JPMorgan Chase - 10-Q quarterly report FY

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Large accelerated filer x   Accelerated filer o   Non-accelerated filer o

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JPMorgan Chase & Co. (the “Firm”), a financial holding company incorporated under Delaware law in 1968, is a leading global financial services firm and one of the largest banking institutions in the United States of America (“U.S.”), with $1.5 trillion in assets, $119.2 billion in stockholders’ equity and operations worldwide. The Firm is a leader in investment banking, financial services for consumers and businesses, financial transaction processing, asset management and private equity. Under the JPMorgan and Chase brands, the Firm serves millions of customers in the U.S. and many of the world’s most prominent corporate, institutional and government clients.

JPMorgan Chase’s principal bank subsidiaries are JPMorgan Chase Bank, National Association (“JPMorgan Chase Bank, N.A.”), a national banking association with branches in 17 states; and Chase Bank USA, National Association (“Chase Bank USA, N.A.”), a national bank that is the Firm’s credit card issuing bank. JPMorgan Chase’s principal nonbank subsidiary is J.P. Morgan Securities Inc., the Firm’s U.S. investment banking firm.

JPMorgan Chase’s activities are organized, for management reporting purposes, into six business segments, as well as Corporate. The Firm’s wholesale businesses comprise the Investment Bank, Commercial Banking, Treasury & Securities Services and Asset Management segments. The Firm’s consumer businesses comprise the Retail Financial Services and Card Services segments. A description of the Firm’s business segments, and the products and services they provide to their respective client bases, follows.

JPMorgan is one of the world’s leading investment banks, with deep client relationships and broad product capabilities. The Investment Bank’s clients are corporations, financial institutions, governments and institutional investors. The Firm offers a full range of investment banking products and services in all major capital markets, including advising on corporate strategy and structure, capital raising in equity and debt markets, sophisticated risk management, market-making in cash securities and derivative instruments, and research. The Investment Bank (“IB”) also commits the Firm’s own capital to proprietary investing and trading activities.

Retail Financial Services (“RFS”), which includes the Regional Banking, Mortgage Banking and Auto Finance reporting segments, helps meet the financial needs of consumers and businesses. RFS provides convenient consumer banking through the nation’s fourth-largest branch network and third-largest ATM network. RFS is a top-five mortgage originator and servicer, the second-largest home equity originator, the largest noncaptive originator of automobile loans and one of the largest student loan originators.

RFS serves customers through more than 3,000 bank branches, 8,600 ATMs and 270 mortgage offices, and through relationships with more than 15,000 auto dealerships and 4,300 schools and universities. Nearly 13,000 branch salespeople assist customers, across a 17-state footprint from New York to Arizona, with checking and savings accounts, mortgage, home equity and business loans, investments and insurance. More than 1,200 additional mortgage officers provide home loans throughout the country.

With more than 150 million cards in circulation and $148.0 billion in managed loans, Chase Card Services (“CS”) is one of the nation’s largest credit card issuers. Customers used Chase cards for more than $169.3 billion worth of transactions in the six months ended June 30, 2007.

Chase offers a wide variety of general-purpose cards to satisfy the needs of individual consumers, small businesses and partner organizations, including cards issued with AARP, Amazon, Continental Airlines, Marriott, Southwest Airlines, Sony, United Airlines, Walt Disney Company and many other well-known brands and organizations. Chase also issues private-label cards with Circuit City, Kohl’s, Sears Canada and BP.

Chase Paymentech Solutions, LLC, a joint venture with JPMorgan Chase and First Data Corporation, is the largest processor of MasterCard and Visa payments in the world, having handled 9.3 billion transactions in the six months ended June 30, 2007.

Commercial Banking (“CB”) serves more than 30,000 clients, including corporations, municipalities, financial institutions and not-for-profit entities. These clients generally have annual revenues ranging from $10 million to $2 billion. Commercial bankers serve clients nationally throughout the RFS footprint and in offices located in other major markets.

