SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549
FORM 10-Q
QUARTERLY REPORT UNDER SECTION 13 OR 15(d)OF THE SECURITIES EXCHANGE ACT OF 1934
J.P. MORGAN CHASE & CO.(Exact name of registrant as specified in its charter)
Registrant’s telephone number, including area code (212) 270-6000
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.
Yesþ No
Number of shares outstanding of each of the issuer’s classes of common stock on July 31, 2002.
TABLE OF CONTENTS
FORM 10-QTABLE OF CONTENTS
This Form 10-Q contains statements that are forward-looking within the meaning of the Private Securities Litigation Reform Act of 1995. Such statements are based upon the current beliefs and expectations of J.P. Morgan Chase & Co.’s management and are subject to significant risks and uncertainties. Actual results may differ from those set forth in the forward-looking statements. Factors that could cause J.P. Morgan Chase & Co.’s results to differ materially from those described in the forward-looking statements are enumerated under “Important Factors That May Affect Future Results” in this Form 10-Q and are further described in the Quarterly Report on Form 10-Q for the quarter ended March 31, 2002 and the 2001 Annual Report on Form 10-K of J.P. Morgan Chase & Co., each filed with the Securities and Exchange Commission.
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Part IItem 1
J.P. MORGAN CHASE & CO.CONSOLIDATED STATEMENT OF INCOME(in millions, except per share data)
The Notes to Consolidated Financial Statements are an integral part of these Statements.
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Part IItem 1 (continued)
J.P. MORGAN CHASE & CO.CONSOLIDATED BALANCE SHEET(in millions, except share data)
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J.P. MORGAN CHASE & CO.CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS’ EQUITY(in millions, except per share data)
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J.P. MORGAN CHASE & CO.CONSOLIDATED STATEMENT OF CASH FLOWS(in millions)
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1 – BASIS OF PRESENTATIONThe accounting and financial reporting policies of J.P. Morgan Chase & Co. (“JPMorgan Chase” or “the Firm”) and its subsidiaries conform to U.S. generally accepted accounting principles (“GAAP”) and prevailing industry practices for interim reporting. Additionally, where applicable, the policies conform to the accounting and reporting guidelines prescribed by bank regulatory authorities. The unaudited consolidated financial statements prepared in conformity with GAAP require management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue and expense, and disclosure of contingent assets and liabilities. In addition, certain amounts have been reclassified to conform with the current presentation. In the opinion of management, all necessary adjustments have been included for a fair presentation of this interim financial information. These unaudited financial statements should be read in conjunction with the audited financial statements included in JPMorgan Chase’s 2001 Annual Report on Form 10-K (“2001 Annual Report”), with the exception of Note 2 in this Form 10-Q, “Goodwill and Other Intangibles.”
Special-Purpose EntitiesRefer to Note 1 of the 2001 Annual Report for a further description of special-purpose entities (“SPE”) and the Firm’s policy on consolidation relating to these entities.
As detailed in the 2001 Annual Report, JPMorgan Chase categorizes SPE transactions as follows: securitizations, commercial paper conduits, and client intermediation. Assets sold to SPEs as part of the Firm’s consumer and commercial securitization activities are generally not reflected in JPMorgan Chase’s balance sheet (except for retained and undivided interests in its securitization trusts and the Providian Master Trust, as described in Note 8 in this Form 10-Q, Loan Securitizations), but are included on the balance sheet of the SPE purchasing the assets. Assets held in securitization-related SPEs as of June 30, 2002 and December 31, 2001 were as follows:
For commercial paper conduits and certain client intermediation vehicles, primarily structured loan vehicles as described in the 2001 Annual Report, JPMorgan Chase provides contingency liquidity. JPMorgan Chase Bank has commitments to provide liquidity to these vehicles in an amount up to $36.6 billion at June 30, 2002, versus $41.9 billion as of December 31, 2001. For certain of the commercial paper conduits, JPMorgan Chase also provides limited credit enhancement through the issuance of letters of credit. As of June 30, 2002 and December 31, 2001, commitments under these letters of credit totaled $3.4 billion. Both the liquidity commitments and the letters of credit are included in the Firm's commitments to lend described in more detail in Note 17 in this Form 10-Q and in the discussion of Liquidity Risk Management in the 2001 Annual Report. As of June 30, 2002, these vehicles had commercial paper outstanding in the amount of $25.6 billion, compared with $29.3 billion as of December 31, 2001.
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The Firm would be required to provide funding under the liquidity commitments in the event that funding for such SPEs became unavailable in the commercial paper market. In addition, if JPMorgan Chase Bank were downgraded below A-1 or P-1, the SPEs could draw on the liquidity commitments, since asset-backed commercial paper rated below A-1 or P-1 is generally not issuable by the vehicle. Under these circumstances, JPMorgan Chase Bank could either replace itself as liquidity provider or facilitate the sale or refinancing of the assets in the SPE in other markets. Under the letters of credit, the Firm would be required to fund the difference between the amounts drawn under the liquidity commitment and the commercial paper outstanding.
The Firm has limited credit exposure to commercial paper conduits. This is because, for the most part, the Firm is not required to fund under the liquidity facilities if the assets in the SPE are in default. Additionally, JPMorgan Chase's obligations under the letters of credit are secondary to the risk of first loss provided by the client or other third parties; for example, by the overcollateralization of the SPE with the assets sold to it.
JPMorgan Chase may, from time to time, have other contractual relationships with the SPEs that it structures. These relationships primarily involve derivative contracts. These contracts are captured in the Firm's balance sheet in Trading assets or Trading liabilities in the same manner as its derivative contracts and are marked-to-market through Trading revenue. For a further discussion of the Firm's derivative instruments, see Note 16 on page 16. Fees received from administrative services provided to these SPEs (underwriter, trustee, custodian, etc.) are included, when earned, in Fees and commissions.
The Firm may also enter into transactions with SPEs structured by other parties. These transactions can include, for example, acting as derivative counterparty, liquidity provider, investor, underwriter, trustee or custodian. JPMorgan Chase records and reports these positions similar to any other third party transaction. JPMorgan Chase receives arm's-length fees for services provided.
The Firm has no commitments to issue its own stock to support an SPE transaction. The Firm's transactions with SPEs have been conducted on an arm's-length basis and reflect market pricing. Consistent with this policy, no JPMorgan Chase employee is permitted to invest in the SPEs with which the Firm is involved.
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NOTE 2 – GOODWILL AND OTHER INTANGIBLESEffective January 1, 2002, the Firm adopted SFAS 142 “Goodwill and Other Intangible Assets” (“SFAS 142”). SFAS 142 requires that goodwill and other intangible assets with an indefinite life no longer be amortized, but instead be tested for impairment at least annually. Intangible assets that have finite useful lives will continue to be amortized over their useful lives. There was no impairment of goodwill upon adoption of SFAS 142. Additionally, upon adoption, JPMorgan Chase reclassified certain intangible assets from Goodwill to All Other Intangibles. There can be no assurance that future goodwill impairment tests will not result in a charge to earnings.
The following table presents the impact of SFAS 142 on net income and earnings per share had the accounting standard been in effect for the 2001 second quarter and six months.
GoodwillDuring the second quarter of 2002, the Firm acquired approximately $32 million of goodwill in its acquisition of an institutional trust services business. Goodwill was not impaired nor written-off during the quarter. As of June 30, 2002, the Firm had goodwill of $8,089 million. Goodwill by business segment is as follows: Investment Bank, $2,053 million; Investment Management & Private Banking, $4,171 million; Treasury & Securities Services, $981 million; JPMorgan Partners, $377 million; and Retail & Middle Market Financial Services, $507 million.
All Other IntangiblesAll of the Firm’s acquired intangible assets are subject to amortization. Intangible assets amortization expense was $92 million for the second quarter of 2002. This amount included a $12 million impairment write-down on purchased credit card relationships related to a small credit card portfolio previously acquired. The intangible assets listed below do not include Mortgage Servicing Rights; amortization of mortgage servicing rights is recorded as a reduction of mortgage servicing revenues within Fees and Commissions. See Note 9 for a discussion of Mortgage Servicing Rights.
The components of intangible assets were as follows:
Amortization expense for the net carrying amount of intangible assets at June 30, 2002 is estimated to be $163 million for the remainder of 2002 (exclusive of the $161 million recorded in the first six months), $300 million in 2003, $282 million in 2004, $268 million in 2005, and $253 million in 2006.
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NOTE 3 – TRADING ASSETS AND LIABILITIESFor a discussion of the accounting policies relating to trading assets and liabilities, see Note 3 of JPMorgan Chase’s 2001 Annual Report.
The following table presents trading assets and trading liabilities for the dates indicated.
NOTE 4 – INTEREST INCOME AND INTEREST EXPENSEThe following table details the components of interest income and interest expense.
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NOTE 5 – MERGER AND RESTRUCTURING COSTSThe following table shows the components of merger and restructuring costs incurred in the second quarter and six months ended June 30, 2002 and 2001 relating to programs announced prior to 2002.
The following table shows the utilization during the six months ended June 30, 2002, of the $1.25 billion merger-related charge recorded on December 31, 2000 and the $300 million “right-sizing” charge recorded September 30, 2001.
For a further discussion of JPMorgan Chase’s merger and restructuring costs relating to programs announced prior to 2002, refer to Note 6 and page 44 of JPMorgan Chase’s 2001 Annual Report.
NOTE 6 – SECURITIESFor a discussion of the accounting policies relating to securities, see Note 7 of JPMorgan Chase’s 2001 Annual Report.
The following table presents realized gains and losses from available-for-sale (“AFS”) securities.
The amortized cost and estimated fair value of securities were as follows for the dates indicated:
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NOTE 7 – LOANSThe composition of the loan portfolio at each of the dates indicated was as follows:
NOTE 8 – LOAN SECURITIZATIONSJPMorgan Chase securitizes, sells and services residential mortgage, credit card, automobile and commercial loans. Refer to Note 9 of the 2001 Annual Report for further information and policies regarding loan securitizations.
During the second quarter of 2002, JPMorgan Chase securitized approximately $2.2 billion of residential mortgage loans, $4.4 billion of credit card loans, $1.4 billion of automobile loans and $1.3 billion of commercial loans, resulting in pre-tax gains on securitizations of $47 million, $18 million, $0.4 million and $10 million, respectively. During the second quarter of 2001, JPMorgan Chase securitized approximately $2.1 billion of residential mortgage loans, $1.5 billion of credit card loans, and $0.9 billion of commercial loans, resulting in pre-tax gains on securitizations of $58 million, $7 million, and $7 million, respectively. In addition, JPMorgan Chase sold residential mortgage loans totaling $12.5 billion and $12.2 billion during the second quarters of 2002 and 2001, respectively, primarily as GNMA, FNMA and Freddie Mac mortgage-backed securities, which sales resulted in gains of $73 million and $76 million, respectively.
During the first six months of 2002, JPMorgan Chase securitized approximately $4.6 billion of residential mortgage loans, $5.4 billion of credit card loans, $3.4 billion of automobile loans and $1.3 billion of commercial loans, resulting in pre-tax gains on securitizations of $59 million, $25 million, $6 million and $10 million, respectively. During the first six months of 2001, JPMorgan Chase securitized approximately $3.3 billion of residential mortgage loans, $2.3 billion of credit card loans, and $2.1 billion of commercial loans, resulting in pre-tax gains on securitizations of $107 million, $11 million, and $16 million, respectively. In addition, JPMorgan Chase sold residential mortgage loans totaling $29.0 billion and $19.8 billion during the first six months of 2002 and 2001, respectively, primarily as GNMA, FNMA and Freddie Mac mortgage-backed securities. These sales resulted in gains of $133 million and $124 million, respectively.
