BANK ONE CORPORATION
 

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 8-K

CURRENT REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934

     
Date of Report:

  Commission file number

 
May 18, 2004   1-15323  

BANK ONE CORPORATION


(Exact name of registrant as specified in its charter)

     
Delaware

  31-0738226

 
(State or other jurisdiction of
incorporation or organization)
  (I.R.S. Employer
Identification No.)
 

     
One Bank One Plaza, Chicago, IL

  60670

 
(Address of principal executive offices)   (Zip Code)  

Registrant’s telephone number, including area code: (312) 732-4000


 

Item 5. Other Events

J.P. Morgan Chase & Co., a Delaware corporation (“JPMorgan Chase”), and Bank One Corporation, a Delaware corporation (“Bank One”), have entered into an Agreement and Plan of Merger, dated as of January 14, 2004 (the “Merger Agreement”). The Merger Agreement provides for the merger of Bank One with and into JPMorgan Chase (the “Merger”). The Merger will be treated as a purchase business combination by JPMorgan Chase under U.S. generally accepted accounting principles. Completion of the Merger is subject to various conditions, including the receipt of all required regulatory approvals and the approval of the Merger by the stockholders of both JPMorgan Chase and Bank One.

Upon completion of the Merger, which is expected to occur in mid-2004, each share of common stock of Bank One, $0.01 par value per share, outstanding immediately prior to the effective time of the Merger, will be converted into 1.32 shares of JPMorgan Chase common stock, $1.00 par value per share.

Certain financial information for JPMorgan Chase and pro forma combined financial information for the combined entity giving effect to the Merger is set forth below.

Management’s Discussion and Analysis of the Financial Condition and Results of Operations for JPMorgan Chase

Reproduced below is management’s discussion and analysis of the financial condition and results of operations for JPMorgan Chase prepared by JPMorgan Chase and included in its Quarterly Report on Form 10-Q for the quarter ended March 31, 2004.

MANAGEMENT’S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

INTRODUCTION

J.P. Morgan Chase & Co. (“JPMorgan Chase” or the “Firm”) is a leading global financial services firm with assets of $801 billion and operations in more than 50 countries. The Firm is a leader in investment banking, financial services for consumers and businesses, financial transaction processing, investment management, private banking and private equity. JPMorgan Chase serves more than 30 million consumers nationwide and many of the world’s most prominent corporate, institutional and government clients. The Firm’s wholesale businesses are known globally as “JPMorgan,” and its national consumer and middle market businesses are known as “Chase.” The wholesale businesses comprise four segments: the Investment Bank (“IB”), Treasury & Securities Services (“TSS”), Investment Management & Private Banking (“IMPB”) and JPMorgan Partners (“JPMP”). IB provides a full range of investment banking and commercial banking products and services, including advising on corporate strategy and structure, capital raising, risk management, and market-making in cash securities and derivative instruments in all major capital markets. The three businesses within TSS provide debt servicing, securities custody and related functions, and treasury and cash management services to corporations, financial institutions and governments. The IMPB business provides investment management services to institutional investors, high-net-worth individuals and retail customers and also provides personalized advice and solutions to wealthy individuals and families. JPMP, the Firm’s private equity business, provides equity and mezzanine capital financing to private companies. The Firm’s national consumer and middle market businesses, which provide lending and full-service banking to consumers and small and middle market businesses, comprise Chase Financial Services (“CFS”).

OVERVIEW

 
                                         
Financial Performance of JPMorgan Chase                           First quarter change
(in millions, except per share and ratio data)   1Q 2004     4Q 2003     1Q 2003     4Q 2003     1Q 2003  
 
                             
Revenue
  $ 8,977     $ 8,068     $ 8,406       11 %     7 %
Noninterest expense
    6,059       5,220       5,541       16       9  
Provision for credit losses
    15       139       743       (89 )     (98 )
Net income
    1,930       1,864       1,400       4       38  
Net income per share – diluted
    0.92       0.89       0.69       3       33  
Average common equity
    45,818       44,177       41,858       4       9  
Return on average common equity (“ROCE”)
    17 %     17 %     13 %     bp     400 bp  
Common dividend payout ratio
    38       38       50             (1,200 )
Effective income tax rate
    34       31       34       300        
Overhead ratio
    67       65       66       200       100  
 
Tier 1 capital ratio
    8.4 %     8.5 %     8.4 %     (10 )bp     bp  
Total capital ratio
    11.4       11.8       12.2       (40 )     (80 )
Tier 1 leverage ratio
    5.9       5.6       5.0       30       90  
 

The momentum in global economic growth seen in 2003 carried into the first quarter of 2004, while business optimism continued to build, supported by attractive financial conditions, ongoing strong productivity and unprecedented recovery in corporate profits. Nevertheless, financial markets were volatile in the first quarter, reflecting uncertainty about the U.S. employment outlook and the actions the Board of Governors of the Federal Reserve System (“Federal Reserve Board”) might take on interest rates. Investors entered 2004 braced for rising interest rates, but with hiring slack, the economy far below potential and inflation benign, a market consensus developed in the quarter that the Federal Reserve Board’s policy would remain on hold for most of the year.

These factors created a favorable capital markets environment for JPMorgan Chase, which contributed to earnings growth in the Firm’s IB and IMPB segments to their highest levels in over three years, and provided opportunities for JPMP to realize gains. The strength in capital markets-related businesses more than offset an earnings decline at CFS, which reflected the slowdown in the mortgage refinancing market. As a result of improved credit quality in the commercial portfolio and ongoing portfolio management activities utilizing credit derivatives and loan sales, the Firm improved its credit risk profile.

Net income for JPMorgan Chase of $1.9 billion, or $0.92 per share, was the highest quarterly result since the December 2000 merger of The Chase Manhattan Corporation and J.P. Morgan & Co. Incorporated.

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Total revenue of $9.0 billion grew by 7% over the first quarter of 2003 and 11% over the fourth quarter. IB trading revenues benefited from favorable fixed income market and currency conditions: corporate credit spreads remained narrow, bond yields declined and the dollar continued to weaken against most major currencies. Equity market values rose and equity issuance increased, adding to the strength in trading and contributing to the increase in private equity gains at JPMP and in fees and commissions at IB, IMPB and TSS. Countering these favorable market conditions was a decline in Global Treasury’s revenues (securities gains and net interest income) and in mortgage origination volumes across the industry. At Chase Home Finance (“CHF”), total mortgage originations declined by 39% compared with the first quarter of 2003.

Total expenses of $6.1 billion increased by 9% year-over-year and 16% over the fourth quarter level. The fourth quarter of 2003 had an unusually low base of expenses due to an adjustment to incentive accruals, which reduced compensation costs to reflect full-year incentives. Incentive accruals were higher relative to prior periods because of higher revenues. The largest expense increases compared with the first quarter of 2003 were in CHF, within CFS, and TSS. As a result of the unprecedented refinancing boom during 2003, CHF increased staff throughout the year to keep pace with volumes; expenses remained comparable to fourth quarter 2003 levels. Management expects expenses in both CHF and TSS to moderate in future quarters to reflect the reduction in business volumes at CHF, and the realization of synergies from acquisitions at TSS.

The first quarter of 2004 Provision for credit losses of $15 million declined significantly from both comparable periods and was $429 million lower than net charge-offs in the quarter. Most of the reduction in the allowance for credit losses was due to improvement in the quality of the commercial portfolio. During the first quarter of 2004, the Firm’s commercial nonperforming loans declined by 45% and criticized exposure levels declined by 49% compared with the first quarter of 2003. At the same time, the consumer portfolio had lower delinquencies and net charge-offs versus both comparable periods. As improvements in the quality of the commercial portfolio taper off and demand for commercial loans picks up, reductions in the allowance for credit losses should moderate and credit costs could increase from the first quarter 2004 level.

The Firm’s capital position at March 31, 2004, was strong. Tier 1 capital of $44.7 billion increased by 16% from the first quarter and 4% from the fourth quarter of 2003 as retained earnings increased. A rise in risk-weighted assets (as defined by banking regulators) resulted in a Tier 1 ratio that was flat compared with the year-ago level and lower than the year-end ratio. The regulatory weightings do not distinguish between the risk ratings of credit exposure. At the same time, the Firm’s internal measure of risk in the businesses, the amount of allocated capital, declined by 11% from the first quarter and 2% from the fourth quarter of 2003, as IB reduced credit risk and JPMP reduced private equity investments.

The table below shows JPMorgan Chase’s segment results. These results reflect the manner in which the Firm’s financial information is currently evaluated by management and are presented on an operating basis. For a discussion of the Firm’s Segment results, including more information about operating results, see pages 32–50 of this Form 10-Q. Prior-period segment results have been adjusted to reflect the alignment of management accounting policies or changes in organizational structure among businesses.

                                                                         
 
Segment results – Operating basis                                                   Return on average
    Operating revenue   Operating earnings   allocated capital
            First quarter change           First quarter change           First quarter change
(in millions, except ratios)   1Q 2004     4Q 2003     1Q 2003     1Q 2004     4Q 2003     1Q 2003     1Q 2004     4Q 2003     1Q 2003  
 
                                                     
Investment Bank
  $ 3,979       31 %     (1 )%   $ 1,110       29 %     24 %     28 %     800 bp     1,100 bp
Treasury & Securities Services
    1,106       3       19       119       (17 )     6       15       (600 )     (100 )
Investment Management & Private Banking
    824             29       115       15       326       8       100       600  
JPMorgan Partners
    249       137       NM       115       400       NM       9       800       NM  
Chase Financial Services
    3,414       (5 )     (8 )     427       (24 )     (34 )     18       (700 )     (1,300 )
Support Units and Corporate
    (122 )     1       (3 )     44       (75 )     NM       NM       NM       NM  
 
                                                                   
JPMorgan Chase
  $ 9,450       11       7     $ 1,930       4       38       17             400  
 

IB reported operating earnings of $1.1 billion for the first quarter of 2004, its best performance in three years, up 24% and 29% from the first and fourth quarters of 2003, respectively. The low–interest rate environment, volatility in credit markets, and improvement in equity markets produced increased client and portfolio management revenue in fixed income and equities. This coupled with negative credit costs (i.e., a benefit to income) drove results.

TSS operating earnings of $119 million for the quarter were up 6% compared with the first quarter of 2003 and down 17% compared with the fourth quarter of 2003; the fourth quarter result included a $41 million pre-tax gain on the sale of a nonstrategic business. Acquisitions in Institutional Trust Services and Treasury Services drove revenue and expense growth in TSS. Higher global equity values resulted in increased fees in Investor Services, as pricing is tied to asset levels. Average deposits for TSS were up 33% from

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the first quarter of 2003, though spreads on deposits were low given the low level of interest rates. At 15%, Return on average allocated capital for TSS was negatively affected by goodwill from acquisitions.

IMPB increased operating earnings and assets under supervision in the first quarter of 2004 compared with the year-ago and prior quarters, aided by increased equity market valuations in client portfolios and increased brokerage activity. Net inflows in the quarter were at their highest levels in more than two years; strong inflows from the retail segment were coupled with net positive institutional inflows for the first time in more than a year, a reflection of improved investment performance.

JPMP performance improved significantly, with a positive $526 million increase in private equity gains from the first quarter of 2003. Net gains on direct private equity investments, at $304 million, benefited from higher sales ($302 million in realized gains) and liquidity events such as initial public offerings and much lower negative net valuation adjustments ($23 million) of companies in the portfolio.

CFS operating earnings declined by $221 million from the first quarter of 2003, 92% of which was due to the decline in earnings at CHF. Strong production results in many of the businesses – including increased purchase volume at Chase Cardmember Services, deposit growth at Chase Regional Banking and Chase Middle Market, and higher home equity originations at CHF – were more than offset by deposit spread compression, weak automobile leasing results and higher severance and related costs.

Business outlook

Toward the end of the first quarter, U.S. economic data began showing a gradual strengthening in hiring and improvement in business conditions. Management expects higher interest rates some time in the second half of 2004. Rising interest rates may negatively affect the Firm’s Home Finance and Global Treasury results compared with 2003. However, rising rates may be indicative of robust economic growth, which is beneficial for many other businesses in the Firm. IB had a stronger pipeline for fees than in December or March of last year. In addition, client trading activity is independent of the direction of rate moves (although trading revenues in future quarters may be lower, as the first quarter is usually seasonally strong). IMPB, Investor Services and JPMP are expected to benefit from rising equity markets. Loan demand should increase as the economy continues to improve and corporations increase investments. The level of deposits may decline as rates rise (although the interest rate spread could widen). Commercial net charge-off ratios may be lower, but credit costs may rise as the reduction in the Allowance for credit losses slows. Consumer loan losses may decline, but the interest rate spread on consumer loans may narrow.

Business events

Agreement to merge with Bank One Corporation

On January 14, 2004, JPMorgan Chase and Bank One Corporation (“Bank One”) announced an agreement to merge. The merger agreement, which has been approved by the boards of directors of both companies, provides for a stock-for-stock merger in which 1.32 shares of JPMorgan Chase common stock will be exchanged, on a tax-free basis, for each share of Bank One common stock; cash will be paid for fractional shares. JPMorgan Chase stockholders will keep their shares, which will remain outstanding and unchanged as shares of JPMorgan Chase following the merger. The merger will be accounted for using the purchase method of accounting. The purchase price to complete the proposed merger is approximately $58 billion.

The merged company, headquartered in New York, will be known as J.P. Morgan Chase & Co. and will have combined assets of $1.1 trillion, a strong capital base, 2,300 branches in 17 states and top-tier positions in retail banking and lending, credit cards, investment banking, asset management, private banking, treasury and securities services, middle markets and private equity. It is expected that cost savings of approximately $2.2 billion (pre-tax) will be achieved by 2007. Merger-related costs are expected to be approximately $3 billion (pre-tax).

Immediately following the announcement of the agreement to merge, integration planning was initiated. To date, detailed integration plans have been developed, with more than 2,000 milestones centrally monitored; decisions have been made on most of the technology platforms that will be used by the combined firm. For further information concerning the merger, see Note 2 on page 7 of this Form 10-Q.

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RESULTS OF OPERATIONS
 
The following section provides a discussion of JPMorgan Chase’s results of operations on a reported basis.
 
                                         
Revenue                           First quarter change
(in millions)   1Q 2004     4Q 2003     1Q 2003     4Q 2003     1Q 2003  
 
                             
Investment banking fees
  $ 692     $ 846     $ 616       (18 )%     12 %
Trading revenue
    1,720       754       1,298       128       33  
Fees and commissions
    2,933       2,871       2,488       2       18  
Private equity gains (losses)
    306       163       (221 )     88       NM  
Securities gains
    126       29       485       334       (74 )
Mortgage fees and related income
    244       140       433       74       (44 )
Other revenue
    126       254       92       (50 )     37  
Net interest income
    2,830       3,011       3,215       (6 )     (12 )
 
                                 
Total revenue
  $ 8,977     $ 8,068     $ 8,406       11       7  
 
                                 
 

Investment banking fees

For a discussion of Investment banking fees, which are primarily recorded in IB, see IB segment results on pages 34–37 of this Form 10-Q.

Trading revenue

For a discussion of Trading revenue, which is primarily recorded in IB, see the IB segment results on pages 34–37 of this Form 10-Q.

Fees and commissions

The table below provides the significant components of fees and commissions:
                                         
 
                            First quarter change
(in millions)   1Q 2004     4Q 2003     1Q 2003     4Q 2003     1Q 2003  
 
                             
Investment management and service fees
  $ 668     $ 618     $ 545       8 %     23 %
Custody and institutional trust service fees
    442       431       358       3       23  
Credit card fees
    734       825       692       (11 )     6  
Brokerage commissions
    401       316       259       27       55  
Lending-related service fees
    139       172       124       (19 )     12  
Deposit service fees
    274       279       285       (2 )     (4 )
Other fees
    275       230       225       20       22  
 
                                 
Total
  $ 2,933     $ 2,871     $ 2,488       2       18  
 
                                 
 

The increases from both periods for Investment management and service fees and Custody and institutional trust service fees were primarily due to higher equity valuations of Assets under supervision (which includes assets under custody); organic growth in the businesses including net inflows of assets under supervision; and to the acquisitions of the Bank One corporate trust business in November 2003 (which contributed $22 million) and JPMorgan Retirement Plan Services (“RPS”) in June 2003 (which contributed $21 million). Credit card fees rose by 6% from the first quarter of 2003, reflecting higher servicing fees on the $1.5 billion growth in average securitized credit card receivables; higher fees earned from the retained credit card portfolio as a result of the more robust customer purchase volume; and the favorable impact of changes in the pricing of several card products and services. The decline in Credit card fees from the immediately preceding quarter reflected the seasonal decrease in purchase volume.

Brokerage commissions increases from both periods were driven by the higher activity levels in the global equities market. Lending-related service fees were up from the first quarter of 2003 as a result of the growth in business volume, including a $3.3 billion, or 85%, growth in the automobile loan servicing portfolio. The decline in Lending-related service fees from the prior quarter was principally attributable to a lower volume of standby letters of credit negotiated in the quarter. The decrease in Deposit service fees compared with the first quarter of 2003 reflected higher balances maintained by institutional customers in their deposit accounts, which reduced fees in lieu of compensating balances or balance deficiency fees. The increase in Other fees was largely due to the acquisition of the Electronic Financial Services (“EFS”) business from Citigroup in January 2004, which contributed $55 million.

For additional information on Fees and commissions, see the segment discussions of IMPB for investment management fees on pages 38–40, TSS for custody and securities processing fees on pages 37–38, and CFS for consumer-related fees on pages 43–49 of this Form 10-Q.

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Private equity gains (losses)

For a discussion of the factors that fueled the improvement in the Firm’s private equity investment results, which are primarily recorded in JPMP, see the JPMP segment discussion on pages 41–42 of this Form 10-Q.

Securities gains

Securities gains decreased by 74% from the first quarter of 2003 due to substantial gains realized last year as rates declined. Most of the gains were realized by Global Treasury in connection with its management of the Firm’s interest rate risk exposure. CHF uses AFS securities to manage the economic risk of changes in the value of mortgage servicing rights (“MSRs”). In the 2004 first quarter, CHF realized a loss of $4 million on its investment securities portfolio, compared with gains of $96 million and $13 million in the 2003 first and fourth quarters, respectively.

Mortgage fees and related income

Mortgage fees and related income decreased by 44% from the first quarter of 2003 principally due to lower mortgage originations. Originations were down 39% from the same quarter of last year. The increase of 74% from the prior linked quarter reflected better origination margins and higher mortgage applications, as rates decreased from the fourth quarter. For a further discussion of total mortgage-related revenues, see the segment discussion for CHF on pages 45–46.

Other revenue

Other revenue rose 37% when compared with the 2003 first quarter, primarily the result of higher gains on credit card and commercial mortgage loan securitizations. Net gains related to credit card securitizations (consisting of new and revolving securitizations) was $39 million, up $26 million from the first quarter of the prior year; the gain on commercial mortgage loan securitizations was $28 million, up $10 million from the 2003 first quarter. In addition, the 2003 first quarter included the recognition of certain nonoperating charges at American Century Companies, Inc. (“American Century”) that reduced equity income. The decline of 50% from the 2003 fourth quarter was attributable to gains of $106 million (versus $24 million in the first quarter of 2004) from sales of securities acquired in loan satisfactions; a gain of $41 million from the sale of a nonstrategic business in TSS; and a gain of $20 million from the sale of a building in Geneva.

Net interest income

The declines of 6% from the fourth quarter and 12% from the first quarter of last year were the result of a lower volume of commercial loans and lower volumes and lower spreads on available-for-sale investment securities. The decrease in commercial loans in IB was driven by softer demand and the Firm’s strategic initiative to improve its credit risk profile; the reduction in available-for-sale investment securities reflected sales in 2003 in anticipation of higher interest rates. Also contributing to the declines was the compression in the overall spread on interest earning assets, including trading assets. Deposits at Chase Regional Banking, Chase Middle Market and TSS realized lower NII from compressed spreads despite an increase in volume.

On an aggregate basis, the Firm’s total average interest-earning assets for the first quarter of 2004 were $601 billion, relatively stable in comparison with the $598 billion recorded in the first quarter of last year. The net interest yield on these assets, on a fully taxable-equivalent basis, was 1.90% in the 2004 first quarter, 29 basis points lower than in the same period last year.

NONINTEREST EXPENSE

The following table presents the components of Noninterest expense:
                                         
 
Noninterest Expense                           First quarter change
(in millions)   1Q 2004     4Q 2003     1Q 2003     4Q 2003     1Q 2003  
 
                             
Compensation expense
  $ 3,370     $ 2,577     $ 3,174       31 %     6 %
Occupancy expense
    431       482       496       (11 )     (13 )
Technology and communications expense
    819       756       637       8       29  
Other expense
    1,439       1,405       1,234       2       17  
 
                                 
Total noninterest expense
  $ 6,059     $ 5,220     $ 5,541       16       9  
 
                                 
 

Compensation expense

The increase from the 2003 first quarter was attributable to salary raises and higher employee benefit costs including social security–related taxes. The 31% rise from the 2003 fourth quarter was largely due to higher performance-related incentive accruals, principally in IB. The increase was partially offset by the transfer, beginning April 1, 2003, of approximately 2,800 employees to IBM in connection with a technology infrastructure outsourcing agreement; the related expenses of these employees, recognized in the prior year in Compensation expense, were approximately $70 million. See Note 5 on page 9 for a discussion of the impact on 2004 expenses of a $1.1 billion contribution to the plan in April 2004. In addition, severance-related costs of $103 million were recognized in the first quarter of 2004, compared with $76 million in the first quarter of 2003 and $102 million in the fourth quarter of 2003.

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The Firm had 93,285 full-time equivalent employees at March 31, 2004, compared with 93,878 at March 31, 2003, and 93,453 at December 31, 2003. The reduction in the number of employees in staff areas was mitigated by increases in growing businesses.

Occupancy expense

The declines in Occupancy from both periods were primarily driven by charges for unoccupied excess real estate of $78 million in the first quarter of 2003 and $71 million in the fourth quarter of 2003. Partially offsetting the decline from the fourth quarter was the recognition of slightly higher property taxes and other building administration costs.

Technology and communications expense

The increase in Technology and communications expense from the first quarter of last year was primarily due to the shift to this category of expenses as a result of the aforementioned IBM outsourcing agreement; last year approximately $70 million of these expenses were recognized in Compensation expense, and $45 million of these expenses were recognized in Other expense. (The IBM agreement was implemented in April 2003.) The increase was also affected by higher amortization of capitalized software development costs, as well as higher market data and IBM-related expenses, the latter items associated with the growing requirements of several business segments. The increase from the fourth quarter also reflected growth in business volume.

Other expense

The following table presents the components of other expense:
                                         
 
                            First quarter change
(in millions)   1Q 2004     4Q 2003     1Q 2003     4Q 2003     1Q 2003  
 
                             
Professional services
  $ 372     $ 394     $ 325       (6 )%     14 %
Outside services
    376       311       272       21       38  
Marketing
    199       200       164       (1 )     21  
Travel and entertainment
    118       128       89       (8 )     33  
Amortization of intangibles
    79       74       74       7       7  
All other
    295       298       310       (1 )     (5 )
 
                                 
Total other expense
  $ 1,439     $ 1,405     $ 1,234       (2 )     17  
 
                                 
 

For Professional services, the increase from last year’s first quarter was associated with higher counsel fees, related to growth in securities underwriting transactions; whereas the decrease from the 2003 fourth quarter reflected lower litigation-related legal expenses. The increase in Outside services from both the first and fourth quarters of 2003 was primarily attributable to greater utilization of third-party vendors for processing activities in TSS and CFS. The expense increase at TSS was affected by the acquisition of a business in the first quarter of 2004, which contributed $26 million. The increase in Marketing from the first quarter of 2003 reflects higher direct marketing campaigns in credit card and advertising by Regional Banking.

Provision for credit losses

The 2004 first quarter Provision for credit losses was $15 million compared with $743 million in the 2003 first quarter and was down $124 million from the 2003 fourth quarter, reflecting improvement in the quality of the commercial loan portfolio. The decline from the first quarter of 2003 was also due to a higher volume of credit card securitizations. For further information on the Provision for credit losses and the Firm’s management of credit risk, see the discussions of net charge-offs associated with the commercial and consumer loan portfolios and the Allowance for credit losses, on pages 64–66 of this Form 10-Q.