Commercial Banking offers its clients industry knowledge, experience, a dedicated service model, comprehensive solutions and local expertise. The Firm’s broad platform positions CB to deliver extensive product capabilities – including lending, treasury services, investment banking and asset management – to meet its clients’ U.S. and international financial needs.

Treasury & Securities Services (“TSS”) is a global leader in providing transaction, investment and information services to support the needs of institutional clients worldwide. TSS is one of the largest cash management providers in the world and a leading global custodian. Treasury Services (“TS”) provides a variety of cash management products, trade finance and logistics solutions, wholesale card products, and liquidity management capabilities to small and midsized companies, multinational corporations, financial institutions and government entities. TS partners with the Commercial Banking, Retail Financial Services and Asset Management business segments to serve clients firmwide. As a result, certain TS revenues are included in other segments’ results. Worldwide Securities Services (“WSS”) stores, values, clears and services securities and alternative investments for investors and broker-dealers; and manages Depositary Receipt programs globally.

With assets under supervision of $1.5 trillion, Asset Management (“AM”) is a global leader in investment and wealth management. AM clients include institutions, retail investors and high-net-worth individuals in every major market throughout the world. AM offers global investment management in equities, fixed income, real estate, hedge funds, private equity and liquidity, including both money market instruments and bank deposits. AM also provides trust and estate and banking services to high-net-worth clients, and retirement services for corporations and individuals. The majority of AM’s client assets are in actively managed portfolios.

On April 16, 2007, an investor group, which comprised of JPMorgan Chase and three other firms, announced it had signed a definitive agreement to purchase SLM Corporation (“Sallie Mae”) for approximately $25 billion. JPMorgan Chase will invest $2.2 billion and will own 24.9% of the company. The transaction requires the approval of Sallie Mae’s stockholders and is subject to regulatory approvals and other closing conditions. If all such approvals are obtained and closing conditions are met, the transaction is expected to close in late 2007.

On May 3, 2007, JPMorgan Chase announced plans to build a new investment banking headquarters in London. The building will have more than one million square feet, with up to five trading floors comprising 72,800 square feet each. The Firm expects the building to open by late 2012. On June 14, 2007, JPMorgan Chase announced it will build a new 1.3 million square-foot global investment banking headquarters in the World Trade Center complex in New York City. The Firm expects the building to open by early 2012.

The Firm reported 2007 second-quarter Net income of $4.2 billion, or $1.20 per share, compared with Net income of $3.5 billion, or $0.99 per share, for the second quarter of 2006. Return on common equity for the quarter was 14% compared with 13% in the prior year.

Net income for the first six months of 2007 was $9.0 billion, or $2.55 per share, compared with $6.6 billion, or $1.85 per share, in the comparable period last year. Return on common equity was 16% for the first six months of 2007 compared with 12% for the prior-year period.

In the first quarter of 2007 the Firm adopted SFAS 157 (“Fair Value Measurements”) and SFAS 159 (“Fair Value Option”). For a discussion of SFAS 157 and SFAS 159, see Note 3 on pages 73-80 and Note 4 on pages 80-83 of this Form 10-Q.

In the second quarter of 2007, the global economy continued to grow, as solid growth in the industrial economies supported continued progress in the emerging markets economies. Global capital markets activity was strong during the second quarter of 2007, with debt and equity underwriting and merger and acquisition activity surpassing levels from the second quarter of 2006. Both domestic and international equity markets rose, benefiting from favorable economic trends and benign inflation, with the S&P 500 and international indices increasing approximately 5.00% on average during the second quarter of 2007. The Federal Reserve Board held the federal funds rate steady at 5.25%. While long-term interest rates rose in response to indications of improving economic activity, the Treasury yield curve remained moderately inverted. During the second quarter, the U.S. economy rebounded to an approximate 3.40% annualized growth rate, even though high energy prices dampened consumer spending and the ongoing housing contraction continued to weigh on the overall economy. While demand for wholesale loans in the U.S. continued to grow in the second quarter at close to a double-digit pace, U.S. consumer loan growth slowed, and mortgage lending contracted.