On February 5, 2002, JPMorgan Chase acquired the Providian Master Trust consisting of credit card receivables of approximately $7.9 billion and related relationships. Accounting guidance requires such receivables to be reflected on JPMorgan Chase’s balance sheet along with a related liability to reflect the securities issued through the trust to third parties. This liability totaled $6.3 billion on February 5, 2002 and is recorded in Other Borrowed Funds. As credit card receivables revolve and new receivables are sold to investors through the trust, the credit card receivables and related liability will be removed from the balance sheet. The interest rate of the liabilities are a combination of fixed and variable rates to reflect the coupon rate of the securities issued to third parties ranging from 1.9% to 8.0% at June 30, 2002. This liability is expected to be fully amortized within approximately one year. As of June 30, 2002, $5.1 billion of credit card receivables and a related liability of $3.2 billion remained on the balance sheet.
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At June 30, 2002 and December 31, 2001, JPMorgan Chase had $5.5 billion and $3.9 billion, respectively, related to its undivided interest in its Chase Credit Card Master Trust. This undivided interest represents the Firm’s interest in the credit card receivables transferred to the trust, but which have not been securitized; this interest is uncertificated and is not represented by a security. The undivided interest is carried at historical cost and is classified in Loans to provide better transparency in evaluating the credit worthiness of the loan portfolio.
The Firm maintains retained interests in the securitized and sold loans, generally in the form of senior or subordinated interest-only strips, subordinated tranches, escrow accounts and servicing rights. The escrow accounts are maintained 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 totaled $2 million, $568 million and $96 million as of June 30, 2002 for residential mortgage, credit card and automobile securitizations, respectively, and $1 million, $341 million and $79 million as of December 31, 2001, respectively. In addition, the Firm had other retained interests as of June 30, 2002 and December 31, 2001 totaling $862 million and $1.0 billion from its residential mortgage, $119 million and $38 million from its credit card, $205 million and $141 million from its automobile securitizations, and $66 million and $66 million from its commercial securitizations, respectively. These retained interests are carried at fair value on the Firm’s balance sheet.
The table below outlines the key economic assumptions and the sensitivity of the fair value at June 30, 2002 of the remaining retained interests to immediate 10% and 20% adverse changes in those assumptions:
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 easily be extrapolated because the relationship between 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.
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The table below presents information about delinquencies, net credit losses, and components of reported and securitized financial assets:
NOTE 9 – MORTGAGE SERVICING RIGHTSFor a further description of mortgage servicing rights (“MSR”), see Note 10 of the 2001 Annual Report. The following table summarizes the changes in residential MSRs.
The carrying value of MSRs is sensitive to changes in interest rates, including the effect of interest rates on prepayment speeds. The Firm offsets interest rate risk exposure by designating certain interest rate derivatives (e.g., a combination of swaps, swaptions and floors that produces an interest rate profile opposite to the MSRs) as fair value hedges of specified MSRs under SFAS 133. SFAS 133 hedge accounting allows the carrying value of the hedged MSRs to be adjusted through earnings in the same period that the change in value of the hedging derivatives is recognized through earnings. Both of these valuation adjustments are recorded in the mortgage servicing fees component within Fees and Commissions. For a further discussion on derivative instruments and hedging activities, see Note 16 on page 16.
AFS securities and certain “nonhedge” derivatives are also used to manage the risk exposure of the MSRs. These instruments are accounted for as stand-alone instruments as AFS securities do not qualify as hedges under SFAS 133 and the derivatives have not been designated by management as hedging derivatives. Accordingly, the securi-
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ties are accounted for as available-for-sale securities under SFAS 115 and the “nonhedge” derivatives are accounted for as trading derivatives. Gains and losses on these instruments are recognized in earnings in Securities Gains (Losses) (i.e., realized gains/losses on securities sold) and Trading Revenue, respectively. Unrealized gains/losses on AFS securities are reported in Other Comprehensive Income.
For the six months ended June 30, 2002, the decrease in revenue resulting from SFAS 133 valuation adjustments of $1,209 million and the change in the valuation allowance due to impairment of $114 million totaled $1,323 million. These losses were more than offset by total gains of $1,440 million relating to a combination of derivative gains, including those that qualify as SFAS 133 hedges, and realized gains from sales of AFS securities.
For the six months ended June 30, 2001, the decrease in revenue resulting from SFAS 133 valuation adjustments of $81 million and the change in the valuation allowance due to impairment of $474 million totaled $555 million. These losses were offset by total gains of $380 million relating to a combination of derivative gains, including those that qualify as SFAS 133 hedges, and realized gains from sales of AFS securities.
NOTE 10 – SUBORDINATED DEFERRABLE INTEREST DEBENTURESAt June 30, 2002, 12 wholly-owned Delaware statutory business trusts established by JPMorgan Chase had issued an aggregate $5,439 million in capital securities, net of discount. For a discussion of the business trusts, see Note 11 in JPMorgan Chase’s 2001 Annual Report and Note 9 of JPMorgan Chase’s March 31, 2002 Form 10-Q. There were no issuances or redemptions of capital securities during the second quarter 2002.
NOTE 11 – PREFERRED STOCK OF SUBSIDIARYOn February 28, 2002, Chase Preferred Capital Corporation redeemed all 22 million outstanding shares of its 8.10% cumulative preferred stock, Series A, at a redemption price per share of $25 plus accrued and unpaid dividends.
NOTE 12 – EARNINGS PER SHAREFor a discussion of JPMorgan Chase’s earnings per share (“EPS”), see Note 15 of the 2001 Annual Report. For the calculation of basic and diluted EPS for the second quarter and six months ended June 30, 2002 and 2001, see Exhibit 11 on page 63.
NOTE 13 – COMPREHENSIVE INCOMEComprehensive 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.
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NOTE 14 – CAPITALFor a discussion of the calculation of risk-based capital ratios, see Note 21 of JPMorgan Chase’s 2001 Annual Report.
The following table presents the risk-based capital ratios for JPMorgan Chase and its significant banking subsidiaries. At June 30, 2002, the Firm and each of its depository institutions, including those listed in the table below, were “well-capitalized” as defined by banking regulators.
NOTE 15 – COMMITMENTS AND CONTINGENCIESFor a discussion of legal proceedings, see Part II, Item 1 of this Form 10-Q.
NOTE 16 – ACCOUNTING FOR DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIESThe majority of JPMorgan Chase’s derivatives are entered into for trading purposes. Certain of the Firm’s trading-related derivatives may have the effect of providing financing to customers. 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 in trading assets and liabilities. For further discussion of the Firm’s use of derivative instruments, see Note 24 and page 51 of the JPMorgan Chase 2001 Annual Report.
The following table presents derivative instrument and hedging related activities for the periods indicated.
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NOTE 17 – OFF-BALANCE SHEET LENDING-RELATED FINANCIAL INSTRUMENTSJPMorgan 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 to its customers. For lending-related financial instruments, the contractual amount of the financial instrument represents the maximum potential credit risk to JPMorgan Chase 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 liquidity requirements.
As with on-balance sheet extensions of credit, management computes specific and expected loss components as well as a residual component for off-balance sheet lending-related commitments. At June 30, 2002 and December 31, 2001, the Allowance for credit losses related to off-balance sheet lending-related commitments, which is reported in Other liabilities, was $281 million and $282 million, respectively.
The following table summarizes the contractual amounts relating to JPMorgan Chase’s off-balance sheet lending-related financial instruments at June 30, 2002 and December 31, 2001:
NOTE 18 – FAIR VALUE OF FINANCIAL INSTRUMENTSFor a discussion of JPMorgan Chase’s fair value methodologies, see Note 27 of JPMorgan Chase’s 2001 Annual Report. The following table presents the financial assets and liabilities valued under SFAS 107.
NOTE 19 – SEGMENT INFORMATIONJPMorgan Chase is organized into five major businesses: Investment Bank, Treasury & Securities Services, Investment Management & Private Banking, JPMorgan Partners and Retail & Middle Market Financial Services. 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 currently evaluated by the Firm’s management. For a further discussion concerning JPMorgan Chase’s business segments, see Segment Results in the Management’s Discussion and Analysis (“MD&A”) section of this Form 10-Q on pages 26 through 36.
JPMorgan Chase uses Shareholder Value Added (“SVA”) and Operating Earnings as its principal measures of franchise profitability. A 12% cost of capital is used for all businesses except JPMorgan Partners, which has a 15% cost of capital. See Segment Results in the MD&A on page 28 and Note 29 of JPMorgan Chase’s 2001 Annual Report for a further discussion of performance measurements and policies for cost allocation. The following table provides the Firm’s segment results for second quarter and six months 2002 and 2001.
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Part IItem 2
Financial Highlights – Reported Basis: Reported net income was $1,028 million, or $0.50 per share, in the second quarter of 2002 compared with $982 million, or $0.48 per share, in the first quarter of 2002 and $378 million, or $0.18 per share, in the second quarter of 2001. For the first six months of 2002, reported net income was $2,010 million, or $0.99 per share, compared with $1,577 million, or $0.76 per share, in the same period last year.
Total revenue of $7.6 billion in the second quarter of 2002 was flat versus the immediately preceding quarter but 9% above the second quarter of last year. The current quarter reflected the strong results of the retail business, particularly the mortgage businesses, and lower losses on private equity investments. These were partially offset by a decline in trading revenue driven by lower positioning gains taken in fixed income, primarily in emerging markets and U.S. interest rate markets, in the latter part of the quarter and lower investment banking fees as a result of lower market volumes. In comparison with the second quarter of last year, the increase of 9% was principally attributable to the significant improvement in the results of the private equity investments. Last year included larger write-downs on several technology, media and telecommunications investments.
For the first half of 2002, total revenue of $15.2 billion was comparatively flat with last year’s year-to-date level. The decline in trading revenue and investment banking fees was offset by reductions in private equity losses and strong results of the retail business.
Total noninterest expenses of $5.2 billion in the second quarter of 2002 declined from both comparable periods. The decline of 3% from the 2002 first quarter was due to lower incentives related to the decrease in revenues, and the cost of the first quarter settlement with Sumitomo Corporation. The decline of 11% from the second quarter of last year was attributable to lower compensation expense as a result of merger-related savings, as well as the implementation of expense management initiatives, which included the right-sizing of resources in response to lower market activity. In addition, the current quarter reflected lower merger and restructuring expenses and the effect of the adoption of SFAS 142, which reduced the amortization of intangibles.
On a year-to-date basis, total expense of $10.6 billion in 2002 was 11% lower than last year, reflecting the expense management initiatives, lower merger and restructuring costs and cessation of amortization of goodwill.
Provision for loan losses for the 2002 second quarter was up 9% from the first quarter of this year and 56% above the second quarter of 2001. The increase from a year ago resulted from the slowdown in the economy, which unfavorably affected both the commercial and consumer loan portfolios. In addition, the increases from both periods were affected by the acquisition of the Providian Master Trust in February 2002. For the first half this year, the provision of $1.6 billion was 62% higher than last year’s equivalent period, reflecting the impact of the slowdown in the economy and the Providian acquisition.
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Part IItem 2 (continued)
Summary of Segment ResultsIn addition to analyzing the Firm’s results on a reported basis management utilizes “operating basis” to assess each of its businesses. For additional information and a reconciliation between the Firm's reported and operating results see pages 26-27 of this Form 10-Q.