Income tax expense

Income tax expense was $973 million in the first quarter of 2004, compared with $722 million in the first quarter and $845 million in the fourth quarter of 2003. The effective tax rates were 33.5% for the first quarter of 2004, 34.0% for the first quarter of 2003 and 31.2% for the fourth quarter of 2003. The differences in the tax rates were primarily reflective of the changes in the proportion of income subject to federal, state and local taxes.

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EXPLANATION AND RECONCILATION OF THE FIRM’S USE OF NON-GAAP FINANCIAL MEASURES
 

The Firm prepares its Consolidated financial statements using GAAP. The Consolidated financial statements prepared in accordance with GAAP appear on pages 3–6 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 consistently tracked from year to year and enables a comparison of the Firm’s performance with other companies’ GAAP financial statements.

In addition to analyzing the Firm’s results on a reported basis, management reviews the line-of-business results on an “operating basis,” which is a non-GAAP financial measure. The definition of operating basis starts with the reported GAAP results. In the case of IB, operating basis includes in Trading revenue the NII related to trading activities. Trading activities generate revenues which are recorded for GAAP purposes in two line items on the income statement: trading revenues, which include the mark-to-market gains or losses on trading positions; and net interest income, which includes the interest income or expense related to those positions. Combining both the trading revenues and related net interest income enables management to evaluate IB’s trading activities by considering all revenue related to these activities and facilitates operating comparisons to other competitors. For a further discussion of Trading-related revenue, see IB on page 34–37 of this Form 10-Q. In the case of Chase Cardmember Services, operating or managed basis excludes the impact of credit card securitizations on revenue, the provision for credit losses, net charge-offs and receivables. JPMorgan Chase uses the concept of “managed receivables” to evaluate the credit performance of the underlying credit card loans, both sold and not sold: as the same borrower is continuing to use the credit card for ongoing charges, a borrower’s credit performance will impact both the receivables sold under SFAS 140 and those not sold. Thus, in its disclosures regarding managed receivables, JPMorgan Chase treats the sold receivables as if they were still on the balance sheet in order to disclose the credit performance (such as net charge-off rates) of the entire managed credit card portfolio. The operating basis for all other lines of business is the same as reported basis. For a further discussion of credit card securitizations, see Chase Cardmember Services on pages 46–47 of this Form 10-Q.

30


 

The following summary table provides a reconciliation from the Firm’s reported to operating results:

 
Reconciliation from reported to operating basis
                                         
Consolidated income statement                           First quarter change
(in millions)   1Q 2004     4Q 2003     1Q 2003     4Q 2003     1Q 2003  
 
                             
Reported
                                       
Revenue:
                                       
Investment banking fees
  $ 692     $ 846     $ 616       (18 )%     12 %
Trading revenue
    1,720       754       1,298       128       33  
Fees and commissions
    2,933       2,871       2,488       2       18  
Private equity gains (losses)
    306       163       (221 )     88       NM  
Securities gains
    126       29       485       334       (74 )
Mortgage fees and related income
    244       140       433       74       (44 )
Other revenue
    126       254       92       (50 )     37  
Net interest income
    2,830       3,011       3,215       (6 )     (12 )
 
                                 
Total revenue
    8,977       8,068       8,406       11       7  
Noninterest expense
    6,059       5,220       5,541       16       9  
 
                                 
Operating margin
    2,918       2,848       2,865       2       2  
Provision for credit losses
    15       139       743       (89 )     (98 )
 
                                 
Income before income tax expense
    2,903       2,709       2,122       7       37  
Income tax expense
    973       845       722       15       35  
 
                                 
Net income
  $ 1,930     $ 1,864     $ 1,400       4       38  
 
                                 
 
Reconciling items(a)
                                       
Revenue:
                                       
Trading-related revenue(b)
  $ 576     $ 518     $ 683       11 %     (16 )%
Fees and commissions(c)
    (149 )     (184 )     (169 )     19       12  
Other revenue
    (39 )     (29 )     (4 )     (34 )     NM  
Net interest income:
                                       
Trading-related(b)
    (576 )     (518 )     (683 )     (11 )     16  
Credit card securitizations(c)
    661       675       630       (2 )     5  
 
                                 
Total net interest income
    85       157       (53 )     (46 )     NM  
Total revenue
    473       462       457       2       4  
Noninterest expense
                             
Operating margin
    473       462       457       2       4  
Securitized credit losses(c)
    473       462       457       2       4  
 
                                 
Income before income tax expense
                             
Income tax expense
                             
Net income
  $     $     $       NM       NM  
 
                                 
 
Operating results
                                       
Revenue:
                                       
Investment banking fees
  $ 692     $ 846     $ 616       (18 )%     12 %
Trading-related revenue (including trading NII)
    2,296       1,272       1,981       81       16  
Fees and commissions
    2,784       2,687       2,319       4       20  
Private equity gains (losses)
    306       163       (221 )     88       NM  
Securities gains
    126       29       485       334       (74 )
Mortgage fees and related income
    244       140       433       74       (44 )
Other revenue
    87       225       88       (61 )     (1 )
Net interest income (excluding trading NII)
    2,915       3,168       3,162       (8 )     (8 )
 
                                 
Total operating revenue
    9,450       8,530       8,863       11       7  
Noninterest expense
    6,059       5,220       5,541       16       9  
 
                                 
Operating margin
    3,391       3,310       3,322       2       2  
Credit costs
    488       601       1,200       (19 )     (59 )
 
                                 
Income before income tax expense
    2,903       2,709       2,122       7       37  
Income tax expense
    973       845       722       15       35  
 
                                 
Operating earnings
  $ 1,930     $ 1,864     $ 1,400       4       38  
 
                                 
 

31


 

 
(a)  
Represents only those line items in the Consolidated income statement affected by the reclassification of trading-related net interest income and the impact of credit card securitizations.
(b)  
The reclassification of trading-related net interest income from Net interest income to Trading revenue primarily affects the Investment Bank segment results. See pages 34–37 of this Form 10-Q for further information.
(c)  
The impact of credit card securitizations affects Chase Cardmember Services. See pages 46–47 of this Form 10-Q for further information.
 

Management uses the SVA framework as its primary measure of profitability for the Firm and each of its business segments. To derive SVA, the Firm applies a cost of capital to each business segment. The capital elements and resultant capital charges provide the businesses and investors with a financial framework by which to evaluate the trade-off between the use of capital by each business unit versus its return to shareholders. JPMorgan Chase varies the amount of capital attributed to lines of business based on its estimate of the economic risk capital required by the line of business as a result of the credit, market, operational and business risk for each particular line of business and private equity risk for JPMorgan Partners. JPMorgan Chase believes this risk-adjusted approach to economic capital compensates for differing levels of risk across businesses, and therefore a constant 12% cost of capital can be applied across businesses with differing levels of risk. The cost of capital for JPMorgan Partners is 15%, because JPMorgan Chase believes that the business risk for JPMP is so sufficiently differentiated that, even after risk-adjustment, a higher cost of capital is warranted. Capital charges are an integral part of the SVA measurement for each business. Under the Firm’s model, average common equity is either underallocated or overallocated to the business segments, as compared with the Firm’s total common stockholders’ equity. The revenue and SVA impact of this over/under allocation is reported under Support Units and Corporate. See segment results on pages 27–28 of JPMorgan Chase’s 2003 Annual Report for a further discussion of SVA, and the Glossary of Terms on pages 74–75 of this Form 10-Q for a definition of SVA.

The following table provides a reconciliation of the Firm’s operating earnings to SVA on a consolidated basis:

 
                                         
                            First quarter change
(in millions)   1Q 2004     4Q 2003     1Q 2003     4Q 2003     1Q 2003  
 
                             
Shareholder value added
                                       
Operating earnings
  $ 1,930     $ 1,864     $ 1,400       4 %     38 %
Less: preferred dividends
    13       13       13              
 
                                 
Earnings applicable to common stock
    1,917       1,851       1,387       4       38  
Less: cost of capital
    1,367       1,337       1,239       2       10  
 
                                 
Total Shareholder value added
  $ 550     $ 514     $ 148       7       272  
 
                                 
 

In addition, management uses certain non-GAAP financial measures at the segment level. Management believes these non-GAAP financial measures provide information to investors in understanding the underlying operational performance and performance trends of the particular business segment and facilitate a comparison with the performance of competitors. These include Total return revenue in IB, Tangible shareholder value added and Tangible allocated capital in IMPB, and managed receivables and managed assets in Chase Cardmember Services. For a discussion of these line of business–specific non-GAAP financial measures, see the respective segment disclosures in segment results on pages 32–50 of this Form 10-Q.

Management measures its exposure to derivative receivables and commercial lending–related commitments on an “economic credit exposure” basis. See Credit risk management in this Form 10-Q on pages 54–62.

The following table provides a reconciliation of the Firm’s average assets to average managed assets, a non-GAAP financial measure on a consolidated basis:

 
                                         
                            First quarter change
(in millions)   1Q 2004     4Q 2003     1Q 2003     4Q 2003     1Q 2003  
 
                             
Average assets
  $ 771,318     $ 778,519     $ 778,238       (1 )%     (1 )%
Average credit card securitizations
    33,357       33,445       31,834             5  
 
                                 
Average managed assets
  $ 804,675     $ 811,964     $ 810,072       (1 )     (1 )
 
                                 
 

 
SEGMENT RESULTS
 

JPMorgan Chase’s lines of business 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. Revenues and expenses directly associated with each segment are included in determining that segment’s results. Management accounting and other policies exist to allocate those remaining expenses that are not directly incurred by the segments.

The segment results also reflect revenue- and expense-sharing agreements between certain lines of business. Revenue and expenses attributed to shared activities are recognized in each line of business, and any double counting is eliminated at the segment level.

32


 

These arrangements promote cross-selling and management of shared client expenses. They also ensure that the contributions of both businesses are fully recognized. Prior-period segment results have been adjusted to reflect alignment of management accounting policies or changes in organizational structure among businesses. Restatements of segment results may occur in the future. See Note 22 on pages 22–23 of this Form 10-Q for further information about JPMorgan Chase’s five business segments.

Contribution of businesses for the first quarter of 2004

(OPERATED REVENUES PIE CHART)

(OPERATED EARNINGS PIE CHART)

As of March 31, 2004, the overhead ratio for each business segment was: IB, 59%; TSS, 83%; IMPB, 77%; and CFS, 59%. Overhead ratios provide comparability for a particular segment with its respective competitors; they do not necessarily provide comparability among the business segments themselves, as each business segment has its own particular revenue and expense structure.

33


 

INVESTMENT BANK

For a discussion of the business profile of the IB, see pages 29-31 of JPMorgan Chase’s 2003 Annual Report. The following table sets forth selected IB financial data:
 
                                         
Selected financial data                           First quarter change
(in millions, except ratios and employees)   1Q 2004     4Q 2003     1Q 2003     4Q 2003     1Q 2003  
 
                             
Revenue
                                       
Investment banking fees
  $ 682     $ 834     $ 620       (18 )%     10 %
Trading-related revenue (a)
    2,270       1,207       1,931       88       18  
Net interest income
    374       463       690       (19 )     (46 )
Fees and commissions
    485       437       378       11       28  
Securities gains
    129       13       383     NM       (66 )
All other revenue
    39       92       8       (58 )     388  
 
 
                                       
Total operating revenue
    3,979       3,046       4,010       31       (1 )
 
 
                                       
Expense
                                       
Compensation expense
    1,401       827       1,312       69       7  
Noncompensation expense
    943       944       871             8  
Severance and related costs
    18       67       105       (73 )     (83 )
 
                                 
Total operating expense
    2,362       1,838       2,288       29       3  
Operating margin
    1,617       1,208       1,722       34       (6 )
Credit costs
    (188 )     (241 )     245       22     NM  
Corporate credit allocation
    2       (5 )     (12 )   NM     NM  
 
                                 
Income before income tax expense
    1,807       1,444       1,465       25       23  
Income tax expense
    697       582       568       20       23  
 
                                 
Operating earnings
  $ 1,110     $ 862     $ 897       29       24  
 
                                 
 
 
                                       
Shareholder value added
                                       
Operating earnings
  $ 1,110     $ 862     $ 897       29       24  
Less: Preferred dividends
    5       5       6             (17 )
 
                                 
Earnings applicable to common stock
    1,105       857       891       29       24  
Less: cost of capital
    477       513       618       (7 )     (23 )
 
                                 
Total shareholder value added
  $ 628     $ 344     $ 273       83       130  
 
                                 
 
                                       
Average allocated capital
  $ 15,973     $ 16,966     $ 20,871       (6 )     (23 )
Average assets
    513,983       511,342       525,773       1       (2 )
Return on average allocated capital
    28 %     20 %     17 %   800 bp   1,100 bp
Overhead ratio
    59       60       57       (100 )     200  
Compensation expense as % of operating revenue (b)
    35       27       33       800       200  
Full-time equivalent employees
    14,810       14,567       14,398       2 %     3 %
 
 
                                       
Business revenue
                                       
Investment banking fees
                                       
Equity underwriting
  $ 177     $ 254     $ 107       (30 )%     65 %
Debt underwriting
    358       423       353       (15 )     1  
 
                                 
Total underwriting
    535       677       460       (21 )     16  
Advisory
    147       157       160       (6 )     (8 )
 
                                 
Total investment banking fees
    682       834       620       (18 )     10  
 
                                 
Capital markets and lending
                                       
Fixed income
    2,065       1,368       1,966       51       5  
Equities
    673       341       431       97       56  
Credit portfolio
    347       360       394       (4 )     (12 )
 
                                 
Total capital markets and lending
    3,085       2,069       2,791       49       11  
 
                                 
 
                                       
Total revenue (excluding Global Treasury)
    3,767       2,903       3,411       30       10  
Global Treasury
    212       143       599       48       (65 )
 
                                 
Total revenue
  $ 3,979     $ 3,046     $ 4,010       31       (1 )
 
                                 
Memo
                                       
Global Treasury
                                       
Total revenue
  $ 212     $ 143     $ 599       48       (65 )
Total-return adjustments
    (229 )     79       (64 )   NM       (258 )
 
                                 
Total-return revenue (c)
  $ (17 )   $ 222     $ 535     NM     NM  
 
                                 
 

34


 

 
(a)  
Includes net interest income of $576 million, $513 million and $683 million for the three months ended March 31, 2004, December 31, 2003, and March 31, 2003, respectively.
(b)  
Excludes severance and related costs.
(c)  
Total return revenue (“TRR”), a non-GAAP financial measure, represents revenue plus the change in unrealized gains or losses on investment securities and hedges (included in Other comprehensive income) and internally transfer-priced assets and liabilities. TRR is a supplemental performance measure used by management to analyze performance of Global Treasury on an economic basis. Management believes the TRR measure is meaningful, because it measures all positions on a mark-to-market basis, thereby reflecting the true economic value of positions in the portfolio. This performance measure is consistent with the manner in which the portfolio is managed, as it removes the timing differences that result from applying the various GAAP accounting policies.
 

IB operating earnings were $1.1 billion in the first quarter, compared with $897 million in the first quarter of 2003 and $862 million in the fourth quarter of 2003. Earnings performance was driven by higher equity and fixed income capital markets results including record trading revenues compared with the first and fourth quarters of 2003. A significant improvement in commercial credit quality, offset in part by the anticipated reduction in Global Treasury, also contributed to the increase over the first quarter of 2003. Return on average allocated capital was 28% for the quarter, compared with 17% and 20% for the first and fourth quarters of 2003, respectively.

Operating revenues of $4.0 billion were 1% lower than in the first quarter of 2003 and up 31% from the fourth quarter of 2003. Investment banking fees were $682 million, up 10% from the 2003 first quarter on higher equity and bond underwriting fees, which were driven by increased market volumes, and partially offset by lower loan syndication and advisory fees. These fees were down 18% from a strong 2003 fourth quarter, due primarily to lower equity underwriting, loan syndication and advisory fees. The decline in equity underwriting compared with the fourth quarter of 2003 reflected lower market volumes of rights issues in Europe; the decline in loan syndication fees reflected lower volumes in new commercial loan syndications. According to Thomson Financial, the Firm maintained its No. 1 ranking in global syndicated loans and No. 2 ranking in global investment-grade bonds. For the first quarter of 2004 compared with full-year 2003, the Investment Bank increased its ranking in global announced M&A to No. 3 from No. 5, while its ranking in U.S. equity and equity-related declined to No. 7 from No. 4. However, in U.S. initial public offerings, the Firm improved its ranking from No. 14 for full-year 2003 to No. 4.

Composition of Capital Markets & Lending Revenue and Global Treasury:

                                         
    Trading-related revenue     Fees and commissions     Securities gains     NII and other     Total revenue  
 
(in millions)                                        
First quarter 2004                                        
 
Fixed income
  $ 1,877     $ 82     $ 10     $ 96     $ 2,065  
Equities
    333       325             15       673  
Credit portfolio
    56       78             213       347  
 
                             
Capital markets & lending revenue
    2,266       485       10       324       3,085  
Global Treasury
    4             119       89       212  
 
                             
 
                                       
Total
  $ 2,270     $ 485     $ 129     $ 413     $ 3,297  
 
 
                                       
Fourth quarter 2003
                                       
 
Fixed income
  $ 1,154     $ 71     $ 3     $ 140     $ 1,368  
Equities
    94       258             (11 )     341  
Credit portfolio
    (50 )     108       1       301       360  
 
                             
Capital markets & lending revenue
    1,198       437       4       430       2,069  
Global Treasury
    9             9       125       143  
 
                             
 
                                       
Total
  $ 1,207     $ 437     $ 13     $ 555     $ 2,212  
 

35


 

                                         
    Trading-related revenue     Fees and commissions     Securities gains     NII and other     Total revenue  
 
(in millions)                                        
First quarter 2003                                        
 
Fixed income
  $ 1,735     $ 102     $ 6     $ 123     $ 1,966  
Equities
    199       200       6       26       431  
Credit portfolio
    (13 )     76             331       394  
 
                             
Capital markets & lending revenue
    1,921       378       12       480       2,791  
Global Treasury
    10             371       218       599  
 
                             
 
                                       
Total
  $ 1,931     $ 378     $ 383     $ 698     $ 3,390  
 

IB’s capital markets and lending activities include fixed income and equities revenue and revenue from the Firm’s credit portfolio, which includes corporate lending and credit risk management activities. The capital markets and lending revenue includes both client (i.e., market-making) revenue and portfolio management revenue; the latter reflects net gains or losses, exclusive of client revenue, generated from managing residual risks in the portfolios, as well as gains or losses related to proprietary risk-taking activities to capture market opportunities. IB evaluates its capital markets activities by considering all revenue related to these activities, including Trading-related revenue, Fees and commissions, Securities gains, lending-related NII and other revenue.

Capital markets and lending revenue (excluding Global Treasury) for the quarter was $3.1 billion, up 11% and 49% from the first and fourth quarters of 2003, respectively, due to substantial gains in equities as well as continued strong performance in fixed income. Equity capital markets revenue of $673 million increased substantially, up 56% and 97% over the first and fourth quarters of 2003, respectively. Results were driven by higher trading revenue in both equity derivatives and convertibles, reflecting higher client revenues in derivatives and increased portfolio management in an upward-moving market environment. Higher brokerage fees and commissions within the equity cash business were driven by higher market volumes. Fixed income revenue of $2.1 billion increased by 5% from the first quarter and 51% from the fourth quarter of 2003, driven by increased trading revenues. The increases in trading revenue reflected strength in both client and portfolio management activities, driven by the continued favorable interest rate environment. Client-related trading revenues were up in both the credit markets and interest rates businesses. In particular, foreign exchange posted record results, driven by increased volumes in foreign exchange options. Credit Portfolio revenue of $347 million was down 12% and 4% from the first and fourth quarters of 2003, respectively, driven primarily by lower loan volume and a continued decline in credit risk capital, resulting in lower NII for the period. The lower NII was partially offset by an increase in Trading revenue due to spread widening on credit derivatives that are used to manage risk in the loan portfolio. For additional information, see the Credit risk management discussion on credit derivatives on pages 61–62 of this Form 10-Q.

Global Treasury’s operating revenue was $212 million, down 65% from the first quarter of 2003 and up 48% from the fourth quarter of 2003. The decrease from the year-ago quarter reflected lower levels of NII, driven by lower coupon reinvestment rates compared with the prior year. Securities gains decreased by 68% from the first quarter of 2003 due to substantial realized gains last year in the Firm’s AFS investment securities portfolio. The increase in securities gains from the fourth quarter of 2003 was attributable to the higher volume of sales in connection with Global Treasury’s repositioning activities to manage, in part, the Asset/liability exposure of the Firm. Global Treasury is managed on a total-return revenue basis, which includes revenue plus the change in unrealized gains or losses on investment securities and risk management activities (included in Other comprehensive income) and internally transfer-priced assets and liabilities. Global Treasury’s total-return revenue was negative $17 million for the first quarter of 2004, down from $535 million in the first quarter and $222 million in the fourth quarter of 2003. The decline was driven by spread widening on mortgage-backed securities, which are used to help manage the Firm’s overall interest rate exposure. Global Treasury’s activities complement, and offer a strategic balance and diversification benefit to, the Firm’s trading and fee-based activities. For a reconciliation of Global Treasury’s total revenue to total-return revenue, see page 34 of this Form 10-Q.

Operating expense of $2.4 billion was up 3% from the first quarter and 29% from the fourth quarter of 2003. The increase from the year-ago quarter was attributable to higher compensation expenses, as a result of salary increases, higher employer taxes on a higher level of restricted stock vestings, and increased travel and entertainment and legal costs. The increase over the prior quarter was largely due to higher compensation expenses, reflecting higher incentives on stronger business performance. Partially offsetting these increases were lower severance and related costs. The overhead ratio for the first quarter of 2004 was 59%, an increase of 200 basis points over the first quarter of 2003, driven by the expense increases mentioned above.

Credit costs were negative $188 million for the quarter, compared with credit costs of $245 million for the first quarter of 2003 and negative $241 million for the fourth quarter of 2003. The reduction in credit costs from the prior-year quarter was primarily attributable to a reduction in the allowance for credit losses as credit quality improved. For additional information, see Credit risk management on pages 64–66 of this Form 10-Q.

36


 

Outlook: IB is expected to continue to benefit from the improved economic environment. IB fees and client trading activity are largely independent of the direction of interest rate moves, although trading revenue in subsequent quarters may be lower as the first quarter is usually seasonally strong. Commercial credit costs may rise, reflecting an increase in demand for loans and lower recoveries.

 
                                 
    First quarter   Full-year
Market Share/Rankings (a)   2004   2003
         
Global syndicated loans
    14 %     # 1       17 %     # 1  
Global investment-grade bonds
    8       # 2       8       # 2  
Global equity & equity-related
    5       # 8       8       # 4  
U.S. equity & equity-related
    6       # 7       11       # 4  
Global announced M&A (b)
    34       # 3       15       # 5  
 
(a)  
Derived from Thomson Financial Securities Data, which reflect subsequent updates to prior-period information. Global announced M&A is based on rank value; all other rankings are based on proceeds, with full credit to each book manager/equal if joint. Because of joint assignments, market share of all participants will add up to more than 100%.
(b)  
First quarter 2004 ranking and market share reflect the announced merger between JPMorgan Chase and Bank One Corporation. Excluding this transaction, the market share would have been 25%, and the ranking would have been No. 4.
 