The second quarter of 2007 economic environment was a contributing factor to the performance of the Firm and each of its businesses. The overall economic expansion, strong level of capital markets activity and positive performance in equity markets helped to drive new business volume and organic growth within each of the Firm’s wholesale businesses. Weakness in the housing markets, however, led to increased losses in Retail Financial Services resulting in an increase in provision related to the home equity portfolio.

Investment Bank net income increased from the prior year driven by strong Total net revenue growth, primarily offset by an increase in Total noninterest expense, as well as an increase in the Provision for credit losses. Investment banking fees were at a record level, driven by record advisory fees, strong debt underwriting fees and record equity underwriting fees. Fixed Income Markets revenue benefited from strong results across most products, partially offset by weaker commodities performance versus a strong prior-year quarter. Equity Markets revenue more than doubled from the prior year, benefiting from strong global derivatives and cash equities trading performance. The increase in the Provision for credit losses was largely related to lending-related commitments, reflecting portfolio activity. The increase in Total noninterest expense was due primarily to higher performance-based compensation expense.

Retail Financial Services net income decreased as declines in Regional Banking and Auto Finance were offset partially by improved results in Mortgage Banking. Total net revenue increased from the prior year due to The Bank of New York transaction, higher mortgage loan originations and increased deposit-related fees. Total net revenue also benefited from the classification of certain mortgage loan origination costs as expense due to the adoption of SFAS 159. These benefits were offset partially by the sale of the insurance business in 2006. The Provision for credit losses increased reflecting weak housing prices in select geographic areas and the resulting increase in estimated losses for high loan-to-value home equity loans, especially those originated through the wholesale channel. Total noninterest expense was up from the prior year due to The Bank of New York transaction, the classification of certain loan origination costs as expense due to the adoption of SFAS 159, an increase in loan originations in Mortgage Banking, and investments in retail distribution. These increases were offset partially by the sale of the insurance business.

Card Services net income decreased when compared with the prior year, primarily due to prior-year results benefiting from significantly lower net charge-offs following the change in bankruptcy legislation in the fourth quarter of 2005. Total net revenue was up compared with the prior year. The increase was driven by increased average loans, higher fees and increased interchange income from higher charge volume. These benefits were largely offset by higher volume-driven payments to partners and increased rewards expense; increased cost of funds on higher introductory, transactor and promotional balances; higher charge-offs, which resulted in increased revenue reversals; and the discontinuation of certain billing practices in the quarter (including the elimination of certain over-limit fees and the two-cycle billing method for calculating finance charges). The managed provision for credit losses increased, primarily due to the prior year benefiting from a lower level of net charge-offs, following the change in bankruptcy legislation in the fourth quarter of 2005. Total noninterest expense was down due mainly to lower Marketing expense and lower fraud-related expense, partially offset by higher volume-related expense.

Commercial Banking net income was flat compared with the prior year, as an increase in Total net revenue was offset by a higher Provision for credit losses. Total net revenue increased due to double-digit growth in liability balances and loans, which reflected organic growth and The Bank of New York transaction. In addition, Total net revenue benefited from higher investment banking revenue and deposit-related fees. These increases in Total net revenue were largely offset by the continued shift to narrower-spread liability products and spread compression in the liability and loan portfolios. The Provision for credit losses increased reflecting portfolio activity. Total noninterest expense was flat to the prior year.

Treasury & Securities Services achieved record net income driven by record Total net revenue partially offset by higher Compensation expense. Total net revenue growth was driven by increased product usage by new and existing clients, market appreciation, and seasonally strong activity in securities lending and depositary receipts. These benefits were offset partially by lower foreign exchange revenue, as a result of narrower-market spreads, and by a continued shift to narrower-spread liability products. Total noninterest expense increased due largely to higher Compensation expense related to business and volume growth, as well as investment in new product platforms.

Asset Management net income was a record benefiting from increased Total net revenue, partially offset by higher Compensation expense. Record Total net revenue, principally fees and commissions, benefited largely from increased assets under management and higher performance and placement fees. The Provision for credit losses was a slight benefit in both time periods. Total noninterest expense increased due largely to higher compensation, primarily performance-based, and investments in all business segments.

