Poor's-equivalent basis:
For further discussion, see the section entitled “Derivative and foreign exchange contracts” in the MD&A on page 51.
Deposits
The following data provides a summary of the average balances and average interest rates of JPMorgan Chase’s various deposits for the years indicated:
At December 31, 2001, domestic time deposits in denominations of $100,000 or more totaled $31.0 billion, substantially all of which mature in three months or less. The table below presents the maturities for domestic time certificates of deposit in denominations of $100,000 or more:
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Short-term and other borrowed funds
The following data provide a summary of JPMorgan Chase’s short-term and other borrowed funds for the years indicated:
Federal funds purchased represents overnight funds. Securities sold under repurchase agreements generally mature between one day and three months. Commercial paper generally is issued in amount of not less than $100,000 and with maturities of 270 days or less. Other borrowed funds consist of demand notes, term federal funds purchased and various other borrowings that generally have maturities of one year or less. For a discussion of JPMorgan Chase's liquidity risk management see page 60.
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Signatures
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on behalf of the undersigned, thereunto duly authorized.
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacity and on the date indicated. JPMorgan Chase does not exercise the power of attorney to sign on behalf of any Director.
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