Operating results for the 2002 second quarter were comparable with the 2002 first quarter. Operating earnings were $1,179 million in the second quarter 2002, compared with $1,150 million in the first quarter of 2002 and $786 million one year ago. Operating earnings for 2001 have been increased by adding back amortization of goodwill to present 2001 results on a basis comparable with the results for 2002, which include the impact of the implementation on January 1, 2002 of SFAS 142. Positives for the quarter included:
Nevertheless, the weak capital markets environment negatively affected, in varying degrees, many of the Firm’s segments. Operating revenues at the Investment Bank, at $3.1 billion, were 14% lower than the 2002 first quarter and 17% lower than the 2001 second quarter. Operating revenues at Investment Management & Private Banking were 5% lower than the 2002 first quarter and 12% lower than the second quarter of 2001 primarily as a result of continued declines in global equity markets valuations and lower investment activity levels. JPMorgan Partners had a private equity loss of $125 million, reflecting limited exit opportunities, constrained availability for financing and a private equity market that continues to be unsettled.
Looking forward, the current crisis in confidence among investors suggests a decline in market activity in the second half of the year, leading to continued pressure on revenues and credit costs. Revenues at Retail & Middle Market Financial Services may be lower in the remaining quarters of the year than the second quarter because of the strong hedge gains recognized in the 2002 second quarter on mortgage servicing rights (“MSR”). Sluggish M&A, equity underwriting and overall trading opportunities will continue to affect negatively revenues at the Investment Bank. Continuing pressures in the commercial portfolio, particularly in the telecommunications (“telecom”) and cable segments of that portfolio, may cause commercial credit costs and nonperforming assets to increase further during the latter half of the year. The anticipated improvement in the consumer credit portfolio may partially offset the anticipated higher credit costs in the commercial portfolio.
In this environment, strong financial and capital discipline will remain a priority of the Firm. The Tier 1 capital ratio at June 30, 2002 was 8.8%, compared with 8.3% at December 31, 2001. Management does not intend to resume stock repurchases until earnings of the Firm improve and generation of internal capital accelerates. Expense discipline is ongoing and management continues to target operating expenses for full year 2002 to be lower than full year 2001. Management continues to believe these actions will enable the Firm to produce higher returns when the economy recovers.
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Investment Banking FeesInvestment banking fees of $785 million in the second quarter of 2002 declined 16% from the 2001 second quarter but increased slightly from the first quarter of 2002. The decline was principally attributable to the continuing weakness in the capital markets, especially mergers and acquisitions. Advisory revenues in the second quarter of 2002 were $189 million, a decline of 39% from the second quarter of 2001. Market share gains in equity underwriting increased underwriting revenue although equity underwriting volumes remained at depressed levels. The market environment also unfavorably affected, to a lesser extent, the volume of debt underwriting and loan syndication transactions in 2002, with fees related to these activities declining slightly from last year.
Capital markets continue to be weak and there continues to be a low level of deals in the pipeline. (For additional information on investment banking fees, see the Investment Bank segment discussion on page 29.)
Trading RevenueIn the second quarter of 2002, trading revenue of $731 million declined 42% from 2001 second quarter and 44% from first quarter of this year. The declines from both periods reflected lower positioning gains taken in fixed income, primarily in emerging markets and U.S. interest rate markets, and lower equity derivative trading revenues compared with the second quarter of 2001 driven by difficult market conditions. As more Nasdaq-market trades are effected in 2002 on a commission basis (rather than based on the bid/offer spread), more of the revenues derived from such trades will be recorded in Brokerage and investment services (rather than in Trading revenues, as had been previously).
Difficult market conditions in both fixed income and equities have continued into the early part of the third quarter, resulting in an overall lower trading revenue environment compared with the second quarter.
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Fees and CommissionsFees and commissions for second quarter 2002 increased 17% and 12% from the second quarter 2001 and the first quarter 2002, respectively. The table below provides the significant components of fees and commissions.
Investment Management, Custody and Processing ServicesInvestment management, custody and processing services fees were relatively flat when compared with both the second quarter of last year and the first quarter of 2002. Investment management fees declined from the 2002 first quarter as a result of the decrease in the value of equity-related assets under management. The decline in investment management fees was partly offset by positive retail mutual fund flows. Custody and processing services increased slightly from the first quarter of 2002 due to new business wins and higher securities lending volume, partly related to the traditional increase in business volume during the second quarter dividend season, which is driven by overseas companies paying annual or semi-annual dividends. (For additional information on these fees, see the Investment Management & Private Banking and the Treasury & Securities Services segment discussions on pages 33 and 30, respectively.)
Credit Card RevenueCredit card revenue rose 44% from the second quarter of 2001 and 14% from the first quarter of 2002. The increase over the 2001 second quarter primarily reflected the increase in securitization revenues related to the additional $9 billion of average securitized assets, including the Providian Master Trust assets acquired in February 2002. Also contributing to the increase from last year was higher balance consolidation fees benefitting from the more active marketing programs. In comparison with the first quarter of 2002, the increase was driven by the higher securitization revenues as a result of the additional $4 billion of average securitized assets in the second quarter, as well as the full-quarter impact of Providian. For a discussion of the treatment of the accounting for securitizations, see page 26.
Brokerage and Investment ServicesIn the second quarter of 2002, brokerage and investment services rose 8% and 10% from the 2001 second quarter and the 2002 first quarter, respectively. The increases included the impact of more Nasdaq-market trades being effected, in 2002 on a commission basis (rather than based on the bid/offer spread). The increases also reflected the reclassification of certain commissions that were previously recorded in trading revenue.
Mortgage Servicing FeesMortgage Servicing fees of $257 million in the 2002 second quarter increased significantly from both the 2001 second quarter and the first quarter of this year principally due to the net positive results of servicing risk management activities relating to the hedging of the value of mortgage servicing rights recorded on the balance sheet. The current quarter net positive results from servicing risk management were driven by very high mortgage-swap spreads and a favorable interest rate environment. At June 30, 2002, the volume of mortgages serviced at Home Finance stood at $436 billion compared with $409 billion at the same period last year and $426 billion at March 31, 2002.
The Firm offsets its mortgage servicing right interest rate (prepayment) risk exposure by designating certain interest rate derivatives as fair value hedges. The results of these hedges and the adjustments of the carrying value of the MSRs under SFAS 133 are recorded in mortgage servicing fees. The results of these fair value hedges more than offset the SFAS 133 MSR valuation adjustment. AFS securities and nonhedge derivatives are also used to manage the risk exposure of the MSRs (for a further discussion see Note 9 on page 14).
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Item 2 (continued)
Other Lending-Related Service FeesOther lending-related fees in the second quarter of 2002 were up 5% from the second quarter of 2001 primarily due to the growth in the auto loan servicing volume at Auto Finance.
Deposit Service ChargesDeposit service charges in the second quarter of 2002 increased 6% from the second quarter of 2001, and declined 6% from the first quarter of 2002. The increase was driven by the impact of lower interest rates, which reduced the value of compensating deposit balances and increased the fees customers pay for deposit services. The decrease from first quarter of 2002 reflected lower account activities. On a year-to-date basis, the increase of 16% from last year was driven by lower interest rates, as well as by higher transaction volume.
Other FeesOther fees of $244 million in the 2002 second quarter were flat from last year’s second quarter but increased 5% from the 2002 first quarter. The current quarter included the full-quarter impact of the credit card-related debt management fees of the Providian Master Trust and the servicing fees associated with Systems & Services Technology (a company engaged in subservicing activities acquired in January 2002 by Institutional Trust Services). These fees were partly offset by lower insurance commissions and volume declines in various other processing transaction businesses.
Private Equity GainsPrivate equity investments of the Firm recorded losses of $125 million in the second quarter of 2002, an improvement of 85% from the second quarter of last year and 47% from the first quarter of 2002.
The recovery in private equity investment gains will be dependent upon the return to more favorable conditions for exiting investments. The current outlook for the second half of the year is for the continuation of the current market environment, with initial public offerings and high-yield financing still at minimum levels, mergers and acquisitions activity slow and continued write-downs in the telecommunications, media and telecom sectors (“TMT”). (For a further discussion of the Firm’s private equity results, see the JPMP line of business results on page 34 of this Form 10-Q.) The table below provides a comparison to prior periods of realized and unrealized gains and losses.
Securities GainsSecurities gains of $124 million in the second quarter of 2002 were up 85% from the 2001 second quarter. The increase reflected gains on sales of mortgage-backed and other asset-backed securities in the portfolios of the Investment Bank and Home Finance.
The decline from last year on a year-to-date basis primarily reflected last year’s $315 million gain on the sale of securities that were used as economic hedges for the value of mortgage servicing rights at Home Finance. During the first half of 2001, the value of the available-for-sale securities in the portfolio of Home Finance rose substantially as a result of declining rates during that period.
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The net gains of $146 million on residential mortgage originations, sales and securitizations of loans in the second quarter of 2002 declined slightly compared with second quarter of 2001 but rose 46% from the first quarter of 2002. Revenue for the six months 2002 declined slightly as a result of the lower volume of subprime loan securitizations, partially offset by higher gains on sales of prime loans and the effect of strong originations. (For additional information on mortgage-related revenue, see the Retail & Middle Market Financial Services segment discussion on page 31 and Note 8 on page 12.)
The decline in gains of securitized mortgage loans, despite the higher amount of mortgage loans securitized during the first six months of 2002 when compared to the same period in 2001 (as noted in Note 8 on page 12), is primarily due to the composition of mortgage securitizations. The first six months of 2002, when compared to the same period in 2001, included a higher volume of prime securitizations, which generally have a lower margin of gain than subprime mortgage securitizations. In addition, the subprime loans securitized in 2002 had a higher cost basis than the subprime loans securitized in 2001.
All other revenue of $146 million increased moderately from the second quarter of 2001 but was up 156% from the first quarter this year. The second quarter of 2002 reflected an increase in the net results of the corporate and bank-owned life insurance (COLI/BOLI). These insurance policies are purchased by the Firm for the purpose of partially defraying the costs of employee benefits and economically hedging deferred compensation costs. Also contributing to the increase in other revenue from the first quarter were the gains on the higher volume of securitizations of credit card receivables and commercial real estate loans, as well as write-downs in the 2002 first quarter of Latin American investments. The year-to-date decline of 26% from last year was primarily attributable to gains recognized in 2001 on the sale of several nonstrategic businesses in Texas and retail properties in New York.
Net Interest IncomeNet interest income of $2.9 billion in the second quarter of 2002 rose slightly from the 2001 second quarter, and the $5.8 billion of net interest income for the first half of 2002 increased 12% from the equivalent period a year ago, reflecting the favorable impact of low interest rates and wider spreads. The low interest rate environment contributed to an increase in domestic consumer loans, such as credit card receivables and auto loans; also contributing to increased outstandings was the acquisition of the Providian portfolio in February of 2002.
NONINTEREST EXPENSETotal noninterest expense for the quarter was $5.2 billion, down 11% from the second quarter of 2001 and slightly below the first quarter of this year. The decline from the 2001 second quarter was due to merger-related savings and expense management initiatives implemented in response to the weak market environment, including lower compensation expense. Also contributing to the decline was the cessation of the amortization of goodwill as a result of the adoption of SFAS 142 and lower merger and restructuring costs related to actions announced before 2002. These factors were partially offset by incremental expenses related to the Providian acquisition and additional severance costs included in Compensation expense in 2002. The following table presents the components of noninterest expense.
Compensation ExpenseCompensation expense in the second quarter of 2002 was $2.8 billion, down 9% from last year’s second quarter and slightly lower than the 2002 first quarter. The declines were the result of the alignment of incentives with the decrease in revenues, as well as the reduction in the number of full-time equivalent employees in businesses affected by the downturn in the economy, particularly the Investment Bank and Investment Management & Private Banking. This was partially offset by the impact of annual salary raises and new employees at expanding business segments, primarily at Retail & Middle Market Financial Services. Compensation expense in 2002 included severance costs of $97 million in the second quarter and $67 million in the first quarter. (In 2001, severance costs associated with the merger and other previously announced restructuring programs were recorded within the restructuring line and not in Compensation expense.)