Corporate segment net income increased primarily from higher private equity gains, lower securities losses and improved Net interest income, partially offset by higher Total noninterest expense. Prior-year results also included Income from discontinued operations. Total net revenue benefited from a higher level of private equity gains, the classification of certain private equity carried interest as Compensation expense, a lower amount of securities losses and improved net interest spread. Total noninterest expense increased due to higher net legal costs, reflecting a lower level of recoveries and higher expense, including settlement costs relating to certain copper antitrust litigation. In addition, Total noninterest expense increased due to the classification of certain private equity carried interest as Compensation expense. These increases were offset partially by lower Compensation expense and business efficiencies.

Income from discontinued operations was $56 million in the prior year. Discontinued operations (included in the Corporate segment results) includes the income statement activity of selected corporate trust businesses that were sold to The Bank of New York.

During the quarter ended June 30, 2007, approximately $730 million (pretax) of merger savings were realized, which is an annualized rate of approximately $2.9 billion. Merger costs of $64 million were expensed during the second quarter of 2007, bringing the total amount expensed since the merger announcement to $3.6 billion (including capitalized costs).

The managed provision for credit losses was $2.1 billion, up by $1.1 billion, or 101%, from the prior year. The wholesale provision for credit losses was $198 million for the quarter compared with a benefit of $77 million in the prior year. The change was largely related to lending-related commitments, reflecting portfolio activity. Wholesale net recoveries were $29 million in the current quarter, compared with net recoveries of $19 million in the prior year, resulting in net recovery rates of 0.07% and 0.05%, respectively. The total consumer managed provision for credit losses was $1.9 billion, compared with $1.1 billion in the prior year. The prior year benefited from significantly lower credit card net charge-offs, following the change in bankruptcy legislation in the fourth quarter of 2005. The increase from the prior year also reflected additions to the allowance for credit losses and higher charge-offs related to the home equity loan portfolio. The Firm had total nonperforming assets of $2.6 billion at June 30, 2007, up by $202 million, or 8%, from the prior-year level of $2.4 billion.

The Firm had, at June 30, 2007, Total stockholders’ equity of $119.2 billion and a Tier 1 capital ratio of 8.4%. The Firm purchased $1.9 billion, or 36.7 million shares, of common stock during the quarter.

JPMorgan Chase’s outlook for the third quarter of 2007 should be viewed against the backdrop of the global economy, financial markets activity and the geopolitical environment, all of which are integrally linked.

The Investment Bank entered the third quarter with a strong Investment banking fee pipeline. However, recent market conditions include problems in the mortgage markets, the inability to successfully complete the syndication of certain leverage buyout financings, general widening of credit spreads, reduced liquidity and increased volatility across all markets. The effect of these market conditions has led and could continue to lead to lower trading revenues, reduced levels of client activity, lower realization of the Investment banking fee pipeline and an increase in retained loans resulting from leveraged finance activities. The increase in retained loans is likely to result in an increase in the allowance for loan losses and/or markdowns of loans related to leveraged buyout financing activities. Management continues to believe that the net loss in Treasury and Other Corporate on a combined basis will be approximately $50 million to $100 million per quarter; and that private equity results, which are dependent upon the capital markets, could continue to be volatile over time. The performance of each of the Firm’s lines of business will be affected by overall global economic growth, financial market movements (including interest rate movements), the competitive environment and client activity levels in any given time period.

Future economic conditions may also cause the provision for credit losses to increase over time. The wholesale provision for credit losses may be increased over time as a result of portfolio activity and by a trend toward a more normal level of provisioning. The consumer provision for credit losses could be increased as a result of a higher level of net charge-offs in Card Services as losses return to a more normal level following the 2005 fourth quarter change in the bankruptcy law, and as a result of a higher level of losses in Retail Financial Services if housing prices continue to weaken. Given the continued downward pressure on housing prices and the elevated level of unsold houses nationally, management remains cautious with respect to the home equity portfolio. In addition, credit spread widening in the prime and subprime mortgage markets is causing downward valuation pressure on the mortgage loans in the Firm’s mortgage warehouse.