TREASURY & SECURITIES SERVICES

For a discussion of the profiles for each business within TSS, see pages 32–33 of JPMorgan Chase’s 2003 Annual Report. The following table sets forth selected financial data of TSS:
 
                                         
Selected financial data                           First quarter change
(in millions, except ratios and employees)   1Q 2004     4Q 2003     1Q 2003     4Q 2003     1Q 2003  
 
                             
Revenue
                                       
Fees and commissions
  $ 745     $ 676     $ 598       10 %     25 %
Net interest income
    313       304       290       3       8  
All other revenue
    48       91       38       (47 )     26  
 
                                 
Total operating revenue
    1,106       1,071       926       3       19  
Expense
                                       
Compensation expense
    343       320       312       7       10  
Noncompensation expense
    571       503       449       14       27  
Severance and related costs
    7       23       4       (70 )     75  
 
                                 
Total operating expense
    921       846       765       9       20  
Operating margin
    185       225       161       (18 )     15  
Credit costs
    1             1     NM        
Corporate credit allocation
    (2 )     5       12     NM     NM  
 
                                 
Operating income before income tax expense
    182       230       172       (21 )     6  
Income tax expense
    63       86       60       (27 )     5  
 
                                 
Operating earnings
  $ 119     $ 144     $ 112       (17 )     6  
 
                                 
 
Shareholder value added
                                       
Operating earnings
  $ 119     $ 144     $ 112       (17 )%     6 %
Less: Preferred dividends
    1       1       1              
 
                                 
Earnings applicable to common stock
    118       143       111       (17 )     6  
Less: cost of capital
    96       82       82       17       17  
 
                                 
Shareholder value added
  $ 22     $ 61     $ 29       (64 )     (24 )
 
                                 
 
                                       
Average allocated capital
  $ 3,196     $ 2,734     $ 2,773       17       15  
Average assets
    19,757       20,525       17,508       (4 )     13  
Average deposits
    98,951       89,647       74,524       10       33  
Return on average allocated capital
    15 %     21 %     16 %   (600 )bp   (100 )bp
Overhead ratio
    83       79       83       400        
Assets under custody (in billions)
  $ 8,001     $ 7,597     $ 6,269       5 %     28 %
Full-time equivalent employees
    14,738       14,518       14,201       2       4  
 
 
                                       
Revenue by business
                                       
Treasury Services
  $ 535     $ 485     $ 474       10 %     13 %
Investor Services
    399       381       341       5       17  
Institutional Trust Services (a)
    258       252       199       2       30  
Other (a)(b)
    (86 )     (47 )     (88 )     (83 )     2  
 
                                 
Total Treasury & Securities Services
  $ 1,106     $ 1,071     $ 926       3       19  
 
                                 
 

37


 

 
(a)  
Includes a portion of the $41 million gain on the sale of a nonstrategic business in the fourth quarter of 2003: $1 million in Institutional Trust Services and $40 million in Other.
(b)  
Includes the elimination of revenues related to shared activities with Chase Middle Market.
 

TSS reported operating earnings of $119 million, a 6% increase from the first quarter of 2003 and a 17% decrease from the fourth quarter of 2003. Return on average allocated capital for the quarter was 15%, compared with 16% for the first quarter and 21% for the fourth quarter of 2003.

Operating revenue was $1.1 billion in the first quarter of 2004, an increase of 19% and 3% from the first and fourth quarters of 2003, respectively. Fees and commissions were up 25% and 10% from the first and fourth quarters of 2003, respectively, primarily driven by the acquisition of Citigroup’s Electronic Financial Services business by Treasury Services, and by Institutional Trust Services’ acquisitions of Bank One’s corporate trust business and of Financial Computer Software, L.P. In addition, Fees and commissions were higher due to increased debt and equity market appreciation, coupled with increased organic growth (i.e., new business and volume growth of existing clients) at Investor Services and Institutional Trust Services. Excluding the acquisitions, Fees and commissions would have increased by 11% from the first quarter of 2003. Net interest income increased by 8% and 3% from the first and fourth quarters of 2003, respectively, due to higher U.S. and non-U.S. deposits, partially offset by lower interest rate spreads on deposits, attributable to the low–interest rate environment. All other revenue was 26% higher than in the first quarter of 2003, primarily driven by higher foreign exchange revenue, which is the result of increased transaction volume at Investor Services. All other revenue was 47% lower than in the fourth quarter of 2003, which included a $41 million gain on the sale of a nonstrategic business.

Operating expense increased by 20% and 9% from the first and fourth quarters of 2003, respectively. Compensation expense was up 10% and 7% from the first and fourth quarters of 2003, respectively, primarily driven by the aforementioned acquisitions, coupled with staff increases to support the new business and volume growth, as well as higher incentives. Noncompensation expense was up 27% and 14% from the first and fourth quarters of 2003, reflecting the impact of the aforementioned acquisitions, higher professional services for strategic investments and technology projects, and increased costs to support new business and higher volumes. Severance costs were up $3 million from the first quarter of 2003 and down $12 million from the fourth quarter of 2003. In addition, fourth quarter 2003 severance and related costs included $4 million in charges to provide for losses on subletting unoccupied excess real estate. The first quarter 2004 overhead ratio was 83%, compared with 83% and 79% for the first and fourth quarters of 2003, respectively. The increase from the fourth quarter was the result of the aforementioned gain on the sale of a nonstrategic business recorded in the fourth quarter of 2003. Excluding the gain on the aforementioned sale, the fourth quarter 2003 overhead ratio would have been 82%.

Assets under custody of $8.0 trillion in the first quarter of 2004 were 28% and 5% higher than in the first and fourth quarter of 2003, respectively, due to increases in the debt and equity markets as well as new business and organic growth.

Outlook: Management anticipates improving overhead ratios for TSS over the balance of the year, as the expense synergies from the acquisitions by Treasury Services and Institutional Trust Services materialize and as revenues in Investor Services benefit from improving equity markets.

INVESTMENT MANAGEMENT & PRIVATE BANKING

For a discussion of the business profile of IMPB, see pages 34-35 of JPMorgan Chase’s 2003 Annual Report. The following table reflects selected financial data of IMPB:
 
                                         
Selected financial data                           First quarter change
(in millions, except ratios and employees)   1Q 2004     4Q 2003     1Q 2003     4Q 2003     1Q 2003  
 
                             
Revenue
                                       
Fees and commissions
  $ 657     $ 617     $ 510       6 %     29 %
Net interest income
    117       118       116       (1 )     1  
All other revenue
    50       87       15       (43 )     233  
 
                                 
Total operating revenue
    824       822       641             29  
Expense
                                       
Compensation expense
    321       299       283       7       13  
Noncompensation expense
    314       317       296       (1 )     6  
Severance and related costs
    1       19       7       (95 )     (86 )
 
                                 
Total operating expense
    636       635       586             9  
Operating margin
    188       187       55       1       242  
Credit costs
    10       36       6       (72 )     67  
 
                                 
Operating income before income tax expense
    178       151       49       18       263  
Income tax expense
    63       51       22       24       186  
 
                                 
Operating earnings
  $ 115     $ 100     $ 27       15       326  
 
                                 
 

38


 

                                         
Shareholder value added
                                       
Operating earnings
  $ 115     $ 100     $ 27       15 %     326 %
Less: preferred dividends
    2       2       2              
 
                                 
Earnings applicable to common stock
    113       98       25       15       352  
Less: cost of tangible allocated capital
    36       37       37       (3 )     (3 )
 
                                 
Tangible shareholder value added (a)
    77       61       (12 )     26     NM  
Less: cost of goodwill capital
    127       129       125       (2 )     2  
 
                                 
Total shareholder value added
  $ (50 )   $ (68 )   $ (137 )     26       64  
 
                                 
 
                                       
Average tangible allocated capital
  $ 1,316     $ 1,318     $ 1,338             (2 )
Average goodwill capital
    4,152       4,148       4,145              
Average allocated capital
    5,468       5,466       5,483              
Average assets
    35,259       34,108       33,634       3       5  
Return on tangible allocated capital (a)
    36 %     30 %     8 %   600 bp   2,800 bp
Return on average allocated capital
    8       7       2       100       600  
Overhead ratio
    77       77       91             (1,400 )
Full-time equivalent employees
    7,922       7,853       7,647       1 %     4 %
 
(a)  
The Firm uses return on tangible allocated capital and tangible SVA, non-GAAP financial measures, as two of several measures to evaluate the economics of the IMPB business segment. Return on tangible allocated capital and tangible SVA measure return on an economic capital basis (that is, on a basis that takes into account the operational, business, credit and other risks to which this business is exposed, including the level of assets) but excludes the capital allocated for goodwill. The Firm utilizes these measures to facilitate operating comparisons of IMPB to other competitors.
 

IMPB reported operating earnings of $115 million in the first quarter of 2004, an increase of 326% from the first quarter and 15% from the fourth quarter of 2003. Return on average allocated capital for the first quarter of 2004 was 8%, compared with 2% in the first quarter of 2003 and 7% in the fourth quarter of 2003. Return on tangible allocated capital was 36%, compared with 8% in the first quarter of 2003 and 30% in the fourth quarter of 2003. For further information on tangible allocated capital, see footnote (a) in the table above.

Operating revenue was $824 million, 29% higher than in the first quarter of 2003 and flat to the fourth quarter of 2003. Global equity markets continued to improve during the first quarter of 2004 (as exemplified by the S&P 500 index, which rose by 33% since the first quarter of 2003, and the MSCI World index, which rose by 41%). The increase from the prior-year quarter in Fees and commissions primarily reflected global equity market appreciation; the impact of the acquisition of American Century Retirement Plan Services Inc., renamed JPMorgan Retirement Plan Services (“RPS”), in June 2003; and increased brokerage activity. Higher earnings from the Firm’s investment in American Century, in addition to the impact of accounting for the RPS joint venture prior to the acquisition, drove the increase in All other revenue. Additionally, Other revenue for the first quarter of 2003 included a gain on the sale of a Brazilian investment management business, offset by charges incurred at American Century. The increase in Fees and commissions from the prior quarter reflected global equity market appreciation and AUS net inflows, offset by a decline in All other revenue associated with real estate gains recorded in the fourth quarter of 2003.

Operating expense of $636 million was 9% higher compared with the first quarter of 2003 and flat compared with the fourth quarter of 2003. The increase from the year-ago quarter reflected the impact of the acquisition of RPS on compensation and noncompensation expense, as well as higher compensation expense reflecting strong earnings and increased marketing expense; these were offset by real estate and software write-offs taken in the first quarter of 2003. The increase from the prior quarter reflected higher compensation and marketing expense, offset by real estate and software write-offs taken in the fourth quarter of 2003. Credit costs were $10 million, up from $6 million in the prior-year quarter and down from $36 million in the prior quarter, reflecting provisions taken in the fourth quarter of 2003 and the first quarter of 2004.

The overhead ratio for the quarter ending March 31, 2004, was 77%, a decrease from 91% for the quarter ended March 31, 2003, and flat compared with the fourth quarter of 2003. The decrease reflected improved operating leverage, as the beneficial impact of higher market valuations on revenues outpaced growth in expenses.

39


 

                                         
Assets under supervision(a)                           First quarter change
    March 31,     December 31,     March 31,     December 31,     March 31,  
(in billions)   2004     2003     2003     2003     2003  
 
                             
Asset class
                                       
Liquidity
  $ 164     $ 160     $ 144       3 %     14 %
Fixed income
    144       144       144              
Equities and other
    276       255       207       8       33  
 
                                 
Assets under management
    584       559       495       4       18  
Custody/brokerage/administration/deposits
    213       199       127       7       68  
 
                                 
Total assets under supervision
  $ 797     $ 758     $ 622       5       28  
 
                                 
 
                                       
Client segment
                                       
Retail
                                       
Assets under management
  $ 112     $ 101     $ 72       11       56  
Custody/brokerage/administration/deposits
    78       71       17       10       359  
 
                                 
Assets under supervision
    190       172       89       10       113  
Private Bank
                                       
Assets under management
    141       138       125       2       13  
Custody/brokerage/administration/deposits
    135       128       110       5       23  
 
                                 
Assets under supervision
    276       266       235       4       17  
Institutional
                                       
Assets under management
    331       320       298       3       11  
 
                                 
Total assets under supervision
  $ 797     $ 758     $ 622       5       28  
 
                                 
 
                                       
Geographic region
                                       
Americas
                                       
Assets under management
  $ 370     $ 360     $ 350       3       6  
Custody/brokerage/administration/deposits
    183       170       99       8       85  
 
                                 
Assets under supervision
    553       530       449       4       23  
Europe, Middle East & Africa and Asia/Pacific
                                       
Assets under management
    214       199       145       8       48  
Custody/brokerage/administration/deposits
    30       29       28       3       7  
 
                                 
Assets under supervision
    244       228       173       7       41  
 
                                 
Total assets under supervision
  $ 797     $ 758     $ 622       5       28  
 
                                 
 
                                       
Assets under supervision rollforward:
                                       
Beginning balance
  $ 758     $ 720     $ 644       5       18  
Net asset flows
    14       (2 )     (8 )   NM     NM  
Market/other impact (b)
    25       40       (14 )     (38 )   NM  
 
                                 
Ending balance
  $ 797     $ 758     $ 622       5       28  
 
                                 
 
(a)  
Excludes AUM of American Century.
(b)  
Other includes the acquisition of RPS in the second quarter of 2003.
 

Total Assets under supervision at March 31, 2004, of $797 billion were 28% higher than at March 31, 2003, and up 5% from December 31, 2003. Assets under supervision increased from the first quarter of 2003, reflecting market appreciation and, to a lesser extent, the acquisition of RPS and AUS net inflows. The increase from the fourth quarter of 2003 reflected market appreciation and AUS net inflows. Not reflected in Assets under management is the Firm’s 44% equity interest in American Century, whose Assets under management were $90 billion at quarter-end, compared with $71 billion as of the first quarter of 2003 and $87 billion as of the fourth quarter of 2003.

Outlook: IMPB is expected to benefit from improving equity markets, which should result in new inflows while increasing the value of assets under supervision.

40


 

JPMORGAN PARTNERS

For a discussion of the business profile of JPMP, see pages 36–37 of JPMorgan Chase’s 2003 Annual Report. The following table sets forth selected financial data of JPMorgan Partners:
                                         
 
Selected financial data                           First quarter change
(in millions, except employees)   1Q 2004     4Q 2003     1Q 2003     4Q 2003     1Q 2003  
 
                             
Revenue
                                       
Direct investments
                                       
Realized gains
  $ 302     $ 202     $ 46       50 %   NM  
Write-ups / (write-downs / write-offs)
    (23 )     (52 )     (176 )     56       87 %
MTM gains (losses) (a)
    25       48       (6 )     (48 )   NM  
 
                                 
Total direct investments
    304       198       (136 )     54     NM  
Private third-party fund investments
    (8 )     (39 )     (94 )     79       91  
 
                                 
Total private equity gains (losses)
    296       159       (230 )     86     NM  
Net interest income (loss)
    (59 )     (65 )     (71 )     9       17  
Fees and other revenue
    12       11       14       9       (14 )
 
                                 
Total operating revenue
    249       105       (287 )     137     NM  
 
                                       
Expense
                                       
Compensation expense
    38       33       34       15       12  
Noncompensation expense
    32       38       29       (16 )     10  
 
                                 
Total operating expense
    70       71       63       (1 )     11  
 
                                 
Operating income (loss) before income tax expense
    179       34       (350 )     426     NM  
Income tax expense (benefit)
    64       11       (127 )     482     NM  
 
                                 
Operating earnings (loss)
  $ 115     $ 23     $ (223 )     400     NM  
 
                                 
 
                                       
Shareholder value added
                                       
Operating earnings (loss)
  $ 115     $ 23     $ (223 )     400     NM  
Less: Preferred dividends
    2       2       2              
 
                                 
Earnings (loss) applicable to common stock
    113       21       (225 )     438     NM  
Less: cost of capital
    182       210       221       (13 )     (18 )
 
                                 
Shareholder value added
  $ (69 )   $ (189 )   $ (446 )     63       85  
 
                                 
 
                                       
Average allocated capital
  $ 4,899     $ 5,541     $ 5,985       (12 )     (18 )
Average assets
    7,780       8,199       9,428       (5 )     (17 )
Return on average allocated capital
    9 %     1 %   NM     800 bp   NM  
Full-time equivalent employees
    302       316       342       (4 )%     (12 )%
 
 
(a)  
Includes mark-to-market gains (losses) and reversals of mark-to-market gains (losses) due to public securities sales.
 

JPMP reported operating earnings of $115 million for the 2004 first quarter, compared with an operating loss of $223 million in the first quarter of 2003 and operating earnings of $23 million in the fourth quarter of 2003.

Total private equity gains in the first quarter were $296 million, compared with losses of $230 million in the first quarter of 2003 and gains of $159 million in the fourth quarter of 2003. During the first quarter, JPMP’s direct private equity investments recorded net gains of $304 million, compared with a net loss of $136 million in the first quarter of 2003 and a net gain of $198 million in the fourth quarter of 2003. JPMP’s direct private equity results included $302 million in realized gains, mark-to-market gains of $25 million on direct public investments, and net write-downs and write-offs of $23 million taken on direct private investment positions. Limited partner interests in third-party funds resulted in net losses of $8 million, compared with net losses of $94 million and $39 million in the first and fourth quarters of 2003, respectively. First quarter results include a significant realized gain attributable to a private sale completed in the Consumer Retail & Services sector. Overall, JPMP’s performance benefited from active public and private capital markets during the period, which generated opportunities for liquidity events and value recognition through sales, recapitalizations and initial public offerings.

41


 

JPMP investment portfolio

The carrying value of the JPMP private equity portfolio at March 31, 2004, was $6.8 billion, a 6% decrease from December 31, 2003, and a 16% decrease from March 31, 2003. JPMP has exited selected investments that are not central to its portfolio strategy, with the goal to reduce, over time, JPMP’s private equity portfolio to approximately 10%, as adjusted, of the Firm’s common stockholders’ equity. As of March 31, 2004, the portfolio has been reduced to approximately 14%.

The private equity business is highly cyclical, and JPMP’s results are subject to significant volatility associated with the public equity markets, availability of high-yield financing for leveraged buyout transactions and investor appetite for private equity. With improving economic conditions, JPMP may have increased opportunities to exit profitably direct investments as well as make new investments that are anticipated to generate high returns.

JPMP invested $162 million in direct private equity for the Firm’s account during the first quarter of 2004, primarily in buyouts in the Consumer Retail & Services sector.

The following table presents the carrying value and cost of the JPMP investment portfolio for the dates indicated:

 
                                                 
    March 31, 2004   December 31, 2003   March 31, 2003
    Carrying             Carrying             Carrying        
(in millions)   Value     Cost     Value     Cost     Value     Cost  
 
                                   
Public securities (46 companies) (a)(b)
  $ 697     $ 520     $ 643     $ 451     $ 478     $ 624  
Private direct securities (791 companies) (b)
    5,177       6,562       5,508       6,960       5,912       7,439  
Private third-party fund investments (234 funds) (b)(c)
    961       1,512       1,099       1,736       1,780       2,360  
 
                                   
Total investment portfolio
  $ 6,835     $ 8,594     $ 7,250     $ 9,147     $ 8,170     $ 10,423  
 
                                   
% of portfolio to the Firm’s common equity
    15 %             16 %             19 %        
 
                                         
% of portfolio to the Firm’s common equity –
as adjusted (d)
    14 %             15 %             20 %        
 
                                         
 
(a)  
The quoted public value was $1.1 billion at March 31, 2004, $994 million at December 31, 2003, and $685 million at March 31, 2003.
(b)  
Represents the number of companies and funds at March 31, 2004.
(c)  
Unfunded commitments to private equity funds were $1.2 billion at March 31, 2004, $1.3 billion at December 31, 2003, and $1.8 billion at March 31, 2003.
(d)  
For purposes of calculating this ratio, the carrying value excludes the post-December 31, 2002 impact of public MTM valuation adjustments, and the Firm’s common equity excludes SFAS 115 equity balances. The market appreciation or depreciation (i.e., MTM) of public securities since December 31, 2002, has been eliminated, because it would cause the numerator of the ratio to increase or decrease without there having been any additional acquisition or disposition of investments by JPMP. The SFAS 115 equity adjustment has been eliminated because it would cause the amount of JPMorgan Chase’s stockholders’ equity to increase or decrease as a result of changes in the value of the Firm’s AFS securities and thus cause the denominator of the ratio to increase or decrease as a result of changes in the carrying values of securities that have no relation to JPMP’s business. Making these adjustments allows JPMP to track, on a consistent basis, its progress in reducing the carrying values of its investments so that they do not constitute more than 10% of JPMorgan Chase’s total common stockholders’ equity.
 

Outlook: JPMP’s performance is expected to improve as a result of improving equity markets and higher merger activity.

42


 

CHASE FINANCIAL SERVICES

For a description of CFS and a discussion of the profiles for each of its businesses, see pages 38–43 of JPMorgan Chase’s 2003 Annual Report. For information regarding loans and residual interests sold and securitized, see Note 11 on pages 12–14 of this Form 10-Q. The following table reflects selected financial data of CFS:
 
                                         
Selected financial data                           First quarter change
(in millions, except ratios and employees)   1Q 2004     4Q 2003     1Q 2003     4Q 2003     1Q 2003  
 
                             
Revenue
                                       
Net interest income
  $ 2,245     $ 2,447     $ 2,300       (8 )%     (2 )%
Fees and commissions
    876       948       825       (8 )     6  
Securities gains
          18       102     NM    NM 
Mortgage fees and related income
    241       137       432       76       (44 )
All other revenue
    52       59       33       (12 )     58  
 
                                 
Total operating revenue
    3,414       3,609       3,692       (5 )     (8 )
Expense
                                       
Compensation expense
    766       698       720       10       6  
Noncompensation expense
    1,170       1,114       1,064       5       10  
Severance and related costs
    63       53       14       19       350  
 
                                 
Total operating expense
    1,999       1,865       1,798       7       11  
Operating margin
    1,415       1,744       1,894       (19 )     (25 )
Credit costs
    748       855       877       (13 )     (15 )
 
                                 
Operating income before income tax expense
    667       889       1,017       (25 )     (34 )
Income tax expense
    240       330       369       (27 )     (35 )
 
                                 
Operating earnings
  $ 427     $ 559     $ 648       (24 )     (34 )
 
                                 
 
Shareholder value added
                                       
Operating earnings
  $ 427     $ 559     $ 648       (24 )%     (34 )%
Less: preferred dividends
    3       3       3              
 
                                 
Earnings applicable to common stock
    424       556       645       (24 )     (34 )
Less: cost of capital
    283       271       251       4       13  
 
                                 
Total shareholder value added
  $ 141     $ 285     $ 394       (51 )     (64 )
 
                                 
Reconciliation of Average reported assets to Average managed assets
Average reported assets
  $ 174,218     $ 184,215     $ 170,570       (5 )     2  
Average credit card securitization
    33,357       33,445       31,834             5  
 
                                 
Average managed assets
  $ 207,575     $ 217,660     $ 202,404       (5 )     3  
 
                                 
Reconciliation of Average reported loans to Average managed loans
Average reported loans
  $ 153,416     $ 158,923     $ 142,209       (3 )     8  
Average credit card securitization
    33,357       33,445       31,834             5  
 
                                 
Average managed loans
  $ 186,773     $ 192,368     $ 174,043       (3 )     7  
 
                                 
Average allocated capital
  $ 9,472     $ 8,972     $ 8,489       6       12  
Average deposits
    111,228       108,703       105,972       2       5  
Return on average allocated capital
    18 %     25 %     31 %   (700 )bp   (1,300 )bp
Overhead ratio
    59       52       49       700       1,000  
Full-time equivalent employees
    45,306       46,111       44,264       (2 )%     2 %
 

CFS reported first quarter 2004 operating earnings of $427 million, a decrease of 34% and 24% from the first and fourth quarters of 2003, respectively. Return on average allocated capital for the first quarter was 18%, compared with 31% for the first quarter and 25% for the fourth quarter of 2003. Average allocated capital increased by 12% from the first quarter of 2003 and 6% from the fourth quarter of 2003, primarily due to an increase in market risk capital that is associated with the MSR risk management activities of Chase Home Finance.

Operating revenue was $3.4 billion, a decrease of 8% and 5% from the first and fourth quarters of 2003, respectively. The national consumer credit businesses, which includes Chase Home Finance, Chase Cardmember Services and Chase Auto Finance, contributed 74% of first quarter 2004 operating revenue. The declines in revenue were primarily driven by the anticipated slowdown in the mortgage refinance business, as well as the continued negative impact of the low–interest rate environment on the deposit businesses. Net interest income of $2.2 billion was down 2% and 8% from the first and fourth quarters of 2003, respectively, primarily due to lower interest on a lower level of AFS securities used to manage the interest rate risk associated with MSRs and lower spreads as a result of low interest rates. Fees and commissions increased by 6% from the first quarter of 2003, driven by higher credit card interchange fees due to higher consumer purchases, and decreased by 8% from the fourth quarter of 2003 due to seasonally lower

43


 

credit card revenue. Securities gains declined from the first and fourth quarters of 2003, primarily due to fewer securities sales associated with MSR risk management activities. Mortgage fees and related income of $241 million decreased from $432 million in the first quarter of 2003 and increased from $137 million in the fourth quarter of 2003. First quarter 2004 mortgage originations were lower when compared with both the first and fourth quarters of 2003, due to the decline in the mortgage refinance market. First quarter 2004 MSR hedging revenue improved over the fourth quarter of 2003.