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The Firm had 95,878 full-time equivalent employees at June 30, 2002, compared with 97,224 at June 30, 2001 and 96,938 at March 31, 2002. The decline in the number of employees was attributable to reductions at the Investment Bank, Investment Management & Private Banking and Corporate and Support business segments, partially offset increases at Retail & Middle Market Financial Services and Treasury & Securities Services.
Occupancy ExpenseOccupancy expense in the 2002 second quarter rose 12% from the second quarter of 2001 and 8% from the first quarter of this year. The increases reflected the costs of the additional leased space in midtown Manhattan and New Jersey. In the second quarter of this year, certain staff that had been previously located in downtown Manhattan were relocated to these new locations. These costs were partly offset by the income received from subletting space at a property owned in downtown Manhattan.
Technology and Communications ExpenseIn the second quarter of 2002, technology and communications expense of $629 million declined from the first quarter of this year and the 2001 second quarter. Expense management initiatives resulted in lower software and telecommunication expenses and lower other technology and equipment-related expenses, such as those associated with workstation leases and repair and maintenance. Also contributing to the decline were rebates received from outside vendors based on the volume of business sourced from them.
Merger and Restructuring CostsIn the second quarter of 2002, merger and restructuring costs were $229 million, down 52% from the 2001 second quarter, and 10% lower than the first quarter of this year. Refer to the discussion of Compensation Expense above for a description of other severance costs incurred in 2002 and to Note 5 of this Form 10-Q and page 44 of JPMorgan Chase’s 2001 Annual Report.
Amortization of IntangiblesAmortization of intangibles of $92 million included a $12 million impairment write-down on purchased credit card relationships related to a small credit card portfolio previously acquired. Amortization of intangibles declined 50% from last year’s second quarter but was 33% higher than the 2002 first quarter. The decline from last year primarily reflected the implementation of SFAS 142, which now requires a periodic review of goodwill for impairment rather than the amortization of goodwill on a monthly basis as was the case last year. In 2002, there were no impairments recognized on goodwill recorded on the balance sheet. The increase from the first quarter was attributable to the amortization of Providian Master Trust’s credit card relationship intangibles. (For a further discussion of the amortization of intangibles and the expected level of expense for the remainder of the year, see Note 2 of this Form 10-Q.)
Other ExpenseIn the second quarter of 2002, other expense was down slightly from each of the 2001 second quarter and the first quarter of this year. The following table presents the components of other expense.
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PROVISION FOR LOAN LOSSESProvision for loan losses in the second quarter of 2002, when compared with the second quarter of 2001, increased 56% partly as a result of the addition of Providian. (See pages 38-43 for a discussion of charge-offs associated with the consumer and commercial loan portfolios and pages 43-44 for a discussion of the allowance for credit losses.)
INCOME TAXESIn the second quarter of 2002, JPMorgan Chase recognized income tax expense of $531 million, compared with $207 million in the second quarter of 2001. The effective tax rates for the periods were 34% and 35%, respectively.
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 in 2002 include the severance and related costs associated with management actions in light of slower market activity. For the second quarter and first six months of 2002, special items included $229 million and $484 million (pre-tax), respectively, in merger and restructuring expenses. For the second quarter and first six months of 2001, special items included $478 million and $806 million (pre-tax), respectively, in merger and restructuring expenses. The first six months of 2001 also included the cumulative effect of a transition adjustment of $(25) million (after-tax) related to the adoption of SFAS 133.
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 fee revenue for continuing to service those receivables and fee revenue representing any interest and fees on the receivables in excess of the interest paid to investors, net credit losses and servicing fees. 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. The Firm also reports credit costs on a “retained” or “reported” basis and on a “managed” or “operating” basis. Credit costs on an operating basis are composed of the provision for loan losses related to credit card receivables on the consolidated balance sheet (“retained” credit costs) as well as the credit costs associated with securitized credit card loans. Credit costs for securitized loans are for the account of the Firm as the holder of the residual interest in the securitization trust. In the Firm’s GAAP financial statements, credit costs associated with securitized credit card loans reduces the noninterest income remitted to the Firm from the trust. This income is reported in credit card revenue in Fees and Commissions over the life of the securitization.
In 2001, the methodology for allocating the allowance (and provision) for loan losses to the business segments was changed. The Firm currently has a methodology where each business is responsible for its credit costs, which will include actual net charge-offs and changes in the specific and expected components of the allowance for loan losses. Minor refinements to the allocation of the allowance are continuing in 2002. The residual component of the allowance for loan losses is maintained at the corporate level.
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JPMorgan Chase’s segment results reflect the manner in which financial information currently is evaluated by the Firm’s management. Adjustments may be made from time to time to reflect changes in methodologies or reporting lines. For a discussion of the Firm’s methodology of allocating equity to its business units, see page 29 of the 2001 Annual Report. The table below provides summary financial information on an operating basis for the five major business segments.
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INVESTMENT BANKFor a discussion of the business profile of the Investment Bank, see pages 30-31 of the JPMorgan Chase 2001 Annual Report. The following table sets forth selected financial data of the Investment Bank.
The Investment Bank had operating earnings of $485 million in the second quarter, a decline of 35% from the first quarter and 38% lower than the second quarter of 2001. Operating ROE was 10% for the quarter compared with 16% last quarter and 17% for the second quarter of 2001.
Operating revenues of $3.09 billion in the second quarter of 2002 were 14% lower than last quarter and down 17% from the second quarter of 2001.
Trading-related revenues (including related net interest income) and brokerage commissions of $1.41 billion decreased 28% from the first quarter and were down 23% from the second quarter of 2001. The decline from the first quarter was driven largely by fixed income results, particularly lower proprietary positioning gains in U.S. interest rate markets and emerging market instruments. The decline from the second quarter of 2001 was primarily due to lower equity derivatives revenues driven by difficult market conditions. Difficult market conditions in both fixed income and equities have continued into the early part of the third quarter resulting in an overall lower trading revenue environment compared to the second quarter.
Investment banking fees totaled $783 million in the second quarter, an increase of 6% from the first quarter but 15% lower than the second quarter of 2001. The increase from the first quarter reflected a 33% increase in equity underwriting fees and flat M&A fees and debt underwriting revenues. Market share gains in the second quarter included global announced M&A (#1), U.S. and global equity and equity-related (#6), U.S. investment grade bonds (#2) and global loan syndications (#1). (Derived from Thomson Financial Securities Data. Global announced M&A based on rank value; all others based on proceeds, with full credit to each book manager/equal if joint). Capital markets continue to be weak and there continues to be a low level of deals in the pipeline.
All other revenue of $148 million in the second quarter of 2002 was 90% higher than the prior linked quarter primarily reflecting the write-downs of Latin American investments recognized in the first quarter.
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Operating expenses for the second quarter of $2.02 billion decreased by 4% from the first quarter and by 11% from the second quarter of 2001. Operating expenses in the second quarter included $123 million in severance and other costs associated with restructuring programs announced in 2002. This compared with $47 million of such costs in the first quarter. The overhead ratio for the second quarter was 65% compared to 58% in the first quarter and 61% in the second quarter of 2001.
Credit costs of $306 million were 9% higher than the first quarter and were 83% higher than the second quarter of 2001, primarily due to increased charge-offs and higher specific reserves, most of which related to the telecom services sector. For a further discussion of the telecom sector, see page 38.
TREASURY & SECURITIES SERVICESFor a discussion of the profiles for each business within Treasury & Securities Services (“T&SS”), see pages 32-33 of JPMorgan Chase’s 2001 Annual Report. The following table sets forth selected financial data of Treasury & Securities Services.
Treasury & Securities Services had record operating earnings of $177 million, an increase of 22% from the first quarter and 16% from the second quarter of 2001, underscored by the implementation of strict cost containment measures. Operating ROE for the quarter was 23% compared with 20% in each of the last quarter and the second quarter of 2001, while SVA rose sharply, up 50% and 40% over the same time periods respectively.
Operating revenues were $985 million in the second quarter of 2002, up 5% from the first quarter and up 2% from the second quarter of 2001. Revenues in Investor Services were up 9% from the first quarter and were virtually flat compared with the second quarter of 2001. The increase from the first quarter was due to higher custody fees, foreign exchange revenue and securities lending fees. Institutional Trust revenues increased 9% from the first quarter of 2002 due to higher American Depositary Receipt revenues and new business. The 12% increase in Institutional Trust revenues from the second quarter of 2001 reflected the impact of acquisitions and new business wins partially offset by the effect of slower fixed income activity. The impact of lower interest rates on Treasury & Securities Services revenues was largely offset by higher deposits resulting from increased business volumes.
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Operating expenses were virtually unchanged from the first quarter and declined 2% from the second quarter of 2001. The business, particularly Treasury Services and Investor Services, continues to focus on cost containment and improving its overhead ratio, while selectively investing in acquisitions for future growth. The overhead ratio for the second quarter was 72% compared to 76% in each of the first quarter of 2002 and the second quarter of 2001.
RETAIL & MIDDLE MARKET FINANCIAL SERVICES
Retail & Middle Market Financial Services had a second consecutive quarter of record revenues and operating earnings. Operating earnings of $686 million were up 29% from the first quarter and up 60% from the second quarter of 2001 driven by strong performances across the consumer credit businesses and middle market. ROE for the second quarter was 26%, compared to 21% last quarter and 19% for the second quarter of 2001.
Operating revenues of $3.50 billion were up 11% from the first quarter and 27% from the second quarter of 2001 driven by continued high production volumes across all consumer businesses and low interest rates. Home Finance revenues were driven by an increase in customer servicing balances and higher mortgage origination and servicing margins impacted by business mix and a strong housing environment as well as better servicing risk management performance resulting from lower rates. Managed credit card outstandings increased 29% from June 30, 2001 to $49.5 billion (which includes other unsecured consumer and commercial credit card portfolios) due to the Providian acquisition in the first quarter of 2002 and to organic growth. Total deposits grew 2% from the first quarter and 12% from the second quarter of 2001.
Operating expenses of $1.67 billion increased by 7% from the first quarter and by 16% from the second quarter of 2001. The increases reflected the impact of higher expenses related to higher volumes. Savings generated by Six Sigma productivity programs continued to partially offset the growth in expenses.
Managed credit costs of $736 million were 1% higher than the first quarter and were 17% higher than the second quarter of 2001, primarily due to increased charge-offs related to the full quarter impact of the Providian credit card portfolio. The provision related to consumer credits was lower than the net charge-offs for the 2002 second quarter because of a lower retained portfolio of credit cards and because of improvement in loss rates in Auto Finance and lower delinquency ratios in cards.
The following table sets forth certain key financial performance measures of the businesses within RMMFS. For further information on the quarterly business-related metrics of these businesses, see page 54.
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Cardmember ServicesCardmember Services had record operating revenues in the second quarter of 2002, up 39% from the second quarter of last year and 10% from the first quarter of 2002. The increase from last year was due to the acquisition of the Providian Master Trust credit card portfolio in February of this year, higher average loans outstanding, lower funding costs to support these assets and higher credit card fees. The higher fees were the result of a 17% increase in transaction volume (customer purchases, cash advances and balance transfers), and higher levels of delinquencies, which increased late fees. The favorable variance from the 2002 first quarter reflected the full quarter impact of the Providian acquisition. End of period outstandings increased 29% from last year’s second quarter to almost $50 billion.