Firmwide, Total noninterest expense is anticipated to reflect investments in each business, recent acquisitions and divestitures, continued merger savings and other operating efficiencies. Management continues to believe that annual merger savings will reach approximately $3.0 billion by the end of 2007 following completion of the last significant conversion activity, which is the wholesale deposit conversion scheduled for the 2007 third quarter. Merger costs of approximately $400 million are expected to be incurred during 2007 (including a modest amount related to The Bank of New York transaction). These additions are expected to bring total cumulative merger costs to $3.8 billion by the end of 2007.

The following section provides a comparative discussion of JPMorgan Chase’s consolidated results of operations on a reported basis. Factors that relate primarily to a single business segment are discussed in more detail within that business segment than they are in this consolidated section. Total net revenue, Noninterest expense and Income tax expense for prior periods have been revised to reflect the impact of discontinued operations. For a discussion of the Critical accounting estimates used by the Firm that affect the Consolidated results of operations, see page 66 of this Form 10-Q and pages 83-85 of the JPMorgan Chase 2006 Form 10-K.

The following table presents the components of Total net revenue.

Total net revenue for the second quarter of 2007 was $18.9 billion, up by $3.8 billion, or 25%, from the prior year. This increase was a result of higher Net interest income, very strong private equity gains, higher Asset management, administration and commissions revenue, record Investment banking fees, a lower level of securities losses, and higher Mortgage fees and related income. For the first six months of 2007, Total net revenue was $37.9 billion, up by $7.6 billion, or 25%, from the prior year. The increase was driven primarily by the aforementioned items including the impact of the adoption of SFAS 157 and 159, and was partially offset by lower Credit card income.

Investment banking fees of $1.9 billion in the second quarter and $3.6 billion for the first six months of 2007 were at record levels for the Firm. These results were driven by record advisory and equity underwriting fees as well as strong debt underwriting fees. For a further discussion of Investment banking fees, which are primarily recorded in the IB, see the IB segment results on pages 17-20 of this Form 10-Q.

Principal transactions revenue consists of trading revenue, which includes changes in fair value associated with financial instruments held by the IB for which the SFAS 159 fair value option was elected, and private equity gains. Trading revenue of $2.1 billion in the second quarter of 2007 was flat compared with the same period last year. In the first six months of 2007, trading revenue of $5.3 billion was higher than in the first six months of 2006, reflecting strong performance in most fixed income and equities products. Credit Portfolio increased in the first six months of 2007 compared with the first six months of 2006 as a result of an adjustment to the valuation of the Firm’s derivative liabilities measured at fair value to reflect the credit quality of the Firm, as a part of the adoption of SFAS 157. Private equity gains in the second quarter and first six months of 2007 benefited from a higher level of gains and the classification of certain private equity carried interest as Compensation expense. Also favorably affecting the first six months of 2007 was a fair value adjustment in the first quarter of 2007 on nonpublic investments resulting from the adoption of SFAS 157. For a further discussion of Principal transactions revenue, see the IB and Corporate segment results on pages 17-20 and 40-42, respectively, and Note 5 on pages 83-85 of this Form 10-Q.

Lending & deposit related fees rose from the second quarter and first six months of 2006 as a result of higher deposit-related fees and The Bank of New York transaction. For a further discussion of Lending & deposit related fees, which are partly recorded in RFS, see the RFS segment results on pages 21-28 of this Form 10-Q.