Operating expense of $2.0 billion was up 11% and 7% compared with the first and fourth quarters of 2003, respectively. Compensation expense increased from both the first and fourth quarters of 2003. The increase from the year-ago quarter was primarily due to higher home equity production, as well as increases in the sales force for home equity and other higher-margin distribution channels. The increase in compensation expense from the fourth quarter was primarily due to higher salaries, benefits and incentives. Noncompensation expense increased from the prior periods primarily due to higher marketing costs, professional services and volume-related expenses. Severance and related costs increased from the prior periods due to restructuring in various lines of businesses, particularly in Chase Regional Banking; costs incurred to move certain credit card facilities to a lower-cost location; and, to a lesser extent, severance related to the anticipated merger with Bank One. CFS’s overhead ratio was 59%, compared with 49% for the first quarter of 2003 and 52% for the fourth quarter of 2003, reflecting a decline in revenue and the higher level of expenses. Savings generated by Six Sigma and other productivity efforts continued to partially offset the growth in expenses.

Credit costs of $748 million were down 15% from the first quarter and 13% from the fourth quarter of 2003. The declines reflected lower net charge-offs of 5% and 3% compared with the first and fourth quarters of 2003, respectively, and a reduction in the allowance for loan losses, reflecting improved credit quality. Delinquency rates in the consumer loan portfolios decreased compared with the first and fourth quarters of 2003.

The following table sets forth certain key financial performance measures of the businesses within CFS:

 
                                         
(in millions)                           First quarter change
Operating revenue   1Q 2004     4Q 2003     1Q 2003     4Q 2003     1Q 2003  
 
                             
Home Finance(a)
  $ 813     $ 867     $ 1,148       (6 )%     (29 )%
Cardmember Services
    1,562       1,620       1,461       (4 )     7  
Auto Finance
    166       207       198       (20 )     (16 )
Regional Banking
    635       653       630       (3 )     1  
Middle Market
    343       359       362       (4 )     (5 )
Other consumer services(b)
    (105 )     (97 )     (107 )     (8 )     2  
 
                                 
Total operating revenue
  $ 3,414     $ 3,609     $ 3,692       (5 )     (8 )
 
                                 
Operating expense
                                       
Home Finance
  $ 478     $ 484     $ 382       (1 )     25  
Cardmember Services
    605       561       539       8       12  
Auto Finance
    81       77       68       5       19  
Regional Banking
    635       645       576       (2 )     10  
Middle Market
    219       211       216       4       1  
Other consumer services(b)
    (19 )     (113 )     17       83     NM 
 
                                 
Total operating expense
  $ 1,999     $ 1,865     $ 1,798       7       11  
 
                                 
Credit costs
                                       
Home Finance
  $ (9 )   $ 13     $ 107     NM    NM 
Cardmember Services
    706       792       695       (11 )     2  
Auto Finance
    36       41       68       (12 )     (47 )
Regional Banking
    28       18       8       56       250  
Middle Market
    (13 )     (9 )     (1 )     (44 )   NM  
Other consumer services(b)
                    NM    NM 
 
                                 
Total credit costs
  $ 748     $ 855     $ 877       (13 )     (15 )
 
                                 
Operating earnings (losses)
                                       
Home Finance
  $ 221     $ 237     $ 424       (7 )     (48 )
Cardmember Services
    162       172       146       (6 )     11  
Auto Finance
    30       53       37       (43 )     (19 )
Regional Banking
    (15 )     (5 )     27       (200 )   NM  
Middle Market
    80       92       87       (13 )     (8 )
Other consumer services(b)
    (51 )     10       (73 )   NM       30  
 
                                 
Total operating earnings
  $ 427     $ 559     $ 648       (24 )     (34 )
 
                                 
 
(a)  
Includes Mortgage fees and related income, Net interest income and Securities gains.
(b)  
Includes the elimination of revenues and expenses related to the shared activities with Treasury Services, and support services.
 

44


 

Outlook: CHF revenues and operating earnings are expected to decline for the remainder of the year as higher interest rates are likely to depress mortgage originations; however, management expects expenses at CHF to moderate in future quarters to reflect the reduced origination volume. CFS’ credit quality in consumer lending is expected to remain stable for the next several quarters.

Chase Home Finance

The following table sets forth key revenue components of Chase Home Finance’s business:
 
                                         
(in millions)                           First quarter change
Revenue   1Q 2004     4Q 2003     1Q 2003     4Q 2003     1Q 2003  
 
                             
Home Finance:
                                       
Operating revenue (excluding MSR hedging revenue)
  $ 820     $ 950     $ 1,062       (14 )%     (23 )%
MSR hedging revenue:
                                       
MSR valuation adjustments(a)
    (685 )     229       (473 )   NM       (45 )
Hedging gains (losses)(b)
    678       (312 )     559     NM      21  
 
                                 
Total MSR hedging revenue
    (7 )     (83 )     86       92     NM 
 
                                 
Total revenue(c)
  $ 813     $ 867     $ 1,148       (6 )     (29 )
 
                                 
 
(a)  
See MSR valuation adjustment table on page 46 of this Form 10-Q.
(b)  
Hedging gains (losses) includes SFAS 133 qualifying hedges of $546 million, $(465) million and $386 million for the first quarter of 2004, fourth quarter of 2003 and first quarter of 2003, respectively.
(c)  
Includes Mortgage fees and related income, Net interest income and Securities gains.
 

After a record performance in 2003, Chase Home Finance (“CHF”) reported operating earnings of $221 million, a decrease of 48% and 7% from the first and fourth quarters of 2003, respectively. For the first quarter of 2004, total revenue of $813 million decreased by 29% and 6% from the first and fourth quarters of 2003, respectively. During the first quarter, CHF operating revenue declined by 23% and 14% from the first and fourth quarters of 2003, respectively, as higher interest rates and a smaller refinance market lowered mortgage originations and margins. As described below, MSR hedging revenue declined relative to the first quarter of 2003 but increased by 92% relative to the fourth quarter of 2003.

CHF manages and measures its results from two key perspectives: its operating businesses (Production, Servicing and Portfolio Lending) and revenue generated through managing the interest rate risk associated with MSRs. The following table reconciles management’s perspective on CHF’s results to the reported GAAP line items shown on the Consolidated statement of income and in the related Notes to consolidated financial statements:

 
                                                                         
    Operating basis revenue      
    Operating   MSR hedging   Reported
(in millions)   1Q 2004     4Q 2003     1Q 2003     1Q 2004     4Q 2003     1Q 2003     1Q 2004     4Q 2003     1Q 2003  
 
                                                     
Net interest income
  $ 539     $ 634     $ 485     $ 38     $ 80     $ 134     $ 577     $ 714     $ 619  
Securities gains
                      (4 )     13       96       (4 )     13       96  
Mortgage fees and related income
    281       316       577       (41 )     (176 )     (144 )     240       140       433  
 
Total
  $ 820     $ 950     $ 1,062     $ (7 )   $ (83 )   $ 86     $ 813     $ 867     $ 1,148  
 

On an operating basis, Net interest income of $539 million declined from the fourth quarter of 2003, as CHF’s average loans declined. Offsetting the decline and driving the increase in Net interest income over the first quarter of 2003 was an increase in home equity balances, driven by origination growth of 60% over the first quarter of 2003. Home equity originations were down 8% compared with the fourth quarter of 2003, although applications were up 36%. Mortgage fees and related income were down compared with the first and fourth quarters of 2003, driven by lower origination volume of $38 billion versus $62 billion and $51 billion, respectively, in the first and fourth quarters of 2003. The declines reflect the smaller refinance market and price competition. Increases in servicing revenues of 7% and 14% over the first and fourth quarters of 2003, respectively, partially offset the decline in production revenue. Servicing balances as of March 31, 2004, were $475 billion, an increase of 10% from March 31, 2003, and 1% from December 31, 2003, the result of lower prepayments.

In its risk management activities, CHF uses a combination of derivatives and AFS securities to manage changes in the market value of MSRs. The intent is to offset any changes in the market value of MSRs with changes in the market value of the related risk management instrument. During the first quarter of 2004, negative MSR valuation adjustments of $685 million were partially offset by $678 million of aggregate derivative gains and net interest earned on AFS securities. Unrealized losses on AFS securities were $71 million at March 31, 2004, and $144 million at December 31, 2003. The decline in the Net interest income and Securities gains components of MSR revenue from the first and fourth quarters of 2003 is primarily due to a lower level of AFS securities used to

45


 

manage the interest rate risk associated with MSRs. The improvement in the Mortgage fees and related income component of MSR revenue from the first and fourth quarters of 2003 reflects the mix of instruments used to manage the interest rate risk associated with MSRs at any point in time and the impact of market conditions on those instruments rather than a particular trend. For a further discussion of the most significant assumptions used to value MSRs, please see “MSRs and certain other retained interests” in the Critical Accounting Estimates used by the Firm section and in Notes 13 and 16 on pages 100–103 and 107–109 of JPMorgan Chase’s 2003 Annual Report.

The following table reconciles the amounts shown as MSR valuation adjustments of CHF’s business:

 
                 
MSR Valuation Adjustments   Three months ended March 31,
(in millions)   2004     2003  
 
           
Reported amounts:
               
SFAS 133 hedge valuation adjustments
  $ (586 )   $ (175 )
SFAS 140 impairment (recovery) adjustments
    (34 )     (130 )
Purchased servicing acquisition losses(a)
    (9 )     (44 )
Management accounting adjustments(b)
    (56 )     (124 )
 
           
MSR valuation adjustments
  $ (685 )   $ (473 )
 
           
 
(a)  
Reflects valuation adjustments on purchased servicing, through the settlement date, that are included in MSR additions in the table in Note 14 on pages 17–18 of this Form 10-Q.
(b)  
Reflects management accounting adjustments to properly attribute MSR hedging revenue between CHF’s operating business and management of the mortgage servicing asset.
 

Operating expense of $478 million increased by 25% from the first quarter of 2003 and decreased by 1% from the fourth quarter of 2003. The increase compared with the year-ago quarter was due to higher home equity production, as well as increases in the sales force for home equity and other higher-margin distribution channels. In the first two months of the first quarter of 2004, application volumes dropped dramatically but then rebounded in March; expenses, however, remained stable throughout the quarter. Higher expenses coupled with lower operating revenues increased CHF’s overhead ratio to 59%, as compared with 33% in the first quarter of 2003. Lower operating revenues drove the increase in CHF’s overhead ratio as compared with 56% in the fourth quarter of 2003.

Credit costs of negative $9 million decreased from both the first and fourth quarters of 2003. The decline from the prior-year quarter was primarily a result of weakness in the manufactured housing market in the beginning of 2003. The decrease from the fourth quarter of 2003 was due to a lower overall level of both actual and expected net charge-offs, which drove a reduction in the allowance for loan losses. Credit quality remained strong as the net charge-off rate for the first quarter of 2004 was 0.16%, down from 0.20% and 0.19% in the first and fourth quarters of 2003, respectively.

Chase Cardmember Services

Operating earnings at Chase Cardmember Services (“CCS”) of $162 million increased by 11% from the first quarter of 2003 and decreased by 6% from the fourth quarter of 2003. The increase from the first quarter of last year was driven by higher revenue, partly offset by higher marketing and severance-related costs. The decrease from the fourth quarter of last year was attributable to seasonally lower purchase volume and higher marketing and severance-related costs, partly offset by lower credit costs.

CCS’s operating results exclude the impact of credit card securitizations on revenue, the provision for credit losses, net charge-offs and receivables. Securitization does not change CCS’s reported net income versus operating earnings; however, it does affect the classification of items on the Consolidated statement of income. The financial information presented below reconciles reported basis and managed basis to disclose the effect of securitizations.

 
                                                                         
    1Q 2004   4Q 2003   1Q 2003
            Effect of                     Effect of                     Effect of        
(in millions)   Reported     securitization     Operating     Reported     securitization     Operating     Reported     securitization     Operating  
 
                                                     
Revenue
  $ 1,089     $ 473     $ 1,562     $ 1,158     $ 462     $ 1,620     $ 1,004     $ 457     $ 1,461  
Expense
    605             605       561             561       539             539  
Credit costs
    233       473       706       330       462       792       238       457       695  
Operating earnings
    162             162       172             172       146             146  
 
Average loans
  $ 18,216     $ 33,357     $ 51,573     $ 17,610     $ 33,445     $ 51,055     $ 19,024     $ 31,834     $ 50,858  
Average assets
    18,524       33,357       51,881       18,171       33,445       51,616       19,763       31,834       51,597  
 

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Operating revenue was $1.6 billion, up 7% from the first quarter of 2003 and down 4% from the fourth quarter of 2003. The increase in revenue from last year reflected growth in both net interest and noninterest revenue. Net interest revenue increased by 5%, reflecting lower funding costs and growth in average managed loans. Average managed loans increased by 1% from a year ago, due partly to lower balance transfer volume and to higher payment rates, which reflected high consumer liquidity. Consumer liquidity remained high because of increased use of home equity products as well as lower tax rates. As a consequence, the volume of purchases increased during the quarter, and the rate of payments was high. Noninterest revenue increased by 10%, reflecting higher interchange fees primarily due to 15% growth in purchase volume. The increase in purchase volume also reflects the continued strategic shift in the portfolio towards higher-volume, rewards-based products, as well as organic growth. CCS added more than one million new accounts in the first quarter, the sixth consecutive quarter of account additions at this level. The decline in revenue from the fourth quarter of 2003 was due to seasonally higher fourth quarter consumer purchases associated with the holiday season.

Operating expense of $605 million increased by 12% from the first quarter and 8% from the fourth quarter of 2003. The increase in expenses from both periods primarily reflected higher marketing expenses and higher severance and related costs, including expenses related to moving certain operations to lower cost locations. The overhead ratio increased to 39% from 37% and 35% in the first and fourth quarters of 2003, respectively. The increase in the overhead ratio from the first quarter of last year was primarily attributed to increased marketing costs to attract and retain customers. The increase from the fourth quarter of last year primarily reflects lower seasonal revenue as well as increased marketing costs.

Credit costs increased by 2% from the first quarter of 2003 and declined by 11% from the fourth quarter of 2003. Credit quality improved, with the managed net charge-off rate declining to 5.80% in the first quarter of 2004 from 5.95% in the first quarter of 2003. The decline in credit costs from the fourth quarter reflected a decrease in the allowance for loan losses. The managed net charge-off rate increased from 5.76% in the fourth quarter of 2003, due primarily to seasonality associated with higher delinquencies in the second half of last year. The 30+ day delinquency rate improved from first and fourth quarter levels.

Chase Auto Finance

Results at Chase Auto Finance (“CAF”) consist of the Auto Finance and Education Finance businesses. CAF’s operating earnings of $30 million decreased by 19% from the first quarter and 43% from the fourth quarter of 2003. The decrease in operating earnings was driven primarily by a $40 million write-off of prepaid premiums for residual risk insurance, which resulted in a reduction of leasing revenue recognized during the current quarter, and higher operating expenses, partially offset by lower credit costs. The write-off was a result of a review in which it was determined that there was an accelerated pace of lease payments and terminations. CAF’s operating revenue declined by 16% from the first quarter and 20% from the fourth quarter of 2003, due to the reduction in leasing revenue mentioned above and lower portfolio spreads, partially mitigated by higher average loans outstanding. Despite an extremely competitive marketing environment, CAF’s auto origination volume increased by 24% compared with the fourth quarter of 2003, and market share remained stable to year-end 2003 at 6.1%.

Operating expense of $81 million was up 19% from the first quarter and 5% from the fourth quarter of 2003. The increase from the year-ago quarter was driven by higher compensation expense, due to volume growth and corresponding increases in staff, and higher performance-based incentives. The increase from the fourth quarter of 2003 was driven primarily by continued portfolio growth, higher compensation expense and slightly higher technology costs. The overhead ratio increased to 49% in the first quarter, up from 34% and 37% in the first and fourth quarters of 2003, respectively, primarily due to the reduction in leasing revenue and higher expenses.

Credit costs of $36 million decreased by 47% from the first quarter and 12% from the fourth quarter of 2003, due to lower net charge-offs and a lower allowance for loan losses as a result of improved credit quality. The net charge-off rate was 0.36% in the first quarter of 2004, down from 0.48% in the first quarter and 0.39% in the fourth quarter of 2003. The 30+ day delinquency rate decreased to 1.10% in the first quarter of 2004, from 1.27% in the first quarter and 1.46% in the fourth quarter of 2003. The 30+ day delinquency rate was the lowest since June 30, 2002.

Chase Regional Banking

Chase Regional Banking (“CRB”) reported an operating loss of $15 million in the first quarter, down from operating earnings of $27 million in the first quarter of 2003 and an operating loss of $5 million in the fourth quarter of 2003. The decrease from the year-ago quarter primarily resulted from higher expense and credit costs, partially offset by slightly higher revenue. The decrease from the fourth quarter of 2003 was primarily due to lower revenue and higher credit costs, partially offset by lower expense.

Operating revenue of $635 million increased by 1% from the first quarter of 2003 and decreased by 3% from the fourth quarter of 2003. Despite lower spreads, growth in average deposits of 10% from the first quarter of 2003 resulted in Net interest income being up slightly. The decline in revenue from the fourth quarter of 2003 was due to narrower spreads and lower noninterest revenue

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related to seasonal declines in deposit service fees, and lower debit card and investment revenues. Average deposits increased by 4% from the fourth quarter of 2003.

Operating expense was up 10% from the comparable 2003 period and down 2% from the fourth quarter of 2003. The increase from the prior-year quarter reflected higher severance and related costs primarily due to restructuring, and higher compensation costs. The decrease from the fourth quarter of 2003 was primarily related to the timing of marketing and professional services expenses. The overhead ratio for the quarter was 100%, up from 91% and 99% in the first and fourth quarters of 2003, respectively. The increase from the first quarter of 2003 was due to higher expenses, while the increase from the fourth quarter was due to lower revenue.

Credit costs of $28 million were up from $8 million and $18 million, respectively, in the first and fourth quarters of 2003. The increase from the prior-year quarter was the result of a higher allowance for loan losses. The increase from the fourth quarter of 2003 was due to a higher allowance for loan losses, partially offset by lower net charge-offs.

As of March 31, 2004, CRB’s deposit mix was 18% demand, 14% interest checking, 47% savings, 11% money market and 10% time (CDs). At March 31, 2003, the deposit mix was 18% demand, 14% interest checking, 46% savings, 9% money market and 13% time (CDs). As of March 31, 2004, core deposits (total deposits less time deposits) grew by 13% from March 31, 2003, and 4% from December 31, 2003.

Chase Middle Market

Chase Middle Market (“CMM”) operating earnings of $80 million were down 8% from the first quarter and 13% from the fourth quarter of 2003. The decrease from both periods was primarily attributable to lower revenues, partially offset by improved credit quality.

Operating revenue of $343 million decreased by 5% from the first quarter and 4% from the fourth quarter of 2003. The decrease from the year-ago quarter was primarily due to lower Net interest income, driven by a 4% decrease in average loans and narrower loan and deposit spreads, partially offset by an 11% increase in average deposits. The decrease from the fourth quarter was due to lower Net interest income, reflecting narrower loan and deposit spreads, partially offset by a 2% increase in average loans and a 9% increase in average deposits.

Operating expenses of $219 million in the quarter were up 1% from the first quarter and 4% from the fourth quarter of 2003. The increase from the first quarter of 2003 was driven by higher performance-based incentives, partially offset by lower severance and related costs. The increase from the fourth quarter was driven by higher incentives and higher severance and related costs. The overhead ratio for the quarter was 64%, up from 60% and 59% in the first and fourth quarters of 2003, respectively, due to the decline in revenue and increase in expenses.

Lower net charge-offs and a reduction in the allowance for loan losses compared with the first and fourth quarters of 2003 resulted in credit costs of negative $13 million.

48


 

CHASE FINANCIAL SERVICES
QUARTERLY BUSINESS-RELATED METRICS

                                         
                            First quarter change
(in billions, except ratios and where otherwise noted)   1Q 2004     4Q 2003     1Q 2003     4Q 2003     1Q 2003  
 
                             
Chase Home Finance
                                       
Origination volume by channel:
                                       
Retail, wholesale and correspondent
  $ 30.1     $ 37.0     $ 40.8       (19 )%     (26 )%
Correspondent negotiated transactions
    7.7       14.0       21.2       (45 )     (64 )
 
                                 
Total
    37.8       51.0       62.0       (26 )     (39 )
Origination volume by product:
                                       
First mortgage
  $ 31.1     $ 43.7     $ 57.8       (29 )     (46 )
Home equity
    6.7       7.3       4.2       (8 )     60  
 
                                 
Total
    37.8       51.0       62.0       (26 )     (39 )
Loans serviced
    475       470       432       1       10  
End-of-period outstandings
    75.0       73.7       67.3       2       11  
Total average loans owned
    72.1       79.4       64.4       (9 )     12  
Number of customers (in millions)
    4.1       4.1       4.0             2  
MSR carrying value
    4.2       4.8       3.2       (13 )     31  
30+ day delinquency rate
    1.32 %     1.81 %     2.31 %   (49 )bp   (99 )bp
Net charge-off ratio
    0.16       0.19       0.20       (3 )     (4 )
Overhead ratio
    59       56       33       300       2,600  
 
Chase Cardmember Services – Reported Basis
                                       
Average outstandings
  $ 17.2     $ 16.6     $ 19.0       4 %     (9 )%
30+ day delinquency
    3.18 %     3.34 %     3.41 %   (16 )bp   (23 )bp
Net charge-off ratio
    6.33       6.68       6.17       (35 )     16  
Overhead ratio
    56       48       54       800       200  
 
Chase Cardmember Services–Managed Basis
                                       
End-of-period outstandings
  $ 51.0     $ 52.3     $ 50.6       (2 )%     1 %
Average outstandings
    51.6       51.1       50.9       1       1  
Total volume(a)
    22.0       23.9       20.7       (8 )     6  
New accounts (in millions)
    1.0       1.0       1.1             (9 )
Active accounts (in millions)
    16.5       16.5       16.5              
Total accounts (in millions)
    30.8       30.8       29.8             3  
Credit cards issued
    35.4       35.3       33.9             4  
30+ day delinquency rate
    4.43 %     4.68 %     4.59 %   (25 )bp   (16 )bp
Net charge-off ratio
    5.80       5.76       5.95       4       (15 )
Overhead ratio
    39       35       37       400       200  
 
Chase Auto Finance
                                       
Loan and lease receivables
  $ 44.0     $ 43.2     $ 41.1       2 %     7 %
Average loan and lease receivables
    44.3       43.5       39.6       2       12  
Automobile origination volume
    6.8       5.5       7.4       24       (8 )
Automobile market share (year-to-date)
    6.1 %     6.1 %     6.7 %   bp   (60 )bp
30+ day delinquency rate
    1.10       1.46       1.27       (36 )     (17 )
Net charge-off ratio
    0.36       0.39       0.48       (3 )     (12 )
Overhead ratio
    49       37       34       1,200       1,500  
 
Chase Regional Banking
                                       
Total average deposits
  $ 79.9     $ 77.1     $ 72.6       4 %     10 %
Total client assets(b)
    118.4       111.1       105.3       7       12  
Number of branches/banking centers
    532       529       527       1       1  
Number of ATMs
    1,718       1,730       1,870       (1 )     (8 )
Overhead ratio
    100 %     99 %     91 %   100 bp   900 bp
 
Chase Middle Market
                                       
Total average loans
  $ 13.8     $ 13.5     $ 14.4       2 %     (4 )%
Total average deposits
    31.6       28.9       28.4       9       11  
Nonperforming average loans as a % of total average loans
    0.91 %     1.00 %     1.41 %   (9 )bp   (50 )bp
Net charge-off ratio
    (0.03 )     0.16       0.75       (19 )     (78 )
Overhead ratio
    64       59       60       500       400  
 
(a)  
Sum of total customer purchases, cash advances and balance transfers.
(b)  
Deposits, money market funds and/or investment assets (including annuities).
 