Operating earnings of $178 million in the second quarter of 2002 were a record, 58% above the second quarter of last year and 18% from the immediate past quarter. The increase from the second quarter of 2001 was primarily attributable to the acquisition of Providian, as well as higher transaction volume and higher average loans. The increase from the first quarter of 2002 largely reflects higher transaction volume and average loans.
The managed net charge-off rate of 6.41% for the second quarter of 2002, up 84 and 59 basis points, respectively, from last year’s second quarter and the first quarter of this year, was primarily due to the impact of Providian. Excluding Providian, the managed net charge-off rate would have been 5.92% and 5.76% for the second and first quarters of 2002, respectively. It is anticipated that the managed net charge-off rate in the second half of 2002 will improve from the second quarter 2002 rate because of decreases in the 30-, 60- and 90-day period delinquencies.
Regional Banking GroupRegional Banking Group’s second quarter 2002 operating revenue of $726 million declined 10% from the 2001 second quarter but only slightly from the 2002 first quarter. The decline in operating revenue reflected the impact of the lower interest rate environment, which resulted in lower net interest earned on deposit balances. This was partially offset by a 7% growth in overall volume of retail deposits. Deposits grew 10% excluding the impact of the sale of the National Deposit group.
Operating earnings declined 31% from the second quarter of 2001 due to the lower interest rate environment partially offset by the higher deposit balances and lower credit costs due to improved credit quality. Operating earnings declined 29% from the first quarter of 2002 principally from the gain on sale of the National Deposit group and the reduction of loan loss reserves (improved credit quality) in the first quarter. In addition, the second quarter included the integration costs related to the Dreyfus discount brokerage acquisition. The overhead ratio in the 2002 second quarter increased from the same period last year to 78% as a result of lower revenues.
Home FinanceHome Finance’s second quarter 2002 operating revenue of $772 million increased 87% from the comparable quarter last year and 46% from the prior quarter of the current year. The increase in revenue was driven by the strong operating performance and the net positive results of servicing risk management activities relating to the hedging of the value of mortgage servicing rights recorded on the balance sheet. The significant increase in operating performance from both past quarters were driven by the prolonged strength of the U.S. housing market, low rates, growth in servicing volume, and the continued expansion and share growth of higher margin businesses (direct to consumer and home equity). The current quarter net positive results from servicing risk management of $186 million were driven by very high mortgage-swap spreads and a favorable interest rate environment. Management anticipates an eventual decrease in this revenue component as spreads and interest rates revert to normal levels.
Operating earnings of $268 million rose 171% versus the second quarter of 2001 and 103% relative to the prior linked quarter. The earnings this quarter were the second consecutive record level for Home Finance. These earnings include slightly higher credit costs as reflected in the increase in net charge-off rates shown on page 54, primarily as a result of losses realized on the transfer of certain subprime loans to a held for sale portfolio.
Originations (residential, home equity and manufactured housing) for the second quarter of 2002 were $27 billion and included originations from the retail, wholesale and correspondent (traditional and negotiated) channels. The mortgage servicing portfolio was $436 billion at June 30, 2002, an increase of 7% from the same quarter last year. Over this same time period, the carrying value of mortgage servicing rights declined 20% from $7.1 billion to $5.7 billion. The overhead ratio decreased to 39% primarily due to the aforementioned strong revenue growth.
Middle MarketsMiddle Markets’ operating revenues in the 2002 second quarter increased 2% in comparison with the second quarter of last year but were 2% lower than the first quarter of this year. The increase from last year was the result of new cash management contracts and increased banking services and fees from lending transactions. The decline from the 2002 first quarter was attributable to the effects of the lower interest rate environment and other seasonal factors.
Operating earnings rose 52% over the second quarter of 2001 and 12% from the first quarter primarily due to lower credit costs. The decrease in credit costs was driven by a general improvement in the credit quality of the Middle Markets loan portfolio and significant recoveries. The overhead ratio improved by 300 bp from the second quarter of 2001 as a result of the lower expense level in the second quarter of 2002.
Auto FinanceAuto Finance’s operating revenue increased 23% from the second quarter of 2001 but declined 2% from the 2002 first quarter. The revenue increase from the 2001 second quarter was principally due to the impact of the favorable interest rate environment, an 8% growth in origination volume, and higher auto loans and leases outstanding. The revenue decrease from the 2002 first quarter was due to the reduced gain recorded from loan securitizations in the second quarter compared to the first quarter of 2002.
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Operating earnings increased 128% from the 2001 second quarter and 148% from first quarter of 2002. The increase was primarily due to the growth in the portfolio, higher spreads on the receivables outstanding, and lower credit costs due to reduced reserve for loan loss levels, reflecting improved loss rates. The overhead ratio for the current year second quarter was 35%, decreasing from the prior year as a result of higher revenue growth combined with increased efficiency in expenses.
INVESTMENT MANAGEMENT & PRIVATE BANKINGFor a discussion of the business profile of Investment Management & Private Banking (“IMPB”) see pages 34-35 of JPMorgan Chase’s 2001 Annual Report. The following table reflects selected financial data for IMPB.
Investment Management & Private Banking had operating earnings of $118 million, down 6% from the first quarter and 2% higher than the second quarter of 2001. Pre-tax margin in the second quarter was 21% compared with 22% last quarter and 19% in the second quarter of 2001.
Operating revenues of $691 million in the second quarter were 5% below the first quarter and 12% lower than the second quarter of 2001. Continued declines in global equity markets valuations and eroding investor activity levels accounted for most of the decreases. Operating expenses of $520 million for the quarter were 5% lower than the first quarter and down 18% from the second quarter of 2001 as a result of continued reductions in compensation and other expenses. Credit costs of $23 million were equal to the first quarter of 2002 but higher than credit costs of $2 million in the second quarter of 2001 reflecting the generally weaker credit environment.
The table below reflects the assets under management in IMPB as of June 30, 2002.
Total assets under management at quarter-end of $541 billion were 7% lower than the first quarter and down 11% from the second quarter of 2001. Falling equity prices accounted for most of the year-on-year declines; outflows from institutional cash management products accounted for the balance. These effects outweighed continued positive flows and a year-over-year increase in assets under management for the retail mutual funds.
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JPMORGAN PARTNERSFor a discussion of the business profile of JPMorgan Partners, see pages 36-37 of the JPMorgan Chase 2001 Annual Report. The following table sets forth selected financial data of JPMorgan Partners.
JPMorgan Partners had an operating loss of $165 million for the 2002 second quarter compared with an operating loss of $248 million in the first quarter and an operating loss of $610 million in the second quarter of 2001.
Total net private equity gains were negative $125 million, as compared to negative $255 million in the first quarter and negative $823 million in the second quarter of 2001. The second quarter 2002 results were driven by write-downs and write-offs on private holdings of $216 million and net mark-to-market losses on public securities of $20 million, partially offset by net realized gains of $111 million. Losses were concentrated in TMT investments. There are limited exit opportunities and constrained financing in the private equity markets and continued weakness in the TMT sector is likely to contribute to further write-downs in the portfolio.
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JPMorgan Partners Investment PortfolioThe following table presents the carrying values and costs of the JPMP investment portfolio for the dates indicated.
The following table presents information about the 10 largest holdings of public securities in the JPMP investment portfolio at June 30, 2002:
Technology, media and telecommunications (“TMT”) investments at June 30, 2002 were $1.7 billion, or 20% of the total portfolio, compared with $2.1 billion, or 24% of the portfolio, at March 31, 2002.
The Firm believes that JPMP will 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. JPMP’s investment pace continues to be slow, at $149 million during the second quarter of 2002, with deal flow well diversified across industry sectors.
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SUPPORT UNITS AND CORPORATEJPMorgan Chase’s support units include Enterprise Technology Services, Corporate Business Services, legal, audit and finance. For a further discussion of the business profiles of these Support Units as well as a description of Corporate, see page 41 of JPMorgan Chase’s 2001 Annual Report.
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.
This sector usually operates at a small loss. Negative revenue is the result of the over-allocation of capital to the other business sectors, and to the over-allocation of revenues that arises from the application of funds transfer pricing and other management accounting policies. Expense items usually result from timing differences in allocations to other business sectors and residuals from interoffice allocation among the business segments. Tax expense reflects the difference between the aggregate recorded at the consolidated level and the amount recorded at the segments.
Although the Corporate segment has no traditional credit product assets, the residual component of the allowance for credit losses is maintained at the corporate level. That is because the residual component of the allowance is not allocated to any specific line of business. In addition, for 2001, credit costs reflected the difference between the aggregate provision recorded at the consolidated level and the provision allocated to the business segments. For a further discussion of the residual component, see pages 26 and 44.
CRITICAL ACCOUNTING POLICIESThe Firm’s accounting policies are integral to understanding the results reported. The Firm’s most complex accounting policies require management’s judgment to ascertain the valuation of certain assets and liabilities. The Firm has established detailed policies and control procedures that are intended to ensure that 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 Firm’s most critical accounting policies involving the more significant management valuation judgments involve the accounting for the allowance for loan losses and for the fair value of financial instruments. For a further description of the types of judgments and estimates required in these accounting policies, see page 41 and the Notes to Consolidated Financial Statements in the 2001 Annual Report.
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RISK MANAGEMENT
JPMorgan Chase is in the business of managing risk to create shareholder value. The major risks to which the Firm is exposed are credit, market, operational and business, liquidity and private equity risk. For a discussion of these risks and definitions of terms associated with managing these risks, see pages 45-62 and the Glossary of Terms in the 2001 Annual Report.
The Firm assesses its credit exposures on a managed basis, taking into account the impact of credit card securitizations. For a reconciliation of credit costs on a managed, or operating basis, to reported results, see page 27 of this Form 10-Q. The following table presents the Firm’s credit-related information for the dates indicated.
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Consumer managed credit-related assets increased $0.9 billion since December 31, 2001, reflecting growth in the credit card portfolio, offset in part by a decline in the residential mortgage warehouse portfolio as a result of increased loan sales.
Commercial credit-related assets (consisting of loans and derivatives) considered investment grade were approximately 69% at June 30, 2002, compared with 65% at year-end 2001. The increase is due to short-term financings at quarter end (subsequently repaid) and a greater percentage of investment grade derivative counterparties. At June 30, 2002, 79% of the Firm's total commercial credit exposure of $416 billion (which includes credit-related assets and unfunded commercial commitments) was considered investment grade compared with 77% considered investment grade at year-end 2001.
The Firm has experienced, during the first six months of 2002, a significant deterioration in the credit quality of commercial loans in the telecommunications (includes other companies with an interdependence upon the telecommunications sector) and cable sectors and, to a lesser extent, the merchant energy sector. Excluding these three industry sectors, the credit quality of the commercial loan portfolio has improved over the same time frame. As of June 30, 2002, credit-related assets in the telecom and cable sectors were $9 billion and $3 billion, respectively, or 5% and 2% of total commercial credit-related assets. The investment grade portion of total credit-related assets in these sectors was 51% and 24%, respectively, as of June 30, 2002. Merchant energy represented a further $1 billion, or less than 1%, of total commercial credit-related assets at June 30, 2002, of which 32% was considered investment grade.
The telecom industry worldwide and the cable industry, particularly in Europe, have been adversely affected by insufficient resources to fund capital expenditures as well as by severe liquidity constraints. The Firm has seen a concurrent deterioration in the risk profile of its telecom and cable credit-related assets, particularly in the emerging telecom and European cable segments of the portfolio. Credit-related assets deemed criticized by the Firm in the telecom and cable sectors have increased from $1.1 billion to $2 billion since year-end. Since the end of the second quarter, there has been a further deterioration in the credits that are criticized and, as a result, it is likely there will be an increase in nonperforming loans in these sectors over the balance of the year.