Asset management, administration and commissions revenue was higher in the second quarter and first six months of 2007 compared with the prior-year periods, primarily due to an increase in assets under management and higher performance and placement fees in AM. The growth in assets under management, which reached $1.1 trillion at the end of the second quarter of 2007, up 23% from the prior year, was the result of net asset inflows into the Institutional, Retail and Private Bank segments, and market appreciation. Also contributing to the increase was higher assets under custody in TSS, driven by market value appreciation and new business, as well as growth in other fees due to a combination of

increased product usage by existing clients and new business growth. In addition, commissions revenue increased due to higher brokerage transaction volume (primarily included within the Markets revenue of the IB), partly offset by the sale of the insurance business in the third quarter of 2006, and a charge in the first quarter of 2007 resulting from accelerated surrenders of customer annuities. For additional information on these fees and commissions, see the segment discussions for IB on pages 17-20, RFS on pages 21-28, TSS on pages 35-36, and AM on pages 37-39 of this Form 10-Q.

The favorable variances in Securities gains (losses) for the second quarter and first half of 2007, when compared with the second quarter and first half of 2006, were due primarily to a lower level of securities losses in Treasury’s portfolio repositioning results. For a further discussion of Securities gains (losses), which are mostly recorded in the Firm’s Treasury business, see the Corporate segment discussion on pages 40-42 of this Form 10-Q.

Mortgage fees and related income increased in the second quarter and first six months of 2007 compared with the prior-year periods. Growth in production revenue reflected higher gain on sale income primarily attributable to increased mortgage loan originations, and the classification of certain loan origination costs as expense (loan origination costs previously netted against revenue are currently recorded as expense) due to the adoption of SFAS 159. Net mortgage servicing revenue improved due to an increase in third-party loans serviced. Mortgage fees and related income exclude the impact of NII and AFS securities gains and losses related to mortgage activities. For a discussion of Mortgage fees and related income, which is recorded primarily in RFS’s Mortgage Banking business, see the Mortgage Banking discussion on pages 26-27 of this Form 10-Q.

Credit card income decreased from the second quarter and first six months of 2006, primarily due to lower servicing fees earned in connection with securitization activities, which were affected unfavorably by lower interest income earned and higher credit losses incurred. Also contributing to the decrease were increases in volume-driven payments to partners and expenses related to reward programs. These were offset partially by a higher level of fee-based revenue and increased customer charge volume that favorably impacted interchange income. For a further discussion of Credit card income, see CS’s segment results on pages 29-32 of this Form 10-Q.

The increases in Other income from the second quarter and first six months of 2006 reflected higher gains on the sale of loans and leveraged leases, partly as a result of a loss in the first quarter of 2006 related to auto loans transferred to held-for-sale, and increased income from automobile operating leases. These benefits were offset partially by the absence of a $103 million gain in the second quarter of 2006 related to the sale of MasterCard shares in its initial public offering and lower revenues from loan workouts.

Net interest income rose from the second quarter and first six months of 2006, primarily from the following: higher trading-related Net interest income due to a shift of Interest expense to Principal transactions revenue related to certain IB structured notes to which fair value accounting was elected in connection with the adoption of SFAS 159; an improvement in Treasury’s net interest spread; an increase in consumer loans; the impact of The Bank of New York transaction; and higher consumer deposits, wholesale liability balances, and loan fees. These increases were offset slightly by narrower spreads on consumer loans as well as deposits, which partly resulted from the continued shift to narrower-spread deposit products; the impact of higher credit card charge-offs which resulted in increased revenue reversals; and the sale of the insurance business. The Firm’s total average interest-earning assets for the second quarter of 2007 were $1.1 trillion, up 9% from the second quarter of 2006. The increase was primarily a result of higher Trading assets - - debt instruments, Loans, and Available-for-sale securities partially offset by a decline in Interests in purchased receivables as a result of the restructuring and deconsolidation during the second quarter of 2006 of certain multi-seller conduits that the Firm administered. The net interest yield on these assets, on a fully taxable equivalent basis, was 2.35%, an increase of 28 basis points from the prior year, partly reflecting the adoption of SFAS 159. The Firm’s total average interest earning assets for the first six months of 2007 were $1.1 trillion, up 10% from the first six months of 2006, and were also driven by the aforementioned items. The net interest yield on these assets, on a fully taxable-equivalent basis, was 2.37%, an increase of 24 basis points from the prior year.