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SUPPORT UNITS AND CORPORATE
 
                                         
                            First quarter change
(in millions, except employees)   1Q 2004     4Q 2003     1Q 2003     4Q 2003     1Q 2003  
 
                             
Operating revenue
  $ (122 )   $ (123 )   $ (119 )     1 %     (3 )%
Operating expense
    71       (35 )     41     NM      73  
Credit costs
    (83 )     (49 )     71       (69 )   NM  
 
                                 
Pre-tax loss
    (110 )     (39 )     (231 )     (182 )     52  
Income tax benefit
    (154 )     (215 )     (170 )     28       9  
 
                                 
Operating earnings (loss)
  $ 44     $ 176     $ (61 )     (75 )   NM  
 
                                 
Average allocated capital
  $ 6,810     $ 4,498     $ (1,743 )     51     NM 
Average assets
    20,321       20,130       21,325       1       (5 )
Shareholder value added
    (122 )     81       35     NM    NM 
Full-time equivalent employees
    10,207       10,088       13,026       1       (22 )
 

The Support Units and Corporate sector includes technology, legal, audit, finance, human resources, risk management, real estate management, procurement, executive management and marketing groups within Corporate. For a further discussion of the business profiles of these Support Units as well as a description of Corporate, see page 44 of JPMorgan Chase’s 2003 Annual Report.

Support Units and Corporate reflects the application of the Firm’s management accounting policies at the corporate level. These policies allocate the costs associated with technology, operational and staff support services to the business segments, with the intent to recover all expenditures associated with these services. Other items are retained within Support Units and Corporate based on policy decisions, such as the over/under allocation of average allocated capital, the residual component of credit costs and taxes. Business segment revenues are reported on a tax-equivalent basis, with the offset reflected in Support Units and Corporate; see Note 22 on pages 22–23 of this Form 10-Q.

For the first quarter of 2004, Support Units and Corporate reported operating earnings of $44 million, compared with an operating loss of $61 million in the first quarter of 2003 and operating earnings of $176 million in the fourth quarter of 2003. Operating earnings in the first quarter of 2004 were driven primarily by higher capital and lower credit costs.

In allocating the allowance (and provision) for credit losses, each business is responsible for its credit costs. Although the Support Units and Corporate sector has no traditional credit assets, the residual component of the allowance, which is available for losses in any business segment, is maintained at the corporate level. For a further discussion of the residual component, see Summary of changes in the Allowance for credit losses on pages 65–66 of this Form 10-Q.

Average allocated capital was $8.6 billion higher than in the first quarter of 2003 and $2.3 billion higher than in the fourth quarter, reflecting a reduction in credit risk capital allocated to the business segments and an increase in common stockholders’ equity.

The Firm’s operating expenses reflected a shift of $115 million from Compensation and Other expense to Technology and communications expense due to the technology infrastructure outsourcing that took effect on April 1, 2003. For additional disclosure, see Results of operations on page 28–29 of this Form 10-Q.

 

RISK AND CAPITAL 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, business, fiduciary, liquidity and private equity risk. For a discussion of these risks and definitions of terms associated with managing these risks, see pages 45–74 and the Glossary of terms in JPMorgan Chase’s 2003 Annual Report.

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CAPITAL AND LIQUIDITY MANAGEMENT
 

CAPITAL MANAGEMENT

 
The following discussion of JPMorgan Chase’s capital management focuses primarily on developments since December 31, 2003, and should be read in conjunction with pages 46–47 and Note 26 of JPMorgan Chase’s 2003 Annual Report.
                 
Available versus required capital   Quarterly Averages
(in billions)   1Q 2004     1Q 2003  
 
           
Common stockholders’ equity
  $ 45.8     $ 41.9  
Economic risk capital:
               
Credit risk
    9.5       15.1  
Market risk
    5.6       4.2  
Operational risk
    3.4       3.5  
Business risk
    1.7       1.7  
Private equity risk
    4.6       5.4  
 
           
Economic risk capital
    24.8       29.9  
Goodwill / Intangibles
    9.5       8.9  
Asset capital tax
    3.9       4.0  
 
           
Capital against nonrisk factors
    13.4       12.9  
 
           
Total capital allocated to business activities
    38.2       42.8  
 
               
Diversification effect
    (5.3 )     (5.0 )
 
           
Total required internal capital
  $ 32.9     $ 37.8  
 
           
Firm capital in excess of required capital
$ 12.9     $ 4.1  
 
           
 

Economic risk capital:

JPMorgan Chase assesses capital adequacy utilizing internal risk assessment methodologies. The Firm assigns economic capital based primarily on five risk factors: credit risk, market risk, operational risk and business risk for each business, and private equity risk, principally for JPMP. The methodologies quantify these risks and assign capital accordingly. These methodologies are discussed in the risk management sections of JPMorgan Chase’s 2003 Annual Report.

Capital also is assessed against business units for certain nonrisk factors. Businesses are assessed capital equal to 100% of any goodwill and 50% for certain other intangibles generated through acquisitions. Additionally, the Firm assesses an “asset capital tax” against managed assets and some off–balance sheet instruments. These assessments recognize that certain minimum regulatory capital ratios must be maintained by the Firm. JPMorgan Chase also estimates the portfolio effect on required economic capital, based on correlations of risk across risk categories. This estimated diversification benefit leads to a reduction in required economic capital for the Firm.

The Firm’s capital in excess of that which is internally required as of March 31, 2004, increased by $8.8 billion over March 31, 2003. The change was primarily due to an increase in average common stockholders’ equity of $3.9 billion, a $5.6 billion reduction in credit risk capital and a $0.8 billion reduction in private equity capital, partially offset by a $1.4 billion increase in market risk capital. The decrease in credit risk capital from the prior year was primarily due to a reduction in commercial exposures and improvement in the credit quality of the commercial portfolio. Private equity risk decreased primarily as a result of the reduction in JPMP’s private equity portfolio. Market risk capital increased, due to growth in the MSR portfolio in CHF as well as higher average trading VAR in IB.

Regulatory capital

JPMorgan Chase’s risk-based capital ratios at March 31, 2004, were well in excess of minimum regulatory guidelines. At March 31, 2004, Tier 1 and Total capital ratios were 8.4% and 11.4%, respectively, and the Tier 1 leverage ratio was 5.9%. At March 31, 2004, the total capitalization of JPMorgan Chase (the sum of Tier 1 and Tier 2 capital) was $60.9 billion, an increase of $1.1 billion from December 31, 2003. This increase was principally driven by a $1.5 billion increase in Tier 1 capital, reflecting $1.2 billion in retained earnings (net income less common and preferred dividends) generated during the period and net stock issuance of $0.5 billion related to employee benefit plans, partially offset by a decrease in the allowance for credit losses component of Tier 2 capital.

51


 

During 2003, the Firm adopted FIN 46 and, as a result, deconsolidated the trusts that issue trust preferred securities. If banking regulators were to exclude these securities from Tier 1 capital, it could significantly reduce the Tier 1 capital ratio of the Firm. On July 2, 2003, the Federal Reserve Board issued a supervisory letter instructing banks and bank holding companies to continue to include trust preferred securities in Tier 1 capital. Based on the terms of this letter and in consultation with the Federal Reserve Board, the Firm continues to include its trust preferred securities in Tier 1 capital.

Stock repurchase

The Firm did not repurchase any shares of its common stock during the first quarter of 2004 or all of 2003. At the time the Firm and Bank One announced their proposed merger, managements at the two firms announced their intention to repurchase shares in an aggregate amount of approximately $3.5 billion annually in 2004, 2005 and 2006 (in addition to shares repurchased to provide common stock required for both firms’ respective dividend-reinvestment and employee equity-based plans). The aforementioned repurchase program was made based on both firms’ respective managements’ determinations that, based upon market conditions, current business plans and expectations for the combined company, stock repurchases present an attractive use of excess capital. The actual amount of shares repurchased will be subject to the discretion of the combined company’s Board of Directors considering factors which include: market conditions; legal considerations; the combined company’s capital position (taking into account purchase accounting adjustments); internal capital generation; and alternative potential investment opportunities over that time frame.

Dividends

In the first quarter of 2004, JPMorgan Chase declared a quarterly cash dividend on its common stock of $0.34 per share, payable April 30, 2004, to stockholders of record at the close of business April 6, 2004.

LIQUIDITY MANAGEMENT

The following discussion of JPMorgan Chase’s liquidity management focuses primarily on developments since December 31, 2003, and should be read in conjunction with pages 47–48 of JPMorgan Chase’s 2003 Annual Report. In managing liquidity, management considers a variety of liquidity risk measures as well as market conditions, prevailing interest rates, liquidity needs and the desired maturity profile of its liabilities.

Consistent with its liquidity management policy, the Firm has raised funds at the holding company sufficient to cover maturing obligations over the next 12 months. Long-term funding needs for the parent holding company over the next several quarters are expected to be consistent with prior periods. The Firm manages its liquidity through a combination of short- and long-term sources of funds to support its balance sheet and its businesses. Under the Firm’s liquidity risk management framework, the Firm maintains sufficient levels of long-term liquidity through a combination of long-term debt, preferred stock, common equity and core deposits to support the less liquid assets on its balance sheet. The Firm’s primary source of short-term funds, excluding unsecured borrowings, includes more than $40 billion of securities available for repurchase agreements and approximately $30 billion of credit card, automobile and mortgage loans available for securitization.

Credit ratings

The credit ratings of JPMorgan Chase’s parent holding company and JPMorgan Chase Bank as of April 30, 2004, were as follows:
 
                 
    JPMorgan Chase   JPMorgan Chase Bank
    Short-term debt   Senior long-term debt   Short-term debt   Senior long-term debt
Moody’s
   P-1    A1    P-1    Aa3
S&P
  A-1   A+   A-1+   AA-
Fitch
  F1   A+   F1   A+
 

Upon the announcement of the proposed merger with Bank One, Moody’s and Fitch placed the ratings of the Firm under review for possible upgrade, while S&P affirmed the Firm’s ratings.

The cost and availability of unsecured financing are influenced by credit ratings. A reduction in these ratings could adversely impact the Firm’s access to liquidity sources, increase the cost of funds, trigger additional collateral requirements and decrease the number of investors and counterparties willing to lend. If the Firm’s ratings were downgraded by one notch, the Firm estimates that the incremental cost of funds to be in the range of 5 basis points to 30 basis points, reflecting a range of terms from three to five years, and the potential loss of funding to be negligible. Additionally, the Firm estimates the additional funding requirements for SPE and

52


 

other third-party commitments to be relatively modest. In the current environment, the Firm believes the likelihood of a downgrade is remote. For additional information on the impact of a credit ratings downgrade on funding requirements for SPEs, and on derivatives and collateral agreements, see Off-balance Sheet Arrangements below and page 61, respectively, of this Form 10-Q.

Balance sheet

The Firm’s total assets increased by $30.2 billion from December 31, 2003, to $801.1 billion at March 31, 2004, largely due to an increase in deposits placed with banks and investment securities. Debt and equity trading assets were also higher due to growth in IB business activities. Commercial loans declined by $3.9 billion, mostly as a result of the deconsolidation of a Firm-sponsored asset-backed commercial paper conduit which had been previously consolidated on the Firm’s balance sheet under the guidance of FIN 46. Consumer loans increased by $2.0 billion, led by increases in home equity loans. Credit card loans declined modestly due to seasonal factors and lower volumes; loan volumes in the quarter were affected by increased securitization activity, partially offset by strong purchase volumes. Automobile loans increased slightly, helped by higher origination volumes over the fourth quarter of last year. Effective January 1, 2004, the Firm elected to net cash paid and received under credit-support annexes to legally enforceable master netting agreements; thereby reducing Derivative receivables by $28.7 billion and Derivative payables by $19.7 billion. The Firm’s liabilities also increased in an amount consistent with the above asset growth, through a combination of continued growth in deposits, which contributed to the growth in investment securities, and higher securities sold under repurchase agreements.

Issuance

During the three months ended March 31, 2004, JPMorgan Chase issued approximately $4.9 billion of long-term debt; during the same period, $2.8 billion of long-term debt matured or was redeemed. In addition, the Firm securitized approximately $2.7 billion of residential mortgage loans, $1.5 billion of credit card loans and $1.6 billion of automobile loans, resulting in pre-tax gains (losses) on securitizations of $48 million, $10 million and $(3) million, respectively. For a further discussion of loan securitizations, see Note 11 of this Form 10-Q and Note 13 on pages 100–103 of JPMorgan Chase’s 2003 Annual Report.

Off–balance Sheet Arrangements

Special-purpose entities (“SPEs”), special-purpose vehicles (“SPVs”) or variable-interest entities (“VIEs”), are an important part of the financial markets, providing market liquidity by facilitating investors’ access to specific portfolios of assets and risks. JPMorgan Chase is involved with SPEs in three broad categories of transactions: loan securitizations (through “qualifying” SPEs), multi-seller conduits, and client intermediation. Capital is held, as appropriate, against all SPE-related transactions and related exposures such as derivative transactions and lending-related commitments. For a further discussion of SPEs and the Firm’s accounting for SPEs, see Notes 11 and 12 of this Form 10-Q and Note 1 on pages 86–87, Note 13 on pages 100–103 and Note 14 on pages 103–106 of JPMorgan Chase’s 2003 Annual Report.

For certain liquidity commitments to SPEs, the Firm could be required to provide funding if the credit rating of JPMorgan Chase Bank were downgraded below specific levels, primarily P-1, A-1 and F1 for Moody’s, Standard & Poor’s and Fitch, respectively. The amount of these liquidity commitments was $32.3 billion at March 31, 2004. If JPMorgan Chase Bank were required to provide funding under these commitments, the Firm could be replaced as liquidity provider. Additionally, with respect to the multi-seller conduits and structured commercial loan vehicles for which JPMorgan Chase Bank has extended liquidity commitments, the Bank could facilitate the sale or refinancing of the assets in the SPE in order to provide liquidity.

Of its $32.3 billion in liquidity commitments to SPEs, $31.1 billion is included in the Firm’s total Other unfunded commitments to extend credit, included in the table on the following page. As a result of the consolidation of multi-seller conduits in accordance with FIN 46, $1.2 billion of these commitments are excluded from the table, as the underlying assets of the SPE have been included on the Firm’s Consolidated balance sheet.

The following table summarizes certain revenue information related to VIEs with which the Firm has significant involvement, and qualifying SPEs:

                         
Quarter ended March 31, 2004           “Qualifying”        
(in millions)   VIEs(a)     SPEs     Total  
 
Revenue
  $ 23       $265     $ 288  
 
(a)  
Includes all VIE-related revenue (i.e., revenue associated with consolidated and nonconsolidated VIEs).
 

The revenue reported in the table above primarily represents servicing and custodial fee income. The Firm also has exposure to certain VIE vehicles arising from derivative transactions with VIEs; these transactions are recorded at fair value on the Firm’s Consolidated balance sheet with changes in fair value (i.e., mark-to-market gains and losses) recorded in Trading revenue. Such MTM gains and losses are not included in the revenue amounts reported in the table above.

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The following table summarizes JPMorgan Chase’s off–balance sheet lending-related financial instruments by remaining maturity at March 31, 2004:

                                         
Off–balance sheet lending-related financial instruments
    Under     1–3     4–5     After        
(in millions)   1 year     years     years     5 years     Total  
 
Consumer-related
  $ 161,060     $ 480     $ 666     $ 27,012     $ 189,218  
Commercial-related:
                                       
Other unfunded commitments to extend credit(a)(b)
    95,487       50,960       25,081       3,617       175,145  
Standby letters of credit and guarantees(a)
    18,141       13,370       5,783       1,564       38,858  
Other letters of credit(a)
    1,632       457       2,164       31       4,284  
 
Total commercial-related
    115,260       64,787       33,028       5,212       218,287  
 
Total lending-related commitments 
  $ 276,320     $ 65,267     $ 33,694     $ 32,224     $ 407,505  
 
     
(a)  
Net of risk participations totaling $17 billion at March 31, 2004.
(b)  
Includes unused advised lines of credit totaling $20 billion at March 31, 2004, which are not legally binding. In regulatory filings with the Federal Reserve Board, unused advised lines are not reportable.
 

 
CREDIT RISK MANAGEMENT
 
The following discussion of JPMorgan Chase’s credit portfolio as of March 31, 2004, focuses primarily on developments since December 31, 2003, and should be read in conjunction with pages 51–65, pages 74–77 and Notes 11, 12, 29 and 30 of JPMorgan Chase’s 2003 Annual Report.

The Firm assesses its consumer credit exposure on a managed basis, including credit card securitizations. For a reconciliation of credit costs on an operating, or managed, basis to reported results, see pages 30–32 of this Form 10-Q.

The Firm allocates credit risk capital to the lines of business based upon its assessment of “economic credit exposure,” a non-GAAP financial measure that, in the Firm’s view, represents actual future credit exposure. The principal difference between The Firm’s credit exposure on a reported basis and its economic view of credit exposure relates to the way the Firm views its credit exposure to derivative receivables and lending-related commitments. For further information, refer to pages 60 and 62 of this Form 10-Q.

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CREDIT PORTFOLIO
 
The following table presents a summary of the Firm’s credit portfolio for the dates indicated:

Commercial and consumer credit portfolio

                                                 
                                    Approximate allocated
    Credit exposure   Economic credit exposure   credit capital
(in millions)   Mar. 31, 2004   Dec. 31, 2003   Mar. 31, 2004   Dec. 31, 2003   Mar. 31, 2004   Dec. 31, 2003
 
Commercial loans:
                                               
Loans–U.S.(a)
  $ 47,273     $ 52,024     $ 47,273     $ 52,024                  
Loans–Non-U.S.
    31,942       31,073       31,942       31,073                  
 
Total commercial loans(b)
    79,215       83,097       79,215       83,097                  
Consumer loans – reported(b)
    138,415       136,421       138,415       136,421                  
 
Total loans – reported
    217,630       219,518       217,630       219,518                  
Credit card securitizations(c)
    34,478       34,856       34,478       34,856                  
 
Total loans – managed
    252,108       254,374       252,108       254,374                  
Derivative receivables(d)
    58,434       83,751       33,383       34,130                  
Other receivables
    108       108       108       108                  
Commercial lending-related commitments(b)(e)
    218,287       215,758 (j)     106,855       106,872                  
Consumer lending-related commitments
    189,218       176,923       189,218       176,923                  
 
Total credit portfolio
  $ 718,155     $ 730,914     $ 581,672     $ 572,407     $ 10,200     $ 11,600  
 
Memo:
                                               
Total credit portfolio by category
                                               
Total commercial exposure(f)
  $ 356,044     $ 382,714     $ 219,561     $ 224,207                  
Total consumer exposure(g)
    362,111       348,200       362,111       348,200                  
 
Total credit portfolio
  $ 718,155     $ 730,914     $ 581,672     $ 572,407                  
 
Credit derivative hedges notional(h)
  $ (37,107 )   $ (37,282 )   $ (37,107 )   $ (37,282 )   $ (1,200 )   $ (1,300 )
Collateral held against derivative receivables(i)
  $ (9,876 )   $ (36,214 )   NA     NA                  
 
(a)  
Includes $1.7 billion and $5.8 billion at March 31, 2004, and December 31, 2003, respectively, of exposure related to consolidated VIEs in accordance with FIN 46, of which $4.8 billion, at December 31, 2003, is associated with multi-seller asset-backed commercial paper conduits. None of this exposure at March 31, 2004 is associated with multi-seller asset-backed commercial paper conduits.
(b)  
Amounts are presented gross of the allowance for credit losses.
(c)  
Represents securitized credit cards. For a further discussion of credit card securitizations, see Chase Cardmember Services on pages 46–47 of this Form 10-Q.
(d)  
Effective January 1, 2004, derivative receivables Credit exposure takes into account net cash received under credit support annexes to legally enforceable master netting agreements.
(e)  
Includes unused advised lines of credit totaling $20 billion at March 31, 2004, and $19 billion at December 31, 2003, which are not legally binding. In regulatory filings with the Federal Reserve Board, unused advised lines are not reportable.
(f)  
Represents Total commercial loans, derivative receivables, other receivables and commercial lending-related commitments.
(g)  
Represents Total consumer loans, credit card securitizations and consumer lending-related commitments.
(h)  
Represents the notional amount of single-name and portfolio credit derivatives used to manage the credit risk of commercial credit exposure; these derivatives do not qualify for hedge accounting under SFAS 133.
(i)  
Effective January 1, 2004, Credit exposure excludes net cash received under credit support annexes to legally enforceable master netting agreements. On an Economic credit exposure basis, collateral is considered “NA” as it is already accounted for in Derivative receivables.
(j)  
Total commitments related to asset-backed commercial paper conduits consolidated in accordance with FIN 46 were $9.8 billion at December 31, 2003, of which $3.5 billion is included in Lending-related commitments. The remaining $6.3 billion of commitments to these VIEs were excluded, as the underlying assets are reported as follows: $4.8 billion in Loans and $1.5 billion in Available-for-sale securities.
 

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JPMorgan Chase’s total credit exposure (including $34 billion of securitized credit cards) totaled $718 billion at March 31, 2004, a decline from $731 billion at year-end 2003. The decrease reflected a 7% reduction in commercial exposure, offset by a 4% increase in consumer exposure.

 
COMMERCIAL CREDIT PORTFOLIO
 
Total commercial exposure was $356 billion at March 31, 2004, compared with $383 billion at December 31, 2003. The $27 billion decline was mainly due to a $25 billion decline in derivative receivables, because, effective January 1, 2004, the Firm elected to net cash paid and received under credit support annexes to legally enforceable master netting agreements. Loans decreased by $4 billion as a result of the deconsolidation of a Firm-sponsored asset-backed commercial paper conduit which was previously consolidated on the Firm’s balance sheet under the guidance of FIN 46; the conduit was deconsolidated due to a restructuring. Lending-related commitments increased by $3 billion; $4 billion was attributable to the deconsolidation of an asset-backed commercial paper conduit, offset by a $1 billion decrease due to deal flow.

Below are summaries of the maturity and ratings profiles of the commercial portfolio as of March 31, 2004, and December 31, 2003. The ratings scale is based on the Firm’s internal risk ratings and is presented on an S&P-equivalent basis.

                                                                                                 
Commercial Exposure   Maturity profile(a)   Ratings profile
                        Investment-grade (“IG”) Noninvestment-grade                 Total %
                                                                        of IG –
                                                    Economic
At March 31, 2004                       AAA   A+   BBB+   BB+   CCC+       Total %   credit
(in billions, except ratios)   <1 year   1–5 years   > 5 years   Total   to AA-   to A-   to BBB-   to B-   & below   Total   of IG   exposure
     
Loans(b)
    51 %     34 %     15 %     100 %   $ 19     $ 10     $ 21     $ 24     $ 5     $ 79       63 %     63 %
Derivative receivables
    20       42       38       100       31       10       9       8       1       59       85       91  
Lending-related commitments(c)
    53       45       2       100       83       61       49       23       2       218       89       88  
     
Total exposure(d)
    47 %     42 %     11 %     100 %   $ 133     $ 81     $ 79     $ 55     $ 8     $ 356       82 %     79 %
     
Credit derivative hedges notional(e)
    21 %     71 %     8 %     100 %   $ (9 )   $ (13 )   $ (12 )   $ (3 )   $     $ (37 )     92 %     92 %
     
                                                                                                 
    Maturity profile(a)   Ratings profile
                        Investment-grade (“IG”) Noninvestment-grade                 Total %
                                                                        of IG –
                                                    Economic
At December 31, 2003                       AAA   A+   BBB+   BB+   CCC+       Total %   credit
(in billions, except ratios)   <1 year   1–5 years   > 5 years   Total   to AA-   to A-   to BBB-   to B-   & below   Total   of IG   exposure
     
Loans(f)
    49 %     37 %     14 %     100 %   $ 20     $ 13     $ 21     $ 23     $ 6     $ 83       65 %     65 %
Derivative receivables
    20       41       39       100       47       15       12       9       1       84       88       91  
Lending-related commitments(c)(g)
    52       45       3       100       80       57       52       25       2       216       88       88  
     
Total exposure(d)
    44 %     43 %     13 %     100 %   $ 147     $ 85     $ 85     $ 57     $ 9     $ 383       83 %     80 %
     
Credit derivative hedges notional(e)
    16 %     74 %     10 %     100 %   $ (10 )   $ (12 )   $ (12 )   $ (2 )   $ (1 )   $ (37 )     92 %     92 %
     
 
(a)  
The maturity profile of loans and lending-related commitments is based upon the remaining contractual maturity. The maturity profile of derivative receivables is based upon the maturity profile of Average exposure. See page 53 of JPMorgan Chase’s 2003 Annual Report for a further discussion.
(b)  
Includes $1.7 billion of exposure related to consolidated VIEs in accordance with FIN 46, none of which is associated with multi-seller asset-backed commercial paper conduits. Excluding the impact of FIN 46, the total percentage of investment-grade would remain 63%.
(c)  
Based on Economic credit exposure, the maturity profile for the <1 year, 1–5 years and >5 years would have been 38%, 58% and 4%, respectively, as of March 31, 2004, and December 31, 2003. See page 53 of JPMorgan Chase’s 2003 Annual Report for a further discussion of Economic credit exposure.