Total nonperforming assets were $4.4 billion at June 30, 2002, which included $1.13 billion in Enron-related surety receivables and letter of credit. Excluding this amount, which is the subject of litigation with credit-worthy entities, nonperforming assets totaled $3.2 billion. This compares with $2.8 billion at December 31, 2001 and $2.5 billion as of June 30, 2001. The increase in nonperforming assets from year-end was primarily due to the continued weakness in the telecom and cable sectors of the commercial loan portfolio.
Total net charge-offs in the Firm’s managed commercial and consumer portfolio were $1.2 billion in the second quarter of 2002, comparatively flat with the first quarter. An increase in consumer charge-offs (primarily due to the full-quarter impact of the Providian credit card portfolio) was offset by a slight decline in charge-offs in the commercial portfolio. Excluding the impact of Providian, the managed credit card charge-off rate would have been 5.89%, compared with 5.54% in the second quarter of 2001. The increase in commercial charge-offs in the first half of 2002 compared with 2001 was largely due to domestic and foreign charge-offs in the telecommunications industry. Telecom represented 34% of total commercial charge-offs in the first half of 2002.
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The following table presents the Firm’s commercial credit exposure for the dates indicated.
(a) Includes unused advised lines of credit totaling $18 billion at June 30, 2002.
The following discussion relates to the specific loan categories within the commercial portfolio:
Commercial and Industrial: The domestic commercial and industrial portfolio decreased $2.5 billion from 2001 year-end. Net charge-offs in the 2002 second quarter were $194 million, compared with $158 million in the second quarter of 2001. Nonperforming domestic commercial and industrial loans were $1,312 million, an increase of $126 million from the 2001 year-end. The foreign commercial and industrial portfolio totaled $33.4 billion at June 30, 2002, comparatively flat with year-end 2001. Nonperforming foreign commercial and industrial loans were $1,073 million, an increase of $394 million from year-end 2001. Net charge-offs in the foreign commercial and industrial loan portfolio for the second quarter of 2002 increased to $95 million from $39 million in the second quarter of 2001.
Financial Institutions: Loans to financial institutions increased $3.4 billion when compared with year-end. Nonperforming financial institution loans decreased from $56 million at year-end to $26 million at June 30, 2002.
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Enron-related exposureThe Firm’s exposure to Enron and Enron-related entities as of June 30, 2002 was $1,682 million. The exposure is comprised of the following:
For additional discussion of the accounting policies related to the above categories, refer to the Notes to Consolidated Financial Statements in the 2001 Annual Report.
The Firm charged-off and wrote-down $456 million of Enron-related exposure in the fourth quarter of 2001. During the first six months of 2002, the Firm’s exposure to Enron was reduced by an additional $24 million as a result of charge-offs and valuation adjustments. The Firm will continue to adjust the valuation of its exposures to Enron nonperforming loans and trading assets in future periods, as appropriate; the Firm currently believes future losses related to nonperforming loans and trading assets will not be material. For a discussion of the Firm's risks associated with the surety receivables included within other assets, see Legal Proceedings on pages 56-58 of this Form 10-Q.
Derivative and Foreign Exchange ContractsFor a discussion of the derivative and foreign exchange contracts utilized by JPMorgan Chase in connection with its trading and Assets/Liabilities (“A/L”) activities, see Note 16 of this Form 10-Q, and pages 51 and 52 and Note 24 of JPMorgan Chase’s 2001 Annual Report. The following table provides the remaining maturities of derivative and foreign exchange contracts outstanding at June 30, 2002 and December 31, 2001.
The following table summarizes the risk profile, as of June 30, 2002, of the Firm’s balance sheet exposure to derivative and foreign exchange contracts, net of 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; ratings below are based upon the Firm’s internal obligor risk ratings and are presented on a Standard & Poor’s-equivalent basis:
The majority of the Firm's derivatives are entered into for trading purposes. Certain of the Firm’s trading-related derivatives include provisions that require the Firm, upon specified downgrades in its credit ratings to terminate the derivative contract (generally upon J.P. Morgan Chase Bank being rated BBB), or to post collateral for the benefit of the counterparty.
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Country ExposureThe following discussion is based on management’s view of country exposure. For a further discussion of the Firm’s country exposure, see page 52 of the 2001 Annual Report.
During the second quarter of 2002, the Firm’s key country exposures remained comparatively the same or declined. The Firm has been carefully monitoring its exposure to Brazil in light of the deteriorating economic condition in the country. Exposure to Brazil declined to $2.1 billion as of June 30, 2002, compared with $2.7 billion as of March 31, 2002 and $3.3 billion as of December 31, 2001. The decline was due to loan maturities, declines in counterparty exposures on derivatives, and a lower level of local issuer exposures. The reduction in counterparty exposure includes the effect of fair value adjustments on derivatives. Mark-to-market exposures on derivatives in Brazil are sensitive to moves in local interest rates and foreign exchange rates.
In Argentina, exposure (before allowance for loan losses) totaled $378 million at June 30, 2002, compared to $589 million at December 31, 2001. The decrease was due to an $82 million decline on trading assets, a $46 million decline due to write-downs on equity investments and an $83 million decline on loans due to a combination of charge-offs taken and loan payments received. The Firm will continue to adjust its exposures to Argentina in future periods, as appropriate; however, the Firm currently believes future losses related to Argentine loans and trading assets will not be material. Exposure to Uruguay, which is suffering a financial crisis, remains limited. In Japan, exposures declined due to fluctuations in trading positions and mark-to-market exposure on derivatives that are sensitive to foreign exchange rates. Trading exposure includes credit derivative positions where the Firm has purchased credit protection to hedge lending exposure. Exposure to Turkey declined across product categories, driven by loan and derivative maturities as well as reduction in bond trading positions.
The following table presents JPMorgan Chase’s exposure to selected countries.
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CONSUMER PORTFOLIO
JPMorgan Chase’s consumer portfolio is primarily domestic and is geographically well-diversified. JPMorgan Chase’s managed consumer portfolio totaled $134.9 billion at June 30, 2002, an increase of approximately $1 billion since 2001 year-end. Consumer net charge-offs, on a managed basis, were $862 million and $586 million for the second quarter of 2002 and 2001, respectively. The increase was primarily due to an increase in credit card net charge-offs due, in part, to a higher level of outstandings and the impact of the Providian acquisition.
The following discussion relates to the specific loan categories within the consumer portfolio:
Residential Mortgage Loans: Residential mortgage loans were $52.7 billion at June 30, 2002, a $6.8 billion decrease from the 2001 year-end. Nonperforming 1-4 family residential mortgage loans decreased $5 million from year-end. The net charge-off rate of 0.16% for the second quarter of 2002 increased from the second quarter of 2001 due to losses realized on the transfer of certain subprime loans to a held for sale portfolio. At June 30, 2002, the Firm had $2 billion of subprime residential mortgage loans, of which $1.4 billion were held for sale. In addition, the Firm had at June 30, 2002, $12.1 billion of securitized loans relating to subprime 1-4 family residential mortgage loans, including $4.3 billion related to the Advanta mortgage business acquired in 2001.
Credit Card Loans: JPMorgan Chase 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.
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Managed credit card receivables were approximately $48.5 billion at June 30, 2002, an increase of 19% when compared with year-end 2001. The increase reflects the acquisition of credit card assets from Providian in February 2002. At June 30, 2002, the Firm had $1.1 billion of subprime credit card loans (no subprime credit card loans were securitized). During the 2002 second quarter, net charge-offs as a percentage of average credit card receivables increased to 6.42%, compared with 5.54% at June 30, 2001. Loans over 90 days past due decreased to 1.98% of the portfolio at June 30, 2002, compared with 2.22% at December 31, 2001. Management anticipates that the managed credit card net charge-off ratio for the full-year 2002 will be higher than full-year 2001, due in part to the contribution of the Providian card portfolio.
Auto Financings: Auto financings outstanding increased by $1 billion at June 30, 2002, when compared with year-end 2001. The charge-off rate of 0.43% for the 2002 second quarter continues to be indicative of this portfolio’s selective approach to asset origination. Total originations were $5.2 billion for the second quarter of 2002, compared with $4.8 billion for the comparable period in 2001.
Other Consumer Loans: Other consumer loans of $7.0 billion at June 30, 2002 declined 13% compared with year-end levels. The net charge-off rate related to this portfolio increased in the 2002 second quarter to 2.35%, as a result of slightly higher charge-offs in a discontinued installment loan portfolio.
Allowance for Credit Losses
Loans: JPMorgan Chase’s allowance for loan losses is intended to cover probable credit losses as of June 30, 2002 for which either the asset is not specifically identified or the size of the loss has not been fully determined. The allowance has both specific and expected loss components and a residual component to reflect the lower credit quality in the Firm's loan portfolio.
As of June 30, 2002, management deemed the allowance to be adequate (i.e., sufficient to absorb losses that currently may exist but are not yet identifiable). The allowance represented 2.36% of loans at June 30, 2002, compared with 2.08% at year-end 2001. The allowance for credit losses was increased by $482 million from year-end 2001 and by $1.3 billion from June 30, 2001.
The commercial specific loss component of the allowance was $1,212 million at June 30, 2002, an increase of $156 million, or 15%, from year-end 2001. 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. All doubtful loans and some substandard loans are categorized as nonperforming. The increase in the specific loss component is primarily due to the deterioration in the telecom and cable sectors, which has led to an increase in criticized loans and to an increase in nonperforming loans.
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The commercial expected loss component of the allowance was $594 million at June 30, 2002, a decrease of $74 million or 11% from year-end 2001. The expected loss component covers noncriticized commercial loans, and is a product of default probability and loss severity. Default probability is a weighted product of actual average defaults through the credit cycle and a current market estimate of defaults, and loss severity is based on the Firm’s historical experience. These factors are continuously refined, and changes in these factors had no significant impact on the determination of the expected loss component during the first half of the year. The $74 million decrease in the expected loss component was due to a reduction in amount, and the improvement in average quality, of the noncriticized portion of the loan portfolio.
The consumer expected loss component of the allowance was $2.4 billion at June 30, 2002, an increase of $282 million, or 13%, from year-end 2001. The increase was due to the acquisition of the Providian portfolio by Chase Cardmember Services and an increase in the net charge-off rate of the Chase Home Finance portfolio, partially offset by a reduction in the amount of retained credit card loans (excluding the Providian acquisition), and a reduction of expected loss rates in the Chase Auto Finance portfolio due to improved delinquency rates.
The residual component of the allowance was $813 million at June 30, 2002, an increase of $118 million, or 17%, from year-end 2001. The residual component is intended to cover both the consumer and commercial portfolios. The Firm anticipates that the residual component will range between 10% and 20% of the total allowance for loan losses. At June 30, 2002, the residual component represented approximately 16% of the total allowance for loan losses.
Lending-Related Commitments: JPMorgan Chase also has an allowance for its off-balance sheet lending-related commitments, using a methodology similar to that for the loan portfolio. This allowance, which is reported in Other Liabilities, was $281 million, $282 million and $285 million at June 30, 2002, December 31, 2001 and June 30, 2001, respectively.
MARKET RISK MANAGEMENT
Aggregate VAR ExposureJPMorgan Chase’s statistical market risk measure value-at-risk (“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 its trading and investment portfolios, plus all of its market risk-related A/L activities.
Although no single risk statistic can reflect all aspects of market risk, the following table provides a meaningful overview of the Firm’s market risk exposure arising from trading activities and the investment and A/L portfolios.