The Provision for credit losses in the second quarter and first half of 2007 rose from the comparable prior-year periods. The increase in the consumer provision for credit losses in the second quarter of 2007 was due to a $329 million addition to the home equity allowance for loan losses driven by weak housing prices in select geographic areas and the resulting increase in estimated losses for high loan-to-value home equity loans, in particular those originated through the wholesale channel; the absence of prior-year benefits from significantly lower credit card net charge-offs following the change in bankruptcy legislation in the fourth quarter of 2005; and the release in the second quarter of 2006 of $90 million of provision related to Hurricane Katrina in CS. For the first half of 2007 the increase in the consumer Provision for credit losses also reflected higher losses in the subprime mortgage portfolio, partially offset by a reversal in the first quarter of 2007 of a portion of the reserves in RFS related to Hurricane Katrina. The increase in the wholesale provision for credit losses was due primarily to lending-related commitments, reflecting portfolio activity. For a more detailed discussion of the loan portfolio and the Allowance for loan losses, refer to Credit risk management on pages 51-62 of this Form 10-Q.

The following table presents the components of Noninterest expense.

Total noninterest expense for the second quarter of 2007 was $11.0 billion, up by $1.6 billion, or 18%, from the prior year. Expense increased due to higher Compensation expense, primarily incentive-based, and increased net legal costs reflecting a lower level of recoveries and higher expense. Expense growth also was driven by The Bank of New York transaction, acquisitions and investments in all of the businesses. The increase in expense was offset partially by business divestitures and expense efficiencies. For the first six months of 2007, Total noninterest expense was $21.7 billion, up by $2.5 billion, or 13%, from the prior year, driven primarily by the aforementioned items.

The increase in Compensation expense from the second quarter and first half of 2006 was primarily the result of higher performance-based incentives; additional headcount in connection with The Bank of New York transaction, acquisitions and investments in businesses; the classification of certain private equity carried interest from Principal transactions revenue, and the classification of certain loan origination costs (previously netted against revenue) due to the adoption of SFAS 159. These increases were offset partially by merger-related savings. Also affecting the six month variance is the absence of a prior-year expense of $459 million from the adoption of SFAS 123R. For a detailed discussion of the adoption of SFAS 123R see Note 9 on page 88 of this Form 10-Q.

The increases in Occupancy expense from the second quarter and first half of 2006 were driven by ongoing investments in the retail distribution network, which included incremental expense from The Bank of New York branches, partially offset by operating expense efficiencies.

The increases in Technology, communications and equipment expense when compared with the second quarter and first six months of 2006 were due primarily to higher depreciation expense on owned automobiles subject to operating leases and technology investments to support business growth. These increases were offset partially by operating expense efficiencies.

Professional & outside services rose from the second quarter and first six months of 2006 reflecting higher brokerage expense and credit card processing costs as a result of growth in transaction volume. Also contributing to the increases were acquisitions and investments in businesses.

Marketing expense was lower when compared with the second quarter and first half of 2006 due to a reduction in credit card marketing.

Other expense was higher from the second quarter and first six months of 2006 due to increased net legal costs reflecting a lower level of recoveries and higher expense. Also contributing to the increase were the growth in business volume, acquisitions and investments in businesses. These increases were offset partially by the sale of the insurance business in the third quarter of 2006 and lower credit card fraud-related losses.

For a discussion of Amortization of intangibles and Merger costs, refer to Note 17 and Note 10 on pages 100-102 and 89, respectively, of this Form 10-Q.

The Firm’s Income from continuing operations before income tax expense, Income tax expense and effective tax rate were as follows for each of the periods indicated.

The effective tax rate increased for the second quarter and first half of 2007 compared with the second quarter and first half of 2006 primarily due to higher reported pretax income, combined with changes in the proportion of income subject to federal, state and local taxes.

Income from discontinued operations was zero in all periods of 2007 compared with $56 million and $110 million in the second quarter and first six months of 2006, respectively. Discontinued operations (included in the Corporate segment results) includes the income statement activity of selected corporate trust businesses that were sold to the Bank of New York on October 1, 2006.