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(d)  
Based on Economic credit exposure, the maturity profile for <1 year, 1–5 years and >5 years would have been 40%, 47% and 13%, respectively, as of March 31, 2004, and 36%, 46% and 18%, respectively, as of December 31, 2003. See page 53 of JPMorgan Chase’s 2003 Annual Report for a further discussion.
(e)  
Ratings are based on the underlying referenced assets.
(f)  
Includes $5.8 billion of exposure related to consolidated VIEs in accordance with FIN 46, of which $4.8 billion is associated with multi-seller asset-backed commercial paper conduits. Excluding the impact of FIN 46, the total percentage of investment-grade would have been 62%.
(g)  
Total commitments related to asset-backed commercial paper conduits consolidated in accordance with FIN 46 are $9.8 billion, of which $3.5 billion is included in Lending-related commitments. The remaining $6.3 billion of commitments to these VIEs is excluded, as the underlying assets are reported as follows: $4.8 billion in Loans and $1.5 billion in Available-for-sale securities.
 

(COMMERICAL EXPOSURE RATINGS PROFILE BAR CHART)

As of March 31, 2004, the commercial exposure ratings profile remained relatively stable compared with December 31, 2003.

Commercial Exposure – selected industry concentration
The Firm continues to focus on the management and diversification of its industry concentrations, with particular attention paid to industries with actual or potential credit concerns. The only significant change in reported industry exposure since December 31, 2003, relates to the Firm’s exposure to Commercial banks, which decreased by $19 billion, or 40%, from December 31, 2003, to $28 billion as of March 31, 2004. The decline was primarily the result of the Firm’s election to net cash received under credit support annexes to legally enforceable master netting agreements, which affected derivative receivables. A significant portion of the Firm’s derivatives portfolio is transacted with customers in the commercial banking industry.

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Commercial Criticized Exposure
Exposures deemed criticized generally represent a ratings profile similar to a rating of CCC+/Caa1 and lower, as defined by Standard & Poors/Moody’s. Continuing the trend experienced during 2003, the criticized component of the portfolio declined by $1.5 billion, or 17%, during the first quarter of 2004. The decrease was due to debt repayments and facility upgrades as a result of client recapitalizations, additional security and collateral taken in refinancings, client upgrades from improved financial performance and a lack of migration of new exposures into the portfolio. Also contributing to the decrease were gross charge-offs of $0.2 billion.

(COMMERICAL CRITICIZED EXPOSURE TREND BAR CHART)

Enron-related exposure
The Firm’s exposure to Enron and Enron-related entities was reduced from $609 million at December 31, 2003, to $545 million at March 31, 2004. The decrease was primarily due to the reduction of debtor-in-possession financing. At March 31, 2004, secured exposure of $207 million is performing and reported on an amortized cost basis.

Country Exposure
The selection of countries is based on the materiality of the Firm’s exposure and its view of actual or potentially adverse credit conditions. Exposure amounts are adjusted for credit enhancements (e.g., guarantees and letters of credit) provided by third parties located outside the country if the enhancements fully cover the country risk, as well as the commercial risk. In addition, the benefit of collateral, credit derivatives used to manage commercial exposure, and short debt or equity trading positions are taken into account. Total exposure includes exposure to both government and private-sector entities in a country.

The exposure to Brazil was $2.4 billion and $2.0 billion at March 31, 2004, and December 31, 2003, respectively. The exposure to Mexico was $2.4 billion and $1.5 billion at March 31, 2004, and December 31, 2003, respectively. The increase in exposure to Brazil and Mexico over the prior year-end was due to trading positions, both cross-border and local.

The Firm’s exposures to other countries disclosed in JPMorgan Chase’s 2003 Annual Report have had immaterial changes in exposure since year-end 2003. Likewise, during the quarter, the credit conditions in these countries remained stable or improved.

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Derivative Contracts
For a further discussion of the derivative contracts utilized by JPMorgan Chase in connection with its trading and end-user activities, see Note 19 of this Form 10-Q, and pages 58–61 and Note 28 on pages 116–117 of JPMorgan Chase’s 2003 Annual Report.

The following table summarizes the aggregate notional amounts and the reported derivative receivables (i.e., the MTM or fair value of the derivative contracts after taking into account the effects of legally enforceable master netting agreements) at each of the dates indicated:

Notional amounts and derivative receivables MTM

                                 
    Notional amounts(a)   Derivative receivables MTM
    March 31,     December 31,     March 31,     December 31,  
(in billions)   2004     2003     2004     2003  
 
Interest rate contracts
  $ 32,914     $ 31,252     $ 42     $ 60  
Foreign exchange contracts
    1,653       1,582       5       10  
Equity
    376       328       7       9  
Credit derivatives
    623       578       3       3  
Commodity
    29       24       2       2  
 
Total notional and credit exposure
  $ 35,595     $ 33,764     $ 59 (b)   $ 84  
Collateral held against derivative receivables
  NA     NA       (10) (b)     (36 )
 
Exposure net collateral
  $ 35,595     $ 33,764     $ 49     $ 48  
 
(a)  
The notional amounts represent the gross sum of long and short third-party notional derivative contracts, excluding written options and foreign exchange spot contracts.
(b)  
The Firm held $39 billion of collateral against derivative receivables as of March 31, 2004, consisting of $29 billion in net cash received under credit support annexes to legally enforceable master netting agreements, and $10 billion of other highly liquid collateral. The benefit of the $29 billion is reflected within the $59 billion of derivative receivables MTM. Excluded from these collateral amounts is $9 billion of collateral delivered by clients at the initiation of transactions; this collateral secures exposure that could arise in the existing portfolio of derivatives should the MTM of the client’s transactions move in the Firm’s favor. Also excluded are credit enhancements in the form of letter of credit and surety receivables.
 

The $36 trillion of notional principal of the Firm’s derivative contracts outstanding at March 31, 2004, significantly exceeds, in the Firm’s view, the possible credit losses that could arise from such transactions. For most derivative transactions, the notional principal amount does not change hands; it is simply used as a reference to calculate payments. In terms of current credit risk exposure, the appropriate measure of risk is, in the Firm’s view, the MTM value of the contract. The MTM exposure represents the cost to replace the contracts at current market rates should the counterparty default. When JPMorgan Chase has more than one transaction outstanding with a counterparty, and a legally enforceable master netting agreement exists with the counterparty, the MTM exposure, less collateral held, represents, in the Firm’s view, the appropriate measure of current credit risk with that counterparty as of the reporting date. At March 31, 2004, the MTM value of derivative receivables (after taking into account the effects of legally enforceable master netting agreements and the impact of net cash received under credit support annexes to such legally enforceable master netting agreements) was $59 billion. Further, after taking into account $10 billion of other highly liquid collateral held by the Firm, the net current MTM credit exposure was $49 billion. As of March 31, 2004, based on the MTM value of its derivative receivables and after taking into account the effects of legally enforceable master netting agreements and collateral held, the Firm did not have a concentration to any single derivative receivable counterparty greater than 5%.

While useful as a current view of credit exposure, the net MTM value of derivative receivables does not capture the potential future variability of that credit exposure. To capture this variability, the Firm calculates, on a client-by-client basis, three measures of potential derivatives-related credit loss: Peak, Derivative Risk Equivalent and Average exposure. These measures all incorporate netting and collateral benefits where applicable. The last measure, Average exposure (“AVG”), is used as the basis for the Firm’s Economic view of its credit exposure, upon which it allocates credit capital to the various lines of business. For more information, see page 53 of JPMorgan Chase’s 2003 Annual Report. The amount of these measures did not change significantly since December 31, 2003.

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The following table reconciles Derivative receivables on a MTM basis with the Firm’s Economic credit exposure, a non-GAAP financial measure, for the dates indicated:

                 
Reconciliation of Derivative Receivables to Economic Credit Exposure
(in billions)   March 31, 2004     December 31, 2003  
             
Derivative receivables:
               
Derivative receivables MTM
  $ 59     $ 84  
Collateral held against derivatives
    (10 )     (36 )
 
           
Derivative receivables – net current exposure
    49       48  
Reduction in exposure to 3-year average exposure(a)
    (16 )     (14 )
 
           
Economic credit exposure
  $ 33     $ 34  
 
           
 
(a)  
For a discussion of the three year average exposure, see page 53 of JPMorgan Chase’s 2003 Annual Report.
 

The MTM value of the Firm’s derivative receivables incorporates a Credit Valuation Adjustment (“CVA”) to reflect the credit quality of counterparties. The CVA was $657 million at March 31, 2004, a slight increase from $635 million at December 31, 2003. The CVA is based on the Firm’s AVG to a counterparty, and on the counterparty’s credit spread in the credit derivatives market. The primary components of changes in CVA are credit spreads, new deal activity or unwinds, and changes in the underlying market environment. For a discussion of the impact of CVA on Trading revenue, see portfolio management activity on page 61 of this Form 10-Q.

The following table summarizes the ratings profile of the Firm’s Consolidated balance sheet derivative receivables MTM, net of cash and other highly liquid collateral, for the dates indicated:

                                 
Ratings profile of derivatives receivables MTM
    March 31, 2004   December 31, 2003
(in millions)   Exposure Net     % of Exposure     Exposure Net     % of Exposure  
Rating equivalent   of Collateral(a)     Net of Collateral     of Collateral     Net of Collateral  
 
AAA to AA-
  $ 25,623       53 %   $ 24,697       52 %
A+ to A-
    8,443       17       7,677       16  
BBB+ to BBB-
    7,509       16       7,564       16  
BB+ to B-
    6,304       13       6,777       14  
CCC+ and below
    679       1       822       2  
 
Total
  $ 48,558       100 %   $ 47,537       100 %
 
(a)  
The Firm held $39 billion of collateral against derivative receivables as of March 31, 2004, consisting of $29 billion in net cash received under credit support annexes to legally enforceable master netting agreements, and $10 billion of other highly liquid collateral. The benefit of the $29 billion is reflected within the $59 billion of derivative receivables MTM. Excluded from these collateral amounts is $9 billion of collateral delivered by clients at the initiation of transactions; this collateral secures exposure that could arise in the existing portfolio of derivatives should the MTM of the client’s transactions move in the Firm’s favor. Also excluded are credit enhancements in the form of letter of credit and surety receivables.
 

The Firm actively pursues the use of collateral agreements to mitigate counterparty credit risk in derivatives. The percentage of the Firm’s derivatives transactions subject to collateral agreements decreased slightly to 75% as of March 31, 2004, from 78% at December 31, 2003. The Firm held $39 billion of collateral as of March 31, 2004 (including $29 billion of net cash received under credit support annexes to legally enforceable master netting agreements), compared with $36 billion as of December 31, 2003. The Firm posted $28 billion of collateral as of March 31, 2004, compared with $27 billion at the end of 2003.

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Certain derivative and collateral agreements include provisions that require both the Firm and the counterparty, upon specified downgrades in their respective credit ratings, to post collateral for the benefit of the other party. The impact on required collateral of a single-notch ratings downgrade to JPMorgan Chase Bank, from its current rating of AA- to A+, would have been an additional $1.3 billion of collateral as of March 31, 2004. The impact of a six-notch ratings downgrade to JPMorgan Chase Bank (from AA- to BBB-) would have been $3.9 billion of additional collateral as of March 31, 2004. Certain derivative contracts also provide for termination of the contract, generally upon JPMorgan Chase Bank being downgraded, at the then-existing MTM value of the derivative receivables.

Use of credit derivatives
The following table presents the Firm’s notional amounts of credit derivatives protection bought and sold as of March 31, 2004, and December 31, 2003:

                                         
Credit derivatives positions
    Portfolio management   Dealer/Client      
    Notional amount   Notional amount      
    Protection     Protection     Protection     Protection        
(in millions)   bought(a)     sold     bought     sold     Total  
 
March 31, 2004
  $ 37,107     $     $ 292,948     $ 292,791     $ 622,846  
December 31, 2003
    37,349       67       264,389       275,888       577,693  
 
(a)  
Includes $2 billion at March 31, 2004, and December 31, 2003, respectively, of portfolio credit derivatives.
 

JPMorgan Chase has limited counterparty exposure as a result of credit derivatives transactions. Of the $59 billion of total derivative receivables at March 31, 2004, approximately $3 billion, or 5%, was associated with credit derivatives, before the benefit of highly liquid collateral. The use of credit derivatives to manage exposures does not reduce the reported level of assets on the balance sheet or the level of reported off–balance sheet commitments.

Portfolio management activity
In managing its commercial credit exposure, the Firm purchases single-name and portfolio credit derivatives. As of March 31, 2004, the notional outstanding amount of protection purchased via single-name and portfolio credit derivatives was $35 billion and $2 billion, respectively. The Firm also diversifies its exposures by providing (i.e., selling) small amounts of credit protection, which increases exposure to industries or clients where the Firm has little or no client-related exposure. This activity is not material to the Firm’s overall credit exposure: at March 31, 2004, no credit protection had been sold, and credit protection sold totaled $67 million in notional exposure at December 31, 2003.

                 
Use of single-name and portfolio credit derivatives   Notional amount of protection bought
(in millions)   March 31, 2004     December 31, 2003  
 
Credit derivatives used to manage risk related to:
               
Loans and lending-related commitments
  $ 23,839     $ 22,471  
Derivative receivables
    13,268       14,878  
 
Total
  $ 37,107     $ 37,349  
 

The credit derivatives used by JPMorgan Chase for its portfolio management activities do not qualify for hedge accounting under SFAS 133, and therefore, effectiveness testing under SFAS 133 is not performed. These derivatives are marked to market in Trading revenue. The MTM value incorporates both the cost of credit derivative premiums and changes in value due to movement in spreads and credit events, whereas the loans and lending-related commitments being risk managed are accounted for on an accrual basis in Net interest income and assessed for impairment in the Provision for credit losses. This asymmetry in accounting treatment, between loans and lending-related commitments and the credit derivatives utilized in portfolio management activities, causes earnings volatility that is not representative of the true changes in value of the Firm’s overall credit exposure. The MTM treatment of both the Firm’s credit derivatives used for managing credit exposure (“short” credit positions) and the CVA, which reflects the credit quality of derivatives counterparty exposure (“long” credit positions), provides some natural offset.

Additionally, commercial credit exposure is actively managed through secondary loan and commitment sales that are not associated with loan syndication activity or securitization activity as described in Note 11 of this Form 10-Q. During the first quarter of 2004, proceeds from the sale of $774 million of loans and $700 million of commitments resulted in a net loss of $8 million. During the same period in 2003, the sale of $607 million of loans and $450 million of commitments resulted in a net loss of $12 million.

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Portfolio management activity in the first quarter of 2004 resulted in $58 million of gains included in Trading revenue. These gains included $26 million related to credit derivatives used to manage the Firm’s credit exposure; of this amount, approximately $21 million was associated with credit derivatives used to manage the risk of accrual lending activities, and the remaining was associated with credit derivatives used to manage the overall derivatives portfolio. The gains were driven by a widening of high-yield credit spreads. Additionally, there were $32 million of gains related to the change in the MTM value of the CVA.

Trading revenue from portfolio management in the first quarter of 2003 resulted in losses of $27 million. The losses consisted of $110 million related to credit derivatives used to manage the Firm’s credit exposure; of this amount, $71 million was associated with credit derivatives used to manage the risk of accrual lending activities, and the remaining was associated with credit derivatives used to manage the risk of the overall derivatives portfolio. The losses were due to an overall global tightening of credit spreads. These losses were offset by $83 million in gains resulting from a decrease in the MTM value of the CVA, the result of spread tightening.

Dealer client activity
As of March 31, 2004, the total notional amounts of protection purchased and sold by the dealer business were both $293 billion. Although the notional amounts were equal as of March 31, 2004, at other times there may be mismatches between these amounts. The mismatch would be the result of the Firm selling protection on large, diversified, predominantly investment-grade portfolios (including the most senior tranches) and then hedging these positions by buying protection on the more subordinated tranches of the same portfolios. In addition, the Firm may use securities to hedge certain derivative positions. Consequently, while there could be a mismatch in notional amounts of credit derivatives, in the Firm’s view, the risk positions are largely matched.

Lending-related commitments
The contractual amount of commercial lending-related commitments was $218 billion at March 31, 2004, compared with $216 billion at December 31, 2003. In the Firm’s view, the total contractual amount of these instruments is not representative of the Firm’s actual credit risk exposure or funding requirements. In determining the amount of credit risk exposure the Firm has to commercial lending-related commitments, which is used as the basis for allocating credit-risk capital to these instruments, the Firm has established a “loan equivalent” amount for each commitment; this represents the portion of the unused commitment or other contingent exposure that is likely, based on average portfolio historical experience, to become outstanding in the event of a default by an obligor.

The following table reconciles the reported contractual amounts of the Firm’s lending-related commitments on a GAAP basis with the Firm’s Economic credit exposure, a non-GAAP financial measure, as of the dates indicated:

                 
Reconciliation of Commercial Lending-Related Commitments to Economic Credit Exposure
(in billions)   March 31, 2004     December 31, 2003  
Commercial lending-related commitments:
               
Reported amount
  $ 218     $ 216  
Loan equivalent (“LEQ”) adjustment(a)
    (111 )     (109 )
 
           
Economic credit exposure
  $ 107     $ 107  
 
           
 
(a)  
For a discussion of LEQ, see page 53 of JPMorgan Chase’s 2003 Annual Report.
 

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CONSUMER CREDIT PORTFOLIO
 
JPMorgan Chase’s consumer portfolio consists primarily of 1-4 family residential mortgages, credit cards and automobile financings. The consumer portfolio is predominantly U.S.-based. The Firm’s managed consumer portfolio totaled $362 billion at March 31, 2004, an increase of 4% from December 31, 2003. Consumer lending-related commitments increased by 7% to $189 billion at March 31, 2004. The following table presents a summary of consumer credit exposure on a managed basis:
 
                 
Consumer portfolio            
(in millions)   March 31, 2004     December 31, 2003  
 
U.S. consumer:
               
1–4 family residential mortgages – first liens
  $ 54,284     $ 54,460  
Home equity
    21,617       19,252  
 
Total 1–4 family residential mortgages
    75,901       73,712  
Credit card – reported
    15,975       16,793  
Automobile financings
    39,118       38,695  
Other consumer(a)
    7,421       7,221  
 
Total consumer loans-reported
    138,415       136,421  
 
Credit card securitizations(b)
    34,478       34,856  
Consumer lending-related commitments:
               
1–4 family residential mortgages
    35,765       28,846  
Credit cards
    146,116       141,143  
Automobile financings
    2,858       2,603  
Other consumer
    4,479       4,331  
 
Total lending-related commitments
    189,218       176,923  
 
Total consumer credit portfolio
  $ 362,111     $ 348,200  
 
(a)  
Consists of manufactured housing loans, installment loans (direct and indirect types of consumer finance), student loans, unsecured revolving lines of credit and non-U.S. consumer loans.
(b)  
Represents the portion of JPMorgan Chase’s credit card receivables that have been securitized.
 

The following discussion relates to the specific loan and lending-related commitment categories within the consumer portfolio:

Residential Mortgages: Residential mortgage loans are primarily secured by first mortgages and were $75.9 billion at March 31, 2004, a $2.2 billion increase from year-end 2003. At March 31, 2004, the Firm had $2.6 billion of sub-prime residential mortgage loans, of which $2.1 billion were held for sale. At December 31, 2003, sub-prime residential mortgage loans outstanding were $1.9 billion, of which $1.4 billion were held for sale. Lending-related commitments on 1–4 family residential mortgages increased by $6.9 billion, or 24%, due to new business.

Credit Cards: JPMorgan Chase analyzes its credit card portfolio on a managed basis, which includes credit card receivables on the Consolidated balance sheet and those that have been securitized. Managed credit card receivables were approximately $50.5 billion at March 31, 2004, a decrease of 2% compared with year-end 2003. The lower amount of receivables primarily reflects seasonal factors. Lending-related commitments on credit cards increased by $5.0 billion, or 4%, due to new business.

Automobile Financings: Automobile financings increased by $423 million at March 31, 2004, when compared with year-end 2003. This increase was driven by originations of $6.8 billion during the first quarter of 2004, a 24% increase over originations in the fourth quarter of 2003.

Other Consumer: Other consumer loans of $7.4 billion at March 31, 2004, increased by 3% compared with year-end levels.

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Commercial and consumer nonperforming exposure and net charge-offs

The following table presents a summary of credit-related nonperforming, past due and net charge-off information for the dates indicated:

                                                                                 
    Nonperforming   Nonperforming assets   Past due 90 days and                   Average annual
    assets   as a % of total   over and accruing   Net charge-offs   net charge-off rate
    Mar. 31,     Dec. 31,     Mar. 31,     Dec. 31,     Mar. 31,     Dec. 31,     First quarter   First quarter
(in millions, except ratios)   2004     2003     2004     2003     2004     2003     2004     2003     2004     2003  
 
Commercial loans:
                                                                               
Loans–U.S.
  $ 976     $ 1,092       2.06 %     2.10 %   $ 56     $ 41     $ 11     $ 118       0.09 %     0.86 %
Loans–Non-U.S.
    839       947       2.63       3.05       26       5       91       174       1.18       2.07  
 
Total commercial loans(a) (b)
    1,815       2,039       2.29       2.45       82       46       102       292       0.50       1.32  
 
Consumer loans
                                                                               
U.S. consumer:
                                                                               
1–4 family residential mortgages – first liens
    285       291       0.53       0.53                   2       5       0.02       0.04  
Home equity
    59       58       0.27       0.30                   3       2       0.06       0.05  
 
Total residential loans
    344       349       0.45       0.47                   5       7       0.03       0.04  
Credit card – reported(c)
    10       11       0.06       0.07       230       248       257       275       6.30       6.17  
Automobile financings
    107       119       0.27       0.31                   40       46       0.41       0.53  
Other consumer(d)
    58       66       0.78       0.91       19       21       40       50       2.06       2.54  
 
Total consumer loans
    519       545       0.37       0.40       249       269       342       378       1.01       1.21  
 
Total loans reported(b)
    2,334       2,584       1.07       1.18       331       315       444       670       0.82       1.26  
 
Derivative receivables
    240       253       0.41       0.30                   NA       NA       NA       NA  
Other receivables
    108       108       100       100       NA       NA       NA       NA       NA       NA  
Assets acquired in loan satisfactions(e)
    200       216       NA       NA       NA       NA       NA       NA       NA       NA  
 
Total credit-related assets
    2,882       3,161       1.04       1.04       331       315       444       670       0.82       1.26  
Credit card securitizations(f)
                            854       879       473       457       5.53       5.82  
 
Total(g)
  $ 2,882     $ 3,161       0.93 %     0.93 %   $ 1,185     $ 1,194     $ 917     $ 1,127       1.46 %     1.85 %
 
Purchased held for sale commercial loans(h)
  $ 331     $ 22       NA       NA                   NA       NA       NA       NA  
 
Credit derivatives hedges notional(i)
  $ (123 )   $ (123 )     NA       NA       NA       NA       NA       NA       NA       NA  
 
(a)  
Average annual net charge-off rate would have been 0.53% for the quarter ended March 31, 2004, excluding the impact of the adoption of FIN 46.
(b)  
Excludes purchased HFS commercial loans.
(c)  
In connection with charge-offs, during the three months ended March 31, 2004 and 2003, $107 million and $90 million, respectively, of accrued credit card interest and fees were reversed and recorded as a reduction of interest income and fee revenue.
(d)  
Consists of manufactured housing loans, installment loans (direct and indirect types of consumer finance), student loans, unsecured revolving lines of credit and non-U.S. consumer loans.
(e)  
At March 31, 2004, and December 31, 2003, includes $9 million and $9 million, respectively, of commercial assets acquired in loan satisfactions, and $191 million and $207 million, respectively, of consumer assets acquired in loan satisfactions.
(f)  
Represents securitized credit cards. For a further discussion of credit card securitizations, see page 41 of JPMorgan Chase’s 2003 Annual Report.
(g)  
At March 31, 2004, and December 31, 2003, excludes $2.1 billion and $2.3 billion, respectively, of residential mortgage receivables in foreclosure status that are insured by government agencies. These amounts are excluded as reimbursement is proceeding normally.
(h)  
Represents distressed commercial loans purchased as part of IB’s proprietary investing activities.
(i)  
Represents the notional amount of single-name and portfolio credit derivatives used to manage the credit risk of commercial credit exposure; these derivatives do not qualify for hedge accounting under SFAS 133.
 
Total nonperforming assets (excluding purchased held-for-sale commercial loans) were $2.9 billion at March 31, 2004, a decline of $279 million, or 9%, from December 31, 2003. The decline was primarily in the commercial portfolio, as a result of gross charge-offs of $184 million taken during the quarter. Commercial loan net charge-offs for the three months ended March 31, 2004, were

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$102 million, including $82 million of recoveries, compared with $292 million of net charge-offs for the three months ended March 31, 2003. The charge-off rate for commercial loans was 0.50% for the first quarter of 2004, compared with 0.04% for the fourth quarter of 2003 and 1.32% for the first quarter of 2003. Commercial net charge-offs in 2004 are expected to decline, but at a slower pace than the decline experienced in the second half of 2003.

For Credit Card loans on a reported basis, the net charge-off rate for the first quarter of 2004 was 6.30%, compared with 6.17% for the first quarter of 2003 and down from 6.66% for the fourth quarter of 2003. Although net charge-offs in the first quarter of 2004 were lower than in the prior-year period, the increase in the net charge-off rate was driven by a lower average balance. Likewise, the credit card loan net charge-off rate on the securitized credit card portfolio for the three months ended March 31, 2004, was 5.53%, down from 5.82% in the first quarter of 2003. The decrease was due to an average balance that increased at a rate greater than the increase in net charge-offs during the first quarter of 2004. Management expects consumer net charge-off rates to remain stable for the next several quarters.

Summary of changes in the allowance for credit losses

                                                                 
    2004   2003
(in millions)   Commercial     Consumer     Residual     Total     Commercial     Consumer     Residual     Total  
 
Loans:
                                                               
Beginning balance at January 1
  $ 1,371     $ 2,257     $ 895     $ 4,523     $ 2,216     $ 2,360     $ 774     $ 5,350  
Net charge-offs
    (102 )     (342 )           (444 )     (292 )     (378 )           (670 )
Provision for loan losses
    (141 )     262       (79 )     42       194       411       65       670  
Other
    (1 )                 (1 )           (138 )(c)     3       (135 )
 
Ending balance at March 31
  $ 1,127 (a)   $ 2,177     $ 816     $ 4,120     $ 2,118 (a)   $ 2,255     $ 842     $ 5,215  
 
Lending-related commitments:
                                                               
Beginning balance at January 1
  $ 277     $     $ 47     $ 324     $ 324           $ 39     $ 363  
Provision for lending- related commitments
    (27 )                 (27 )     65             8       73  
 
Ending balance at March 31
  $ 250 (b)   $     $ 47     $ 297     $ 389 (b)         $ 47     $ 436  
 
(a)  
Includes $716 million and $411 million of commercial specific and commercial expected loss components, respectively, at March 31, 2004. Includes $1,528 million and $590 million of commercial specific and commercial expected loss components, respectively, at March 31, 2003.
(b)  
Includes $146 million and $104 million of commercial specific and commercial expected loss components, respectively, at March 31, 2004. Includes $305 million and $84 million of commercial specific and commercial expected loss components, respectively, at March 31, 2003.
(c)  
Represents the transfer of the allowance for accrued fees on securitized credit card loans.
 
                                                                 
Credit costs            
For the three months            
ended March 31,   2004   2003
(in millions)   Commercial     Consumer     Residual     Total     Commercial     Consumer     Residual     Total  
 
Provision for loan losses
  $ (141 )   $ 262     $ (79 )   $ 42     $ 194     $ 411     $ 65     $ 670  
Provision for lending- related commitments
    (27 )                 (27 )     65             8       73  
Securitized credit losses
          473             473             457             457  
 
Total managed credit costs
  $ (168 )   $ 735     $ (79 )   $ 488     $ 259     $ 868     $ 73     $ 1,200  
 

Overall: The allowance for credit losses decreased from December 31, 2003, to March 31, 2004 reflecting declines across all components of the allowance.

Loans: JPMorgan Chase’s allowance for loan losses is intended to cover probable credit losses as of March 31, 2004, 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. As of March 31, 2004, management deemed the allowance to be adequate (i.e., sufficient to absorb losses that currently may exist but are not yet identifiable). The allowance for loan losses declined by $403 million from year-end 2003 and $1.1 billion from March 31, 2003.

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The commercial specific loss component of the allowance was $716 million at March 31, 2004, a decrease of $201 million, or 22%, from year-end 2003. The decrease was primarily attributable to reduced credit exposure as well as charge-offs taken.

The commercial expected loss component of the allowance was $411 million at March 31, 2004, a decrease of $43 million, or 9%, from year-end 2003. The decrease reflected improvement in credit quality.

The consumer expected loss component of the allowance was $2.2 billion at March 31, 2004, a decline of $80 million, or 4%, from year-end 2003. The decrease was primarily attributable to reduced credit card balances, which experienced seasonal highs at year-end 2003, as well as lower manufactured housing net charge-off rates.

The residual component of the allowance was $816 million at March 31, 2004, a decrease of $79 million from year-end 2003. The reduction was a result of complying with the Firm’s internal policy of maintaining the residual component within a target range of 10% to 20% of the total allowance, including the residual component. At March 31, 2004, the residual component represented approximately 20% of the total allowance for loan losses. The formula-based commercial specific and expected components do not consider uncertainties in the economic environment or the impact of concentrations in the commercial loan portfolio. These uncertainties are addressed by the residual component of the allowance, which incorporates management’s judgment. If current trends in commercial loan quality continue, the Firm’s policies may require a further reduction in the overall allowance, including the residual component.

Lending-related commitments: To provide for the risk of loss inherent in the Firm’s process of extending credit, management also computes specific and expected loss components, as well as a residual component, for commercial lending-related commitments. These are computed using a methodology similar to that used for the commercial loan portfolio, modified for expected maturities and probabilities of drawdown. This allowance, which is reported in Other liabilities, was $297 million, $324 million and $436 million at March 31, 2004, December 31, 2003, and March 31, 2003, respectively. The allowance for lending-related commitments decreased by $27 million during the three months ended March 31, 2004, due to improvement in the credit quality of the portfolio.

 
MARKET RISK MANAGEMENT
 

Risk management process

For a discussion of the Firm’s market risk management organization, see pages 66-67 of JPMorgan Chase’s 2003 Annual Report.

Value-at-Risk

JPMorgan Chase’s statistical risk measure, VAR, gauges the potential loss from adverse market moves in an ordinary market environment and provides a consistent cross-business measure of risk profiles and levels of risk diversification. Each business day, the Firm undertakes a comprehensive VAR calculation that includes both trading and nontrading activities, including the private equity business. The Firm calculates VAR using a one-day time horizon and a 99% confidence level. This means the Firm would expect to incur losses greater than that predicted by VAR estimates only once every 100 trading days, or about 2.5 times a year. For the quarter ended March 31, 2004, there were no days on which actual Firmwide market risk-related losses exceeded corporate VAR. For a further discussion of the Firm’s VAR methodology, see pages 67-68 of JPMorgan Chase’s 2003 Annual Report.

The table below shows trading VAR by risk type. Details of the VAR exposures are discussed in the Trading Risk section below.

 

Trading VAR by risk type

                                 
    Three Months Ended March 31, 2004      
    Average     Minimum     Maximum        
(in millions)   VAR     VAR     VAR     At March 31, 2004  
 
                       
By risk type:
                               
Interest rate
  $ 84.0     $ 58.8     $ 108.6     $ 58.8  
Foreign exchange
    22.2       11.5       32.5       28.4  
Equities
    40.6       27.8       57.8       27.8  
Commodities
    2.5       1.4       3.9       1.5  
Hedge fund investment(a)
    5.7       5.5       5.8       5.6  
Less: portfolio diversification
    (49.5 )     NM (c)     NM (c)     (38.1 )
 
                       
Total Trading VAR(b)
  $ 105.5     $ 84.0     $ 134.1     $ 84.0  
 
                       

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    Three Months Ended December 31, 2003      
    Average     Minimum     Maximum        
(in millions)   VAR     VAR     VAR     At December 31, 2003  
 
                       
By risk type:
                               
Interest rate
  $ 75.8     $ 56.8     $ 101.4     $ 83.7  
Foreign exchange
    20.3       15.8       27.5       23.5  
Equities
    40.9       9.3       51.6       45.6  
Commodities
    2.7       1.7       4.8       3.3  
Hedge fund investments(a)
    5.4       4.8       5.6       5.5  
Less: portfolio diversification
    (50.6 )     NM (c)     NM (c)     (58.4 )
 
                       
Total Trading VAR(b)
  $ 94.5     $ 65.8     $ 114.7     $ 103.2  
 
                       
 
(a)  
Represents investment in numerous hedge funds that are diversified by strategic goals, investment strategies, industry concentrations, portfolio size and management styles. They are passive, long-term investments made by JPMorgan Chase, generally as a limited partner, and are marked to market. Individual hedge funds may have exposure to interest rate, foreign exchange, equity and commodity risk within their portfolio risk structures.
(b)  
Amounts exclude VAR related to the Firm’s private equity business. For a discussion of Private equity risk management, see page 74 of JPMorgan Chase’s 2003 Annual Report.
(c)  
Designated as NM because the minimum and maximum may occur on different days for different risk components, and hence it is not meaningful to compute a portfolio diversification effect. In addition, JPMorgan Chase’s average and period-end VARs are less than the sum of the VARs of its market risk components, due to risk offsets resulting from portfolio diversification.
 

Trading risk

The largest contributor to trading VAR in the first quarter of 2004 was interest rate risk, which includes credit spread risk. Before portfolio diversification, interest rate risk accounted for roughly 54% of the average Trading Portfolio VAR. The diversification effect, which on average reduced the daily average Trading Portfolio VAR by $49.5 million in the first quarter, reflects the fact that the largest losses for different positions and risks do not typically occur at the same time. The risk of a portfolio of positions is therefore usually less than the sum of the risks of the positions themselves. The degree of diversification is determined both by the extent to which different market variables tend to move together, and by the extent to which different businesses have similar positions.

Average trading VAR rose to $105.5 million from $94.5 million in the previous quarter. The increase was driven by a rise in interest rate VAR, primarily due to increased risk positions, greater market volatility and higher correlation between lines of business.

In contrast, period-end VAR declined to $84.0 million at March 31, 2004, from $103.2 million at December 31, 2003, primarily driven by a decrease in interest rate VAR due to reduced risk positions and lower correlation between lines of business.

For a complete discussion of the Firm’s Trading Risk, see page 70 of JPMorgan Chase’s 2003 Annual Report.

VAR backtesting

To evaluate the soundness of its VAR model, the Firm conducts daily backtesting of VAR against actual financial results, based on daily market risk-related revenue. Market risk-related revenue 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.

The Firm’s definition of market risk-related revenue is consistent with the Federal Reserve Board’s implementation of the Basel Committee’s market risk capital rules. The histogram below illustrates the Firm’s daily market risk-related revenue for trading businesses for the first quarter of 2004. The chart shows that the Firm posted positive daily market risk-related revenue on 61 out of 64 days in the first quarter, with five days exceeding $100 million. The inset graph looks at those days on which the Firm experienced trading losses and depicts the amount by which the VAR exceeded the actual loss on each of those days. Losses were sustained on three days, with no loss greater than $10.6 million, below the losses predicted by the VAR measure.

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(BAR CHART)

Economic-value stress testing

While 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. JPMorgan Chase performs a number of different scenario-based stress tests monthly. Three corporate-wide stress tests are performed on all business lines with trading activity. Scenarios are continually reviewed and updated to reflect changes in the Firm’s risk profile and economic events.

The following table represents the worst-case potential economic-value stress-test loss (pre-tax) in the Firm’s trading portfolio as predicted by stress-test scenarios:

Trading economic value stress-test loss results – pre-tax

                                                                 
For the three months                          
ended   March 31, 2004           December 31, 2003      
          At         At  
(in millions)   Avg.   Min.   Max.   March 11   Avg.   Min.   Max.   Dec. 4
 
Stress-test loss – pre-tax
  $ (779 )   $ (522 )   $ (1,158 )   $ (1,158 )   $ (459 )   $ (366 )   $ (574 )   $ (436 )
 

The worst-case results of the three corporate-wide stress tests are shown above. These scenarios are based on historical events and incorporate economic relationships among market prices. The March 11, 2004 and the first quarter 2004 maximum and minimum results are from the “Equity Market Collapse” stress scenario, which is broadly modeled on the events of October 1987. Under this scenario, there is a significant equity sell-off along with a decline in credit prices and interest rates rally in major currencies. Results from March 11 reflect equity cash underwriting and options positions held by the Firm on that date, which led to losses under the “Equity Market Collapse” stress scenario. Positions that drove the stress-test results subsequently declined and were materially lower at the end of the first quarter of 2004.

The December 4, 2003, results are also from the “Equity Market Collapse” scenario. The fourth quarter 2003 maximum and minimum results are from the “Bond Market Collapse” stress scenario. Under this stress scenario, interest rates rise sharply in major currencies, accompanied by moderate credit spread widening and equity price declines. For a further discussion of the Firm’s stress testing methodology, see pages 68-69 of the 2003 Annual Report.

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The Firm conducts simulations of NII for its nontrading activities under a variety of interest rate scenarios, which are consistent with the scenarios used for economic-value stress testing. NII stress tests measure the potential change in the Firm’s NII over the next 12 months. These stress tests highlight exposures to various rate-sensitive factors, such as the rates themselves (e.g., the prime lending rate), pricing strategies on deposits and changes in product mix. The stress tests also take into account forecasted balance sheet changes, such as asset sales and securitizations, as well as prepayment and reinvestment behavior.

The following table shows the change in the Firm’s NII over the next 12 months that would result from uniform increases or decreases of 100 basis points in all interest rates. For the quarter ended March 31, 2004, JPMorgan Chase’s largest potential NII stress-test loss was estimated at $209 million, primarily the result of increased funding costs associated with a +100 basis-points parallel change. JPMorgan Chase’s NII stress-test loss of $102 million for a -100 basis-points parallel change is primarily the result of potential compression in deposit spreads associated with a further interest rate decline in a low rate environment.

Nontrading NII stress-test loss results – pre-tax

                 
March 31, (in millions)   2004     2003  
 
+ 100bp parallel change
  $ (209 )   $ 24  
- 100bp parallel change
    (102 )     (292 )
 

However, JPMorgan Chase believes that the standard +100/-100 basis-points parallel change stress-test scenarios do not adequately reflect the actual complexity of markets. To that end, the Firm also applies several additional scenarios to test how NII would change in response to unlikely but plausible events in abnormal markets. The worse-case stress-test loss scenario simulates the yield curve and spread changes that occurred during 1994, when the Federal Open Market Committee raised interest rates six times for a total of 250 basis points. This scenario indicates that the Firm’s U.S. dollar NII stress-test loss would be approximately $125 million.

Other statistical and nonstatistical risk measures

For a discussion of the Firm’s other risk measures, see page 69 of JPMorgan Chase’s 2003 Annual Report.

Capital allocation for market risk

For a discussion of the Firm’s capital allocation for market risk, see page 71 of JPMorgan Chase’s 2003 Annual Report.

Risk monitoring and control

For a discussion of the Firm’s risk monitoring and control process, including limits, qualitative risk assessments, model review, and policies and procedures, see pages 71-72 of JPMorgan Chase’s 2003 Annual Report.

 
OPERATIONAL RISK MANAGEMENT
 
For a discussion of JPMorgan Chase’s operational risk management, refer to pages 72-74 of JPMorgan Chase’s 2003 Annual Report.

 
PRIVATE EQUITY RISK MANAGEMENT
 
For a discussion of JPMorgan Chase’s private equity risk management, refer to page 74 of JPMorgan Chase’s 2003 Annual Report. While JPMorgan Chase computes VAR on its public equity holdings, the potential loss calculated by VAR may not be indicative of the loss potential for these holdings due to the fact that most of the positions are subject to sale restrictions and, often, represent significant concentration of ownership. Because VAR assumes that positions can be exited in a normal market, JPMorgan Chase believes that the VAR for public equity holdings does not necessarily represent the true value-at-risk for these holdings.

 
SUPERVISION AND REGULATION
 
The following discussion should be read in conjunction with the Supervision and Regulation section on pages 1-5 of JPMorgan Chase’s 2003 Form 10-K.

Dividends

JPMorgan Chase’s bank subsidiaries could pay dividends to their respective bank holding companies, without the approval of their relevant banking regulators, in amounts up to the limitations imposed upon such banks by regulatory restrictions. These limitations, in the aggregate, totaled approximately $5.1 billion at March 31, 2004.

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CRITICAL ACCOUNTING ESTIMATES USED BY THE FIRM
 

The Firm’s accounting policies and use of estimates are integral to understanding the reported results. The Firm’s most complex accounting estimates require management’s judgment to ascertain the valuation of assets and liabilities. The Firm has established detailed policies and control procedures intended to ensure that valuation methods, including any judgments made as part of such methods, are well controlled, independently reviewed 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 believes its estimates for determining the valuation of its assets and liabilities are appropriate. For a further description of the Firm’s critical accounting estimates involving significant management valuation judgments, see pages 74-77 and the Notes to Consolidated Financial Statements in JPMorgan Chase’s 2003 Annual Report.

Allowance for Credit Losses

The Firm’s allowance for loan losses is sensitive to the risk rating assigned to a loan. Assuming, for all commercial loans, a one-notch downgrade in the Firm’s internal risk ratings, the allowance for loan losses for commercial loans would increase by approximately $450 million at March 31, 2004. Furthermore, assuming a 10% increase in the loss severity on all downgraded noncriticized loans, the allowance for commercial loans would increase by approximately $50 million at March 31, 2004. These sensitivity analyses are hypothetical and should be used with caution. The purpose of these analyses is to provide an indication of the impact risk ratings and loss severity have on the estimate of the allowance for loan losses for commercial loans. It is not intended to imply management’s expectation of future deterioration in risk ratings or changes in loss severity. Given the process the Firm follows in determining risk ratings of its loans and assessing loss severity, management believes the risk ratings and loss severity currently assigned to commercial loans are appropriate. Furthermore, the likelihood of a one-notch downgrade for all commercial loans within a short time frame is remote.

Trading and Available-for-Sale Portfolios

The following table summarizes the Firm’s trading and available-for-sale portfolios by valuation methodology at March 31, 2004:

 
                                         
    Trading Assets   Trading Liabilities      
    Securities             Securities             AFS  
    purchased(a)     Derivatives(b)     sold(a)     Derivatives(b)     securities  
 
Fair value based on:
                                       
Quoted market prices
    91 %     3 %     94 %     2 %     93 %
Internal models with significant observable market parameters
    8       96       4       97       3  
Internal models with significant unobservable market parameters
    1       1       2       1       4  
 
Total
    100 %     100 %     100 %     100 %     100 %
 
(a)  
Reflected as debt and equity instruments on the Firm’s Consolidated balance sheet.
(b)  
Based on gross mark-to-market valuations of the Firm’s derivatives portfolio prior to netting positions pursuant to FIN 39, as cross-product netting is not relevant to an analysis based upon valuation methodologies.
 

MSRs and certain other retained interests

For a discussion of the most significant assumptions used to value these retained interests, as well as the applicable stress tests for those assumptions, see Notes 13 and 16 on pages 100-103 and 107-109, respectively, of JPMorgan Chase’s 2003 Annual Report.

 
ACCOUNTING AND REPORTING DEVELOPMENTS
 

Consolidation of variable interest entities

In December 2003, the FASB issued a revision to FIN 46 (“FIN 46R”) to address various technical corrections and implementation issues that have arisen since the issuance of FIN 46. Effective March 31, 2004, JPMorgan Chase implemented FIN 46R for all variable interest entities (VIEs), excluding certain investments made by JPMP. For further details regarding FIN 46, refer to Note 12 on pages 14-16 of this Form 10-Q.

Impairment of available-for-sale and held-to-maturity securities

In March 2004, the EITF reached a consensus on EITF Issue 03-1, determining the meaning of other-than-temporary impairment and its application to investments classified as either available-for-sale or held-to-maturity under SFAS 115 (including individual securities and investments in mutual funds) and to investments accounted for under the cost method. The provisions of this EITF are effective for reporting periods beginning after June 15, 2004; thus, the Firm will implement the new provisions effective July 1,

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2004. The Firm does not believe that the application of EITF Issue 03-1 will have a material impact on the Firm’s Consolidated financial statements.

Accounting for certain loans or debt securities acquired in a transfer

In December 2003, the AICPA issued Statement of Position 03-3 (“SOP 03-3”), Accounting for Certain Loans or Debt Securities Acquired in a Transfer. SOP 03-3 provides guidance on the accounting for differences between contractual and expected cash flows from the purchaser’s initial investment in loans or debt securities acquired in a transfer, if those differences are attributable, at least in part, to credit quality. Among other things, SOP 03-3: (1) prohibits the recognition of the excess of contractual cash flows over expected cash flows as an adjustment of yield, loss accrual or valuation allowance at the time of purchase; (2) requires that subsequent increases in expected cash flows be recognized prospectively through an adjustment of yield; and (3) requires that subsequent decreases in expected cash flows be recognized as an impairment. In addition, SOP 03-3 prohibits the creation or carrying over of a valuation allowance in the initial accounting of all loans within its scope that are acquired in a transfer. SOP 03-3 becomes effective for loans or debt securities acquired in fiscal years beginning after December 15, 2004.

Accounting for interest rate lock commitments (“IRLCs”)

IRLCs associated with mortgages to be held for sale represent commitments to extend credit at specified interest rates. On March 9, 2004, the Securities and Exchange Commission (“SEC”) issued Staff Accounting Bulletin No. 105 – Application of Accounting Principles to Loan Commitments (“SAB 105”), which summarizes the views of the SEC staff regarding the application of GAAP to loan commitments accounted for as derivative instruments. SAB 105 states that the value of the servicing asset should not be included in the estimate of fair value of IRLCs. SAB 105 is applicable for all IRLCs accounted for as derivatives and entered into on or after April 1, 2004.

Prior to April 1, 2004, JPMorgan Chase recorded IRLCs at estimated fair value. The fair value of IRLCs included an estimate of the value of the loan servicing right inherent in the underlying loan, net of the estimated costs to close the loan. Beginning April 1, 2004, and as a result of SAB 105, there will be no fair value assigned to IRLCs on the date they are entered into, with any initial expected gain being recognized upon the sale of the resultant loan. Also in connection with SAB 105, the Firm will record any changes in the value of the IRLCs excluding the servicing asset component due to changes in interest rates after they are locked. Adopting SAB 105 will not have a material impact on the Firm’s Consolidated financial statements.

Management’s Report on Internal Control over Financial Reporting

In June 2003, the Securities and Exchange Commission adopted final rules under Section 404 of the Sarbanes-Oxley Act of 2002 (“Section 404”). Commencing with its 2004 Annual Report, JPMorgan Chase will be required to include a report of management of the Firm’s internal control over financial reporting.

The internal control report must include a statement: of management’s responsibility for establishing and maintaining adequate internal control over financial reporting for the Firm; of management’s assessment of the effectiveness of the Firm’s internal control over financial reporting as of year-end; of the framework used by management to evaluate the effectiveness of the Firm’s internal control over financial reporting; and that the Firm’s independent accounting firm has issued an attestation report on management’s assessment of the Firm’s internal control over financial reporting, which report is also required to be filed as part of the Annual Report. The Firm intends to be in compliance with the requirements of Section 404 when they become effective in 2004.

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J.P. MORGAN CHASE & CO.
FINANCIAL HIGHLIGHTS
(in millions, except per share data, ratios and employees)

                                         
                            First quarter change
Selected income statement data   1Q 2004     4Q 2003     1Q 2003     4Q 2003     1Q 2003  
 
                             
Revenue
  $ 8,977     $ 8,068     $ 8,406       11 %     7 %
Provision for credit losses
    15       139       743       (89 )     (98 )
Noninterest expense
    6,059       5,220       5,541       16       9  
Income tax expense
    973       845       722       15       35  
Net income
  $ 1,930     $ 1,864     $ 1,400       4       38  
Per common share:
                                       
Net income per share
                                       
Basic
  $ 0.94     $ 0.92     $ 0.69       2       36  
Diluted
    0.92       0.89       0.69       3       33  
Cash dividends declared
    0.34       0.34       0.34              
Book value at period end
    22.62       22.10       20.73       2       9  
Average common shares outstanding:
                                       
Basic
    2,032.3       2,016.2       1,999.8       1       2  
Diluted
    2,092.7       2,079.3       2,021.9       1       4  
Common shares at period-end
    2,081.7       2,042.6       2,030.0       2       3  
Financial ratios(a)
                                       
Return on average assets
    1.01 %     0.95 %     0.73 %     6 bp     28 bp
Return on average common equity
    17       17       13             400  
Common dividend payout ratio
    38       38       50             (1,200 )
Effective income tax rate
    34       31       34       300        
Overhead ratio
    67       65       66       200       100  
Capital ratios
                                       
Tier 1 capital ratio
    8.4 %     8.5 %     8.4 %     (10) bp     bp
Total capital ratio
    11.4       11.8       12.2       (40 )     (80 )
Tier 1 leverage ratio
    5.9       5.6       5.0       30       90  
Selected balance sheet items:
                                       
Net loans
  $ 213,510     $ 214,995     $ 212,256       (1 )%     1 %
Total assets
    801,078       770,912       755,156       4       6  
Deposits
    336,886       326,492       300,667       3       12  
Long-term debt(b)
    56,794       54,782       48,290       4       18  
Common stockholders’ equity
    47,092       45,145       42,075       4       12  
Total stockholders’ equity
    48,101       46,154       43,084       4       12  
Full-time equivalent employees
    93,285       93,453       93,878             (1 )
Share price:(c)
                                       
High
  $ 43.84     $ 36.99     $ 28.29       19       55  
Low
    36.30       34.45       20.13       5       80  
Close
    41.95       36.73       23.71       14       77  
 
(a)  
Based on annualized amounts.
(b)  
Includes Junior subordinated deferrable interest debentures held by trusts that issued guaranteed capital debt securities and Guaranteed preferred beneficial interests in capital debt securities issued by consolidated trusts. Excludes $2.9 billion and $2.4 billion of FIN 46 long-term beneficial interests at March 31, 2004 and December 31, 2003, respectively, included in Beneficial interests issued by consolidated variable interest entities on the Consolidated balance sheet.
(c)  
JPMorgan Chase’s common stock is listed and traded on the New York Stock Exchange, the London Stock Exchange Limited and the Tokyo Stock Exchange. The high, low and closing prices of JPMorgan Chase’s common stock are from the New York Stock Exchange Composite Transaction Tape.
 

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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)

                                                 
    First Quarter 2004   First Quarter 2003
    Average             Rate     Average             Rate  
    Balance     Interest     (Annualized)     Balance     Interest     (Annualized)  
 
                                   
ASSETS
                                               
Deposits with Banks
  $ 21,535     $ 87       1.62 %   $ 9,998     $ 63       2.58 %
Federal Funds Sold and Securities Purchased under Resale Agreements
    82,555       307       1.49       87,657       474       2.19  
Securities Borrowed
    48,609       94       0.77       38,654       97       1.02  
Trading Assets – Debt and Equity Instruments
    166,389       1,800       4.35       161,753       1,850       4.64  
Securities: Available-for-sale
    63,726       667       4.21 (a)     83,864       955       4.62 (a)
Held-to-maturity
    266       3       4.43       390       8       8.78  
Loans
    217,478       2,533       4.69       215,882       2,835       5.32  
 
                                       
Total Interest-Earning Assets
    600,558       5,491       3.68       598,198       6,282       4.26  
Allowance for Loan Losses
    (4,486 )                     (5,498 )                
Cash and Due from Banks
    20,255                       16,718                  
Trading Assets – Derivative Receivables
    58,956                       86,447                  
Other Assets
    96,035                       82,373                  
 
                                           
Total Assets
  $ 771,318                     $ 778,238                  
 
                                           
LIABILITIES
                                               
Interest-Bearing Deposits
  $ 238,206     $ 814       1.37 %   $ 225,389     $ 1,068       1.92 %
Federal Funds Purchased and Securities Sold under Repurchase Agreements
    145,370       448       1.24       191,163       726       1.54  
Commercial Paper
    13,153       31       0.96       14,254       46       1.30  
Other Borrowings(b)
    80,388       913       4.57       68,453       842       4.99  
Beneficial interests issued by consolidated VIEs(c)
    9,764       39       1.60       NA       NA       NA  
Long-Term Debt
    53,574       403       3.02       46,001       366       3.23  
 
                                       
Total Interest-Bearing Liabilities
    540,455       2,648       1.97       545,260       3,048       2.27  
 
                                           
Noninterest-Bearing Deposits
    76,147                       74,345                  
Trading Liabilities – Derivative Payables
    53,223                       67,156                  
All Other Liabilities, Including the Allowance for Lending- Related Commitments
    54,666                       48,610                  
 
                                           
Total Liabilities
    724,491                       735,371                  
 
                                           
STOCKHOLDERS’ EQUITY
                                               
Preferred Stock
    1,009                       1,009                  
Common Stockholders’ Equity
    45,818                       41,858                  
 
                                           
Total Stockholders’ Equity
    46,827                       42,867                  
 
                                           
Total Liabilities, Preferred Stock of Subsidiary and Stockholders’ Equity
  $ 771,318                     $ 778,238                  
 
                                           
INTEREST RATE SPREAD
                    1.71 %                     1.99 %
 
                                           
NET INTEREST INCOME AND NET YIELD ON INTEREST-EARNING ASSETS
          $ 2,843       1.90 %           $ 3,234       2.19 %
 
                                       
 
(a)  
For the three months ended March 31, 2004, and March 31, 2003, the annualized rate for available-for-sale securities based on amortized cost was 4.22% and 4.70%, respectively.
(b)  
Includes securities sold but not yet purchased.
(c)  
Not applicable for periods prior to the Firm’s adoption of FIN 46 on July 1, 2003.
 

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GLOSSARY OF TERMS

AICPA: American Institute of Certified Public Accountants.

Asset capital tax: Capital allocated to each business segment based on its average asset level and certain off–balance sheet credit-related exposures; reflects the need for the Firm to maintain minimum leverage ratios to meet bank regulatory definitions of “well capitalized.”

Assets under management: Represent assets managed by Investment Management & Private Banking on behalf of institutional, retail and private banking clients.

Assets under supervision: Represent assets under management as well as custody, brokerage, administration and deposit accounts.

Average allocated capital: Represents the portion of average common stockholders’ equity allocated to the business segments, based on their respective risks. The total average allocated capital of all business segments equals the total average common stockholders’ equity of the Firm.

Average goodwill capital: The Firm allocates capital to businesses equal to 100% of the carrying value of goodwill. Average goodwill capital is equal to the average carrying value of goodwill.

Average managed assets: Includes credit card receivables that have been securitized.

Average tangible allocated capital: Average allocated capital less the average capital allocated for goodwill.

bp: Denotes basis points; 100 bp equals 1%.

Credit derivatives are contractual agreements that provide protection against a credit event of one or more referenced credits. The nature of a credit event is established by the protection buyer and protection seller at the inception of a transaction, and such events include bankruptcy, insolvency and failure to meet payment obligations when due. The buyer of the credit derivative pays a periodic fee in return for a payment by the protection seller upon the occurrence, if any, of a credit event.

Credit risk: Risk of loss from obligor or counterparty default.

Criticized: An indication of credit quality based on JPMorgan Chase’s internal risk assessment system. “Criticized” assets generally represent a risk profile similar to a rating of a CCC+/Caa1 or lower, as defined by the independent rating agencies.

EITF: Emerging Issues Task Force.

EITF Issue 03-1: “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments.”

FASB: Financial Accounting Standards Board.

FIN 39: FASB Interpretation No. 39, “Offsetting of Amounts Related to Certain Contracts.”

FIN 45: FASB Interpretation No. 45, “Guarantor’s Accounting and Disclosure Requirement for Guarantees, including Indirect Guarantees of Indebtedness of Others.”

FIN 46: FASB Interpretation No. 46, “Consolidation of Variable Interest Entities, an interpretation of Accounting Research Bulletin No. 51.”

Foreign exchange contracts are contracts that provide for the future receipt and delivery of foreign currency at previously agreed-upon terms.

Interest rate options, including caps and floors, are contracts to modify interest rate risk in exchange for the payment of a premium when the contract is initiated. A writer of interest rate options receives a premium in exchange for bearing the risk of unfavorable changes in interest rates. Conversely, a purchaser of an option pays a premium for the right, but not the obligation, to buy or sell a financial instrument or currency at predetermined terms in the future.

Investment-grade: An indication of credit quality based on JPMorgan Chase’s internal risk assessment system. “Investment-grade” generally represents a risk profile similar to a rating of a BBB-/Baa3 or better, as defined by independent rating agencies.

Liquidity risk: The risk of being unable to fund a portfolio of assets at appropriate maturities and rates, and the risk of being unable to liquidate a position in a timely manner at a reasonable price.

Managed credit card receivables: Refers to credit card receivables on the Firm’s balance sheet plus credit card receivables that have been securitized.

Mark-to-market exposure: Mark-to-market exposure is a measure, at a point in time, of the value of a derivative or foreign exchange contract in the open market. When the mark-to-market value is positive, it indicates the counterparty owes JPMorgan

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Chase and, therefore, creates a repayment risk for the Firm. When the mark-to-market value is negative, JPMorgan Chase owes the counterparty. In this situation, the Firm does not have repayment risk.

Market risk: The potential loss in value of portfolios and financial instruments caused by movements in market variables, such as interest and foreign exchange rates, credit spreads, and equity and commodity prices.

Master netting agreement: An agreement between two counterparties that have multiple derivative contracts with each other that provides for the net settlement of all contracts through a single payment, in a single currency, in the event of default on or termination of any one contract. See FIN 39.

NA: Not applicable.

Net yield on interest-earning assets: The average rate for interest-earning assets less the average rate paid for all sources of funds.

NM: Not meaningful.

Operating (Managed) Basis or Operating Earnings: In addition to analyzing the Firm’s results on a reported basis, management looks at results on an “operating basis,” which is a non-GAAP financial measure. The definition of operating basis starts with the reported U.S. GAAP results. In the case of the Investment Bank, the operating basis includes the reclassification of net interest income related to trading activities to Trading revenue. In the case of Chase Financial Services and Chase Cardmember Services, “operating” or “managed” basis excludes the impact of credit card securitizations. These adjustments do not change JPMorgan Chase’s reported net income.

Operational risk: The risk of loss resulting from inadequate or failed processes or systems, human factors or external events.

Other Consumer Loans: Consists of manufactured housing loans, installment loans (direct and indirect types of consumer finance), student loans, unsecured revolving lines of credit and non-U.S. consumer loans.

Overhead ratio: Noninterest expense as a percentage of revenue before provision for credit losses.

Return on Tangible Allocated Capital: Operating earnings less preferred dividends as a percentage of average allocated capital, excluding the capital allocated for goodwill.

SFAS: Statement of Financial Accounting Standards.

SFAS 107: “Disclosures about Fair Value of Financial Instruments.”

SFAS 115: “Accounting for Certain Investments in Debt and Equity Securities.”

SFAS 123: “Accounting for Stock-Based Compensation.”

SFAS 133: “Accounting for Derivative Instruments and Hedging Activities.”

SFAS 140: “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities – a replacement of FASB Statement No. 125.”

Shareholder value added (“SVA”): Represents operating earnings minus preferred dividends and an explicit charge for capital.

Six Sigma: Represents a business management approach that enables firms to improve the quality of products and services delivered to clients through understanding client priorities, and then eliminating process defects and failures. “Sigmas” (or standard deviations) are statistical measures of the defects or failures generated by a business process.

Staff Accounting Bulletin (“SAB”) 105: “Application of Accounting Principles to Loan Commitments.”

Statement of Position (“SOP”) 03-3: “Accounting for Certain Loans or Debt Securities Acquired in a Transfer.”

Stress testing: A scenario that measures market risk under unlikely but plausible events in abnormal markets.

Tangible shareholder value added: SVA less the impact of goodwill on operating earnings and capital charges.

Unaudited: The financial statements and information included throughout this document are unaudited, and have not been subjected to auditing procedures sufficient to permit an independent certified public accountant to express an opinion.

U.S. GAAP: Accounting principles generally accepted in the United States of America.

Value-at-Risk (“VAR”): A measure of the dollar amount of potential loss from adverse market moves in an ordinary market environment.

75


 

Reproduced below is management’s discussion and analysis of the financial condition and results of operations for JPMorgan Chase prepared by JPMorgan Chase and included in its Annual Report on Form 10-K for the year ended December 31, 2003.

Management’s discussion and analysis

J.P. Morgan Chase & Co.

Overview

J.P. Morgan Chase & Co. is a leading global financial services firm with assets of $771 billion and operations in more than 50 countries. The Firm serves more than 30 million consumers nationwide through its retail businesses, and many of the world’s most prominent corporate, institutional and government clients through its global wholesale businesses.

Financial performance of JPMorgan Chase

                         
As of or for the year ended December 31,                  
(in millions, except per share and ratio data)   2003     2002     Change  
 
Revenue
  $ 33,256     $ 29,614       12 %
Noninterest expense
    21,688       22,764       (5 )
Provision for credit losses
    1,540       4,331       (64 )
Net income
    6,719       1,663       304  
Net income per share – diluted
    3.24       0.80       305  
Average common equity
    42,988       41,368       4  
Return on average common equity (“ROCE”)
    16 %     4 %   1,200 bp
 
Tier 1 capital ratio
    8.5 %     8.2 %   30 bp
Total capital ratio
    11.8       12.0       (20 )
Tier 1 leverage ratio
    5.6       5.1       50  
 

In 2003, global growth strengthened relative to the prior two years. The U.S. economy improved significantly, supported by diminishing geopolitical uncertainties, new tax relief, strong profit growth, low interest rates and a rising stock market. Productivity at U.S. businesses continued to grow at an extraordinary pace, as a result of ongoing investment in information technologies. Profit margins rose to levels not seen in a long time. New hiring remained tepid, but signs of an improving job market emerged late in the year. Inflation fell to the lowest level in more than 40 years, and the Board of Governors of the Federal Reserve System (the “Federal Reserve Board”) declared that its long-run goal of price stability had been achieved.

Against this backdrop, J.P. Morgan Chase & Co. (“JPMorgan Chase” or the “Firm”) reported 2003 Net income of $6.7 billion, compared with Net income of $1.7 billion in 2002. All five of the Firm’s lines of business benefited from the improved economic conditions, with each reporting increased revenue over 2002. In particular, the low–interest rate environment drove robust fixed income markets and an unprecedented mortgage refinancing boom, resulting in record earnings in the Investment Bank and Chase Financial Services.

Total revenue for 2003 was $33.3 billion, up 12% from 2002. The Investment Bank’s revenue increased by approximately $1.9 billion from 2002, and Chase Financial Services’ revenue was $14.6 billion in 2003, another record year.

Total Noninterest expense was $21.7 billion, down 5% from the prior year. In 2002, the Firm recorded $1.3 billion of charges, principally for Enron-related surety litigation and the establishment of litigation reserves; and $1.2 billion for Merger and restructuring costs related to programs announced prior to January 1, 2002. Excluding these costs, expenses rose by 7% in 2003, reflecting higher performance-related incentives; increased costs related to stock-based compensation and pension and other postretirement expenses; and higher occupancy expenses. The Firm began expensing stock options in 2003. Restructuring costs associated with initiatives announced after January 1, 2002, were recorded in their relevant expense categories and totaled $630 million in 2003, down 29% from 2002.

The 2003 Provision for credit losses of $1.5 billion was down $2.8 billion, or 64%, from 2002. The provision was lower than total net charge-offs of $2.3 billion, reflecting significant improvement in the quality of the commercial loan portfolio. Commercial nonperforming assets and criticized exposure levels declined 42% and 47%, respectively, from December 31, 2002. Consumer credit quality remained stable.

Earnings per diluted share (“EPS”) for the year were $3.24, an increase of 305% over the EPS of $0.80 reported in 2002. Results in 2002 were provided on both a reported basis and an operating basis, which excluded Merger and restructuring costs and special items. Operating EPS in 2002 was $1.66. See page 28 of this Annual Report for a reconciliation between reported and operating EPS.

Summary of segment results

The Firm’s wholesale businesses are known globally as “JPMorgan,” and its national consumer and middle market businesses are known as “Chase.” The wholesale businesses comprise four segments: the Investment Bank (“IB”), Treasury & Securities Services (“TSS”), Investment Management & Private Banking (“IMPB”) and JPMorgan Partners (“JPMP”). IB provides a full range of investment banking and commercial banking products and services, including advising on corporate strategy and structure, capital raising, risk management, and market-making in cash securities and derivative instruments in all major capital markets. The three businesses within TSS provide debt servicing, securities custody and related functions, and treasury and cash management services to corporations, financial institutions and governments. The IMPB business provides investment management services to institutional investors, high net worth individuals and retail customers and also provides personalized advice and solutions to wealthy individuals and families. JPMP, the Firm’s private equity business, provides equity and mezzanine capital financing to private companies. The Firm’s national consumer and middle market businesses, which provide lending and full-service banking to consumers and small and middle market businesses, comprise Chase Financial Services (“CFS”).



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Segment results – Operating basis (a)

                                                 
    Operating revenue (loss)     Operating earnings (losses)        
Year ended December 31,   Change from     Change from     Return on allocated capital  
(in millions, except ratios)   2003     2002     2003     2002     2003     2002  
   
Investment Bank
  $ 14,440       16 %   $ 3,685       183 %     19 %     6 %
Treasury & Securities Services
    3,992       3       520       (16 )     19       23  
Investment Management & Private Banking
    2,878       1       268       3       5       5  
JPMorgan Partners
    (190 )     81       (293 )     64     NM     NM  
Chase Financial Services
    14,632       9       2,495       8       28       27  
Support Units and Corporate
    (626 )           44     NM     NM     NM  
   
JPMorgan Chase
  $ 35,126       13 %   $ 6,719       99 %     16 %     8 %
   
(a)  
Represents the reported results excluding the impact of credit card securitizations and, in 2002, merger and restructuring costs and special items.

The table above shows JPMorgan Chase’s segment results. These results reflect the manner in which the Firm’s financial information is currently evaluated by management and is presented on an operating basis. Prior-period segment results have been adjusted to reflect alignment of management accounting policies or changes in organizational structure among businesses.

IB reported record earnings of $3.7 billion for 2003, up 183% from 2002, driven by strong growth in capital markets revenues and equity underwriting fees, coupled with a significant decline in credit costs. The low–interest-rate environment, improvement in equity markets and volatility in credit markets produced increased client and portfolio management revenue in fixed income and equities, as well as strong returns in Global Treasury. Market-share gains in equity underwriting contributed to the increase in Investment banking fees over 2002. IB’s return on allocated capital was 19% for the year.

TSS earnings of $520 million for the year were down 16% compared with 2002. Revenues were $4.0 billion for the full year, up 3% from 2002. Institutional Trust Services and Treasury Services posted single-digit revenue growth. Investor Services revenue declined year-over-year but showed an improving trend over the last four consecutive quarters. Return on allocated capital for TSS was 19% for the year.

IMPB increased earnings and assets under supervision in 2003. Earnings of $268 million for the full year were up 3% from 2002, reflecting an improved credit portfolio, slightly higher revenues and the benefits of managed expense growth. The increase in revenues reflected the acquisition of Retirement Plan Services, and increased average equity market valuations in client portfolios and brokerage activity, mostly offset by the impact of institutional net outflows. Investment performance in core institutional products improved, with all major asset classes in U.S. institutional fixed income and equities showing above-benchmark results. Return on allocated capital was 5% for the year; return on tangible allocated capital was 20%.

JPMP performance improved significantly, with private equity gains of $27 million, compared with private equity losses of $733 million for 2002. Results for the direct investments portfolio improved by $929 million from 2002, driven by realized gains on sales and declining write-downs in the second half of 2003.

JPMP revenue was impacted in 2003 by losses on sales and writedowns of private third-party fund investments. JPMP decreased its operating loss for the year by 64% compared with 2002.

CFS posted record earnings of $2.5 billion, driven by record results and origination volumes at each of the national credit businesses –mortgage, credit card and auto. Record revenues for CFS of $14.6 billion were up 9% from 2002, driven by record revenues in Chase Home Finance. Despite significant deposit growth, Chase Regional Banking revenues decreased due to deposit spread compression. CFS’s return on allocated capital was 28% for the year.

In 2003, JPMorgan Chase revised its internal management reporting policies to allocate certain revenues, expenses and tax-related items that had been recorded within the Corporate segment to the other business segments. There was no impact on the Firm’s overall earnings.

For a discussion of the Firm’s Segment results, see pages 27–44 of this Annual Report.

Capital and liquidity management

JPMorgan Chase increased capital during 2003. At December 31, 2003, the Firm’s Tier 1 capital was $43.2 billion, $5.6 billion higher than at December 31, 2002. The Tier 1 capital ratio of 8.5% was well in excess of the minimum regulatory guidelines, it was 8.2% at year-end 2002. The Firm maintained the quarterly dividend of $0.34 per share on its common stock. JPMorgan Chase did not repurchase shares of its common stock in 2003. Management expects to recommend to the Board of Directors that the Firm resume its share repurchase program after the completion of the pending merger with Bank One Corporation (see Business events below).

The Firm’s liquidity management is designed to ensure sufficient liquidity resources to meet all its obligations, both on- and off–balance sheet, in a wide range of market environments. The Firm’s access to the unsecured funding markets is dependent upon its credit rating. During 2003, the Firm maintained senior debt ratings of AA-/Aa3/A+ at JPMorgan Chase Bank and A+/A1/A+ at the parent holding company. Upon the announcement of the proposed merger with Bank One Corporation, Moody’s and Fitch placed the Firm’s ratings on review for an



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Management’s discussion and analysis

J.P. Morgan Chase & Co.

upgrade, and S&P affirmed all of the Firm’s ratings. See Business events below.

Risk management

The Firm made substantial progress in lowering its risk profile in 2003.

Total commercial credit exposure, which includes loans, derivative receivables, lending-related commitments and other assets, declined by $30.2 billion, or 7%, from December 31, 2002. Increased financings in the public markets, reduced loan demand and loan sales drove the decline. In 2003, the Firm implemented a more stringent exposure-review process and lower absolute exposure limits for industry and single-name concentrations, including investment-grade obligors. The Firm was also more active in managing commercial credit by selling higher-risk loans and commitments and entering into single-name credit default swap hedges.

Total consumer loans on a managed basis, which includes both reported and securitized loans, increased by $15.7 billion, or 10%, from December 31, 2002. The consumer portfolio is predominantly U.S.-based. The largest component, 1–4 family residential mortgage loans, which are primarily secured by first mortgages, comprised 43% of the total consumer portfolio at December 31, 2003.

JPMP’s private equity portfolio declined by 12% to $7.3 billion at December 31, 2003, from $8.2 billion at December 31, 2002. At year-end 2003, the portfolio was diversified across industry sectors and geographies – with a higher percentage invested in more mature leveraged buyouts and a lower percentage in venture investments than at year-end 2002. The carrying value of JPMP’s portfolio has decreased year-over-year, consistent with management’s goal to reduce, over time, the capital committed to private equity.

The Firm uses several tools, both statistical and nonstatistical, to measure market risk, including Value-at-Risk (“VAR”), Risk identification for large exposures (“RIFLE”), economic value stress tests and net interest income stress tests. The Firm calculates VAR daily on its trading and nontrading activities. Average trading VAR decreased for full-year 2003. The year-end trading VAR increased compared with year