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Histogram:The following histogram illustrates JPMorgan Chase’s daily market risk-related revenue, which is defined as the daily change in value of the mark-to-market trading portfolios plus any trading-related net interest income, brokerage commissions, underwriting fees or other revenue. In the first half of 2002, JPMorgan Chase posted positive daily market risk-related revenue for 116 out of 125 days, with 74 days exceeding positive $25 million. Losses were sustained on 9 of the 125 days represented in the histogram. JPMorgan Chase incurred four daily trading losses in excess of $20 million in the first half of 2002.
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. For a further discussion of the Firm’s stress testing methodology, see page 56 of the 2001 Annual Report.
The following table represents at, and for the periods ended, June 30, 2002 and December 31, 2001, 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 stress results at, and for the period ended, June 30, 2002 were mostly driven by exposures that are sensitive to a stress scenario in which credit and equity prices decline and, at the same time, interest rates fall in the major currencies.
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CapitalJPMorgan Chase’s capital levels at June 30, 2002 continued to improve with ratios well in excess of regulatory guidelines. At June 30, 2002, the Tier 1 and Total Capital ratios were 8.8% and 12.7%, respectively, and the Tier 1 leverage ratio was 5.4%. At June 30, 2002, the total capitalization of JPMorgan Chase (the sum of Tier 1 and Tier 2 Capital) was $55.9 billion, an increase of $1.8 billion from December 31, 2001. Approximately half of the increase was due to changes in Tier 1 capital, reflecting $0.6 billion in retained earnings (net income less common and preferred dividends) generated during the period, the issuance of $1 billion in trust preferred securities, and the net stock issuance of $0.5 billion related to employee benefit plans, partially offset by the redemption of $550 million in preferred stock of subsidiary. The balance of the increase was attributable to increases in the subordinated debt and allowance for credit losses components of Tier 2 capital. The Firm did not repurchase shares of its common stock during the first six months.
DividendsIn the second quarter of 2002, JPMorgan Chase declared a quarterly cash dividend on its common stock of $0.34 per share payable July 31, 2002 to stockholders of record at the close of business July 5, 2002. 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 since the merger of The Chase Manhattan Corporation and J.P. Morgan & Co. Incorporated. 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.
The following table shows JPMorgan Chase’s capital generation and use during the periods indicated.
Economic risk capital: JPMorgan Chase assesses capital adequacy by measuring risk utilizing internal risk assessment methodologies. The Firm quantifies credit, market and operating risk for each business and, for JPMP, private equity risk, and assigns capital to each business accordingly. These methodologies are discussed in the risk management sections of the 2001 Annual Report on pages 45-62. The following table presents the assessment at June 30, 2002 of capital adequacy for each risk factor as estimated by the Firm’s economic capital allocation model. Credit risk capital increased since June 30, 2001 due to higher retail credit exposure (principally as a result of the acquisition of the Providian portfolio) and higher capital factors on, and downward migration of, the commercial loan portfolio. The increase in market risk capital is due largely to an increase in stress loss exposure in several trading businesses, primarily Credit & Rate Markets and Institutional Equities. Private equity capital declined over the period due to the lower carrying value of the portfolio. Internal capital allocations may change from time to time to reflect refinements of economic capital methodologies.
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LiquidityDuring the first six months of 2002, JPMorgan Chase issued approximately $9.6 billion of long-term debt and $1 billion of trust preferred capital securities. During the same period, $7.7 billion of long-term debt matured or was redeemed, and $550 million of preferred stock of subsidiary was redeemed.
JPMorgan Chase has access to diverse global funding sources. The Firm uses asset securitization programs as alternative funding sources, to provide liquidity and for asset/liability management purposes. During the second quarter of 2002, the Firm securitized approximately $2.2 billion of residential mortgage loans, $4.4 billion of credit card loans, $1.4 billion of automobile loans and $1.3 billion of commercial loans, resulting in pre-tax gains on securitizations of $47 million, $18 million, $0.4 million and $10 million, respectively. For a further discussion on loan securitizations, see Note 8 on page 12.
Derivatives are used in liquidity risk management to swap fixed-rate debt to floating-rate obligations and to swap floating-rate debt to fixed-rate obligations to achieve the Firm’s desired interest rate risk profile. The Firm also enters into derivatives contracts to hedge the cash flow risk associated with the variability in interest rates that arises from other floating-rate financial instruments and forecasted transactions such as the rollover of short-term assets and liabilities.
Credit ratingsThe cost and availability of unsecured financing are influenced by credit ratings. A reduction in these ratings could increase funding costs and limit market access. See Note 1 and page 40 of this Form 10-Q for further information about the implications of a ratings downgrade for the Firm.
JPMorgan Chase’s parent holding company credit ratings as of August 9, 2002 were as follows:
The ratings of the senior obligations of JPMorgan Chase Bank are generally one notch higher than the parent holding company. As of August 9, 2002, the ratings outlook for the parent holding company by Standard & Poor’s, Moody’s and Fitch were negative.
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DividendsJPMorgan Chase’s bank subsidiaries, without the approval of their relevant banking regulators, could pay dividends to their respective bank holding companies in amounts up to the limitations imposed upon such banks by regulatory restrictions. These dividend limitations, in the aggregate, totaled approximately $3.2 billion at June 30, 2002.
In July 2002, the FASB released an exposure draft on Consolidation of Certain Special-Purpose Entities, an interpretation of ARB No. 51. The proposed interpretation provides guidance for determining when an entity is not an SPE, and would therefore not be subject to this proposed interpretation. The proposed interpretation also introduces a new framework to identify when a controlling financial interest has been established by means other than voting interests and requires consolidation of an SPE by an enterprise that holds such a controlling financial interest (the primary beneficiary). The proposed interpretation is not intended to require consolidation if the SPE effectively disperses the risks and benefits among the various parties involved. The Firm is currently reviewing the exposure draft, and its impact is yet to be determined.
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J.P. MORGAN CHASE & CO.FINANCIAL HIGHLIGHTS(in millions, except per share data and ratios)
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J.P. MORGAN CHASE & CO.CONSOLIDATED AVERAGE BALANCE SHEET, INTEREST AND RATES(Taxable-Equivalent Interest and Rates; in millions, except rates)
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51
J.P. MORGAN CHASE & CO.QUARTERLY CONSOLIDATED STATEMENT OF INCOME(in millions, except per share data)
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J.P. MORGAN CHASE & CO.QUARTERLY CONSOLIDATED BALANCE SHEET(in millions)
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J.P. MORGAN CHASE & CO.QUARTERLY RETAIL & MIDDLE MARKET FINANCIAL SERVICESBUSINESS-RELATED METRICS
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GLOSSARY OF TERMS
Chase USA: Chase Manhattan Bank USA, National Association.
FASB: Financial Accounting Standards Board.
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.
Net Yield on Interest-Earning Assets: The average rate for interest-earning assets less the average rate paid for all sources of funds.
Operating Basis or Operating Earnings: Reported results excluding the impact of merger and restructuring costs, special items, credit card securitizations and the amortization of goodwill.
Overhead Ratio: Operating expense (excluding merger and restructuring costs and special items) as a percentage of the operating revenues.
SFAS: Statement of Financial Accounting Standards.
SFAS 5: “Accounting for Contingencies.”
SFAS 107: “Disclosures about Fair Value of Financial Instruments.”
SFAS 133: “Accounting for Derivative Instruments and Hedging Activities.”
SFAS 142: “Goodwill and Other Intangible Assets.”
Shareholder Value Added (“SVA”): Represents operating earnings minus preferred dividends and an explicit charge for capital.
Special Items: The first six months of 2002 included $484 million (pre-tax) in merger and restructuring expenses. The first six months of 2001 included $806 million (pre-tax) in merger and restructuring expenses and the cumulative effect of a transition adjustment of $(25) million (after-tax) related to the adoption of SFAS 133.
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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This Form 10-Q contains statements that are forward-looking within the meaning of the Private Securities Litigation Reform Act of 1995. Such statements are based upon the current beliefs and expectations of JPMorgan Chase’s management and are subject to significant risks and uncertainties. Actual results may differ from those set forth in the forward-looking statements. These uncertainties include: the risk of adverse movements or volatility in the debt and equity securities markets or in interest or foreign exchange rates or indices; the risk of adverse impacts from an economic downturn; the risk of a downturn in domestic or foreign securities and trading conditions or markets; the risks involved in deal completion including an adverse development affecting a customer or the inability by a customer to receive a regulatory approval; the risks associated with increased competition; the risks associated with unfavorable political and diplomatic developments; the risks associated with adverse changes in domestic or foreign governmental or regulatory policies, including adverse interpretations of regulatory guidelines; the risk that material litigation or investigations will be determined adversely to the Firm; the risk that a downgrade in the Firm’s credit ratings will adversely affect the Firm’s businesses or investor sentiment; the risk that management's assumptions and estimates used in applying the Firm’s critical accounting policies prove unreliable, inaccurate, or not predictive of actual results; the risk that the Firm’s business continuity plans or data security systems prove not to be sufficiently adequate; the risk that external vendors are unable to fulfill their contractual obligations to the Firm; the risk that the merger integration will not be successful or that the revenue synergies and cost savings anticipated from the merger may not be fully realized or may take longer to realize than expected; the risk that the integration process may result in the disruption of ongoing business or in the loss of key employees or may adversely affect relationships with employees, clients or suppliers; the risk that the credit, market, liquidity, private equity, and operational risks associated with the various businesses of JPMorgan Chase are not successfully managed; or other factors affecting operational plans. Additional factors that could cause JPMorgan Chase’s results to differ materially from those described in the forward-looking statements can be found in the Quarterly Report on Form 10-Q for the quarter ended March 31, 2002 and in the 2001 Annual Report on Form 10-K of J.P. Morgan Chase & Co., each filed with the Securities and Exchange Commission and available at the Securities and Exchange Commission’s internet site (http://www.sec.gov).
Any forward-looking statements made by or on behalf of the Firm in this Form 10-Q speak only as of the date of this Form 10-Q. 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.
Item 3 Quantitative and Qualitative Disclosures about Market Risk
For a discussion of the quantitative and qualitative disclosures about market risk, see the market risk management section of the MD&A on pages 44-45 of this Form 10-Q.
Part II – OTHER INFORMATION
Item 1 Legal Proceedings
Enron litigation. JPMorgan Chase is involved in a number of lawsuits and investigations arising out of its banking relationships with Enron Corp. and its subsidiaries (“Enron”). The Firm, for and on behalf of Mahonia Limited and Mahonia Natural Gas Limited (collectively, “Plaintiffs”) initiated a lawsuit in New York in December 2001 against eleven insurance companies. That suit, which is currently pending in the United States District Court for the Southern District of New York, seeks payment of $965 million under Enron-related surety bonds issued by these companies. The Firm also commenced a lawsuit in London against Westdeutsche Landesbank Girozentrale seeking to compel payment of $165 million under an Enron-related letter of credit issued by the bank. 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.
On June 28, 2002, Plaintiffs amended the complaint to include fraud and breach of contract claims arising out of the defendants’ issuance of the surety bonds. The breach of contract claim asserts the insurance company defendants have failed to make payment in breach of their obligations under the surety bonds, each of which states that the obligations of each surety are absolute and unconditional, irrespective of the value, validity or enforceability of the obligations of the Principal which, in this case, is Enron. JPMorgan Chase asserts an independent claim against the
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Part IIItem 1 (continued)
insurance company defendants for fraud based on their failure to disclose certain facts known to the defendants at the time they issued the surety bonds, which facts the defendants knew JPMorgan Chase did not know, and which they knew, if disclosed, would have caused JPMorgan Chase to refuse to accept the surety bonds as security for transactions with Enron. JPMorgan Chase has alleged in its amended complaint that these fraud claims arise from a scheme by the defendant insurance companies to generate premium revenue by inducing JPMorgan Chase to accept the surety bonds issued by the defendants in the place of letters of credit. The defendant insurance companies have moved to dismiss JPMorgan Chase’s fraud claims. JPMorgan Chase’s opposition to that motion to dismiss is due on August 12, 2002, and oral argument on that motion has been scheduled for August 27, 2002.
Each of the defendant insurance companies has also asserted affirmative defenses, as well as counterclaims, for misrepresentation and fraud, among other things, claiming that Plaintiffs misrepresented the nature of the underlying forward sale contracts for the delivery/supply of natural gas or crude oil. The defendant insurance companies contend that JPMorgan Chase, Mahonia and Enron misrepresented, concealed and/or withheld material facts, which would have revealed to the defendant insurance companies that the forward sale contracts were actually “disguised” loans without any real delivery obligations. Based on those defenses, among others, the defendant insurance companies seek to avoid liability under the surety bonds. Plaintiffs believe defendants’ affirmative defenses and counterclaims lack merit as a matter of fact and law.
Actions have also been initiated by other parties against JPMorgan Chase and its directors and certain of its officers involving Enron. These lawsuits include a series of purported class actions brought on behalf of shareholders of Enron, captioned Newby v. Enron Corp., and a series of purported class actions brought on behalf of Enron employees who participated in various employee stock ownership plans, captioned Tittle v. Enron Corp., both of which are pending in Houston. The consolidated complaint filed inNewby names as defendants, among others, JPMorgan Chase, several other investment banking firms, two law firms, Enron’s former accountants and affiliated entities and individuals and other individual defendants, including present and former officers and directors of Enron and purports to allege claims against JPMorgan Chase and the other defendants under federal and state securities laws. The Tittle complaint names as defendants, among others, JPMorgan Chase, several other investment banking firms, a law firm, Enron’s former accountants and affiliated entities and individuals and other individual defendants, including present and former officers and directors of Enron and purports to allege claims against JPMorgan Chase and certain other defendants under the Racketeer Influenced and Corrupt Organizations Act (“RICO”) and state common law. On May 8, 2002, JPMorgan Chase filed motions to dismiss the Newby and Tittle actions, on the grounds that the allegations in the consolidated complaints in each action against JPMorgan Chase, even if assumed to be true (which allegations JPMorgan Chase vigorously denies) fail to state a cause of action. In moving to dismiss theNewby action, JPMorgan Chase argued, among other things, that the allegations against it stated, at most, a theory of aiding and abetting liability that has been rejected by the United States Supreme Court in Central Bank of Denver v. First Interstate Bank of Denver. Central Bank and subsequent cases applying it hold that aiding and abetting another’s alleged fraud is not actionable under the federal securities laws. In seeking dismissal of the Newby action, JPMorgan Chase also argued that plaintiffs had otherwise failed to state a claim against JPMorgan Chase under federal or state securities laws because the consolidated complaint failed to allege any intentionally false misrepresentation or omission on the part of JPMorgan Chase. In moving to dismiss theTittle action, JPMorgan Chase argued, among other things, that the RICO statute on which plaintiffs purported to base their claims was expressly amended to prohibit plaintiffs from bringing claims under RICO alleging fraud in the purchase or sale of securities. JPMorgan Chase’s brief in support of its motion to dismiss further argued that the consolidated complaint in Tittle, otherwise failed to state a claim against JPMorgan Chase under RICO or state common law because, among other things, plaintiffs failed to allege any intentionally false misrepresentation or omission on the part of JPMorgan Chase. JPMorgan Chase’s motions to dismiss in Newby and Tittle have been fully briefed and are currently pending determination by the court.
Additional actions against JPMorgan Chase or its affiliates relating to Enron that have been filed as of August 1, 2002 include (i) purported class action lawsuits by JPMorgan Chase stockholders alleging that JPMorgan Chase 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; (ii) purported shareholder derivative actions alleging breaches of fiduciary duties and alleged failures to exercise due care and diligence by the Firm’s directors and named officers in the management of JPMorgan Chase; (iii) a lawsuit filed by the Retirement Systems of Alabama alleging claims under the Alabama Securities Act and common law claims of fraud and unjust enrichment; (iv) a lawsuit filed by Unicredito Italiano (“Unicredito”) and its affiliate, Bank Pekao SA (“Bank Pekao”), alleging various common law claims relating to two credit agreements and a letter of credit and reimbursement agreement among Enron and a group of banks, including The Chase Manhattan Bank (predecessor to JPMorgan Chase Bank), Unicredito and Bank Pekao; (v) a lawsuit filed in Texas state court by eight insurance companies and related entities asserting claims under Texas statutory and common law arising from alleged purchases of Enron securities; (vi) a lawsuit originally filed in Texas State Court, and now removed to federal District Court, by the Brazos Electric Power Cooperative
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asserting various state common law and statutory claims arising out of The Chase Manhattan Bank, N.A.’s alleged 1994 involvement in a Construction Term and Loan Agreement related to the construction and operation of a power plant in Johnson County, Texas; and (vii) a purported class action lawsuit by current and former shareholders of Enron Capital Trust I (“Capital Trust”) alleging that JPMorgan Chase and another investment banking firm participated in a scheme to defraud shareholders of the Capital Trust by, among other actions, misleading the Capital Trust shareholders as to the financial condition of Enron. JPMorgan Chase believes that each of the lawsuits filed against the Firm, its affiliates, its directors and the named officers is without merit, and the Firm intends to defend each of these actions vigorously.
In addition, a number of federal, state and local regulatory and law enforcement authorities and Congressional committees have initiated investigations of Enron and of certain of the Firm’s financial transactions with Enron. In that regard, the Firm has delivered, or is currently in the process of delivering, voluntarily and pursuant to subpoena, information to the House Energy and Commerce Committee, the Senate Government Affairs Committee, the Senate Permanent Subcommittee on Investigations, U.S. Representative Henry Waxman, the Securities and Exchange Commission, the Federal Reserve Bank of New York, the New York State Banking Department, the New York County District Attorney’s Office and the U.S. Department of Justice. The Firm intends to continue to cooperate with these authorities and with such other agencies and authorities as may request information from JPMorgan Chase.
Worldcom litigation. JPMSI and JPMorgan Chase have been named as defendants in nine actions that were filed in either United States District Courts or state courts in six states beginning in July 2002 arising out of alleged accounting irregularities in the books and records of WorldCom Inc. Plaintiffs in these actions are institutional investors, including state pension funds, who purchased debt securities issued by WorldCom pursuant to public offerings in May 2000 and May 2001. JPMSI acted as an underwriter of both of those offerings. In addition to JPMSI and JPMorgan Chase, the defendants in various of the actions include other underwriters, certain executives of WorldCom and WorldCom’s auditors. In the actions, plaintiffs allege that defendants either knew or were reckless or negligent in not knowing that the securities were sold to plaintiffs on the basis of misrepresentations and omissions of material facts concerning the financial condition of WorldCom. The complaints against JPMorgan Chase and JPMSI assert claims under federal and states securities laws, ERISA, other state statutes and under common law theories of fraud and negligent misrepresentation.
Commercial Financial Services litigation. 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 or New York 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.
IPO Allocation litigation. Beginning in May 2001, JPMorgan Chase and certain of its securities subsidiaries have been named, along with numerous other firms in the securities industry, as defendants in a large number of putative class action lawsuits filed in the United States District Court for the Southern District of New York. These suits purport to challenge alleged improprieties in the allocation of stock in various public offerings, including some offerings for which a JPMorgan Chase entity served as an underwriter. The suits allege violations of securities and antitrust laws arising from alleged material misstatements and omissions in registration statements and prospectuses for the initial public offerings and with respect to aftermarket transactions in the offered securities. The securities claims allege, among other things, misrepresentations concerning commissions paid to JPMorgan Chase and aftermarket transactions by customers who received allocations of shares in the respective initial public offerings. The antitrust claims allege an illegal conspiracy to require customers, in exchange for initial public offering allocations, to pay undisclosed and excessive commissions and to make aftermarket purchases of the initial public offering securities at a price higher than the offering price, as a precondition to receiving allocation. JPMorgan Chase also has received various subpoenas and informal requests from governmental and other agencies seeking information relating to initial public offering allocation practices. Recently, JPMSI was advised by the staff of the National Association of
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Securities Dealers (“NASD”) that it was considering recommending that disciplinary action be brought concerning activities of one of JPMSI’s predecessor entities (Hambrecht & Quist Group). JPMSI has submitted to the NASD staff a letter outlining the basis for JPMSI’s position that no such action is warranted.
Research Analysts’ Conflicts. In connection with its review of the independence of research analysts, the New York State Attorney General’s Office, the Texas State Securities Board, the Securities and Exchange Commission, the National Association of Securities Dealers and the New York Stock Exchange have issued subpoenas and other information requests to several financial services firms, including the Firm. The Firm is cooperating with this investigation.
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. Other claims, investigations or proceedings may be brought in the future. Some of the legal actions, proceedings or investigations in which the Firm is involved assert claims for amounts that could be material to the financial condition of the Firm and could result in adverse judgments, penalties or fines. In view of the inherent difficulty of predicting the outcome of legal matters, particularly in cases where the claimants seek very large or indeterminate damages, JPMorgan Chase cannot state with confidence what the eventual outcome of its pending matters will be, or predict with confidence what the eventual loss or range of losses related to such pending matters will be. JPMorgan Chase believes, based on its current knowledge and after consultation with counsel, that the outcome of the pending matters should 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, among other things, on the level of JPMorgan Chase’s income for such period.
Item 2 Sales of Unregistered Common Stock
During the second quarter of 2002, 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; these shares were issued to retired directors who had deferred receipt of such common stock pursuant to the Deferred Compensation Plan for Non-Employee Directors, as follows: April 1, 2002 – 516 shares.
Item 4 Submission of Matters to a Vote of Security Holders
The following is a summary of matters submitted to vote at the Annual Meeting of Stockholders of JPMorgan Chase. The Annual Meeting of Stockholders was held on May 21, 2002. A total of 1,646,270,691 shares, or 82.7% of the 1,989,679,679 shares entitled to vote at the Annual Meeting, were represented at the meeting.
The following thirteen (13) directors were elected to hold office until the 2003 Annual Meeting or until their successors are elected and have qualified.
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Part IIItem 4 (continued)
A proposal to ratify PricewaterhouseCoopers LLP as independent accountants was approved by 96.01% of the votes cast. The proposal received a “for” vote of 1,567,975,898 and an “against” vote of 65,147,215. The number of votes abstaining was 13,039,414. There were 108,164 broker non-votes.
A proposal by Evelyn Y. Davis requiring that management disclose in future proxy statements the names and titles of certain executive officers receiving annual compensation in excess of $250,000 was rejected by 92.17% of the votes cast. The vote “for” was 104,176,310 and the vote “against” was 1,226,498,393. The number of votes abstaining was 22,934,072 and there were 292,661,916 broker non-votes.
A proposal by Bartlett Naylor requesting that the Board of Directors adopt a policy requiring the Governance Committee to nominate two candidates for each directorship to be filled upon voting at the annual meetings was rejected by 94.99% of the votes cast. The vote “for” was 66,529,708 and the vote “against” was 1,261,476,978. The number of votes abstaining was 25,616,225 and there were 292,647,780 broker non-votes.
Item 6 Exhibits and Reports on Form 8-K
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SIGNATURE
Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
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INDEX TO EXHIBITS
SEQUENTIALLY NUMBERED
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