The Firm prepares its Consolidated financial statements using accounting principles generally accepted in the United States of America (“U.S. GAAP”); these financial statements appear on pages 68-71 of this Form 10-Q. That presentation, which is referred to as “reported basis,” provides the reader with an understanding of the Firm’s results that can be tracked consistently from year to year and enables a comparison of the Firm’s performance with other companies’ U.S. GAAP financial statements.

In addition to analyzing the Firm’s results on a reported basis, management reviews the Firm’s and the lines’ of business results on a “managed” basis, which is a non-GAAP financial measure. The Firm’s definition of managed basis starts with the reported U.S. GAAP results and includes certain reclassifications that assumes credit card loans securitized by CS remain on the balance sheet and presents revenue on a fully taxable-equivalent (“FTE”) basis. These adjustments do not have any impact on Net income as reported by the lines of business or by the Firm as a whole.

The presentation of CS results on a managed basis assumes that credit card loans that have been securitized and sold in accordance with SFAS 140 still remain on the balance sheet and that the earnings on the securitized loans are classified in the same manner as the earnings on retained loans recorded on the balance sheet. JPMorgan Chase uses the concept of managed basis to evaluate the credit performance and overall financial performance of the entire managed credit card portfolio. Operations are funded and decisions are made about allocating resources, such as employees and capital, based upon managed financial information. In addition, the same underwriting standards and ongoing risk monitoring are used for both loans on the balance sheet and securitized loans. Although securitizations result in the sale of credit card receivables to a trust, JPMorgan Chase retains the ongoing customer relationships, as the customers may continue to use their credit cards; accordingly, the customer’s credit performance will affect both the securitized loans and the loans retained on the balance sheet. JPMorgan Chase believes managed basis information is useful to investors, enabling them to understand both the credit risks associated with the loans reported on the balance sheet and the Firm’s retained interests in securitized loans. For a reconciliation of reported to managed basis of CS results, see Card Services segment results on pages 29-32 of this Form 10-Q. For information regarding the securitization process, and loans and residual interests sold and securitized, see Note 15 on pages 94-98 of this Form 10-Q.

Total net revenue for each of the business segments and the Firm is presented on an FTE basis. Accordingly, revenue from tax-exempt securities and investments that receive tax credits is presented in the managed results on a basis comparable to taxable securities and investments. This non-GAAP financial measure allows management to assess the comparability of revenues arising from both taxable and tax-exempt sources. The corresponding income tax impact related to these items is recorded within Income tax expense.

Management also uses certain non-GAAP financial measures at the segment level because it believes these non-GAAP financial measures provide information to investors about the underlying operational performance and trends of the particular business segment and therefore facilitate a comparison of the business segment with the performance of its competitors.

The following summary table provides reconciliation from the Firm’s reported U.S. GAAP results to managed basis.

The Firm is managed on a line-of-business basis. The business segment financial results presented reflect the current organization of JPMorgan Chase. There are six major reportable business segments: the Investment Bank, Retail Financial Services, Card Services, Commercial Banking, Treasury & Securities Services and Asset Management, as well as a Corporate segment. The segments are based upon the products and services provided, or the type of customer served, and they reflect the manner in which financial information is currently evaluated by management. Results of these lines of business are presented on a managed basis. For further discussion of Business segment results, see pages 34-35 of JPMorgan Chase’s 2006 Annual Report.

Results of the business segments are intended to reflect each segment as if it were essentially a stand-alone business. The management reporting process that derives business segment results allocates income and expense using market-based methodologies. For a further discussion of those methodologies, see Business Segment Results – Description of business segment reporting methodology on page 34 of JPMorgan Chase’s 2006 Annual Report. The Firm continues to assess the assumptions, methodologies and reporting classifications used for segment reporting, and further refinements may be implemented in future periods.

The following table summarizes the business segment results for the periods indicated.

 

For a discussion of the business profile of the IB, see pages 36-37 of JPMorgan Chase’s 2006 Annual Report and page 4 of this Form 10-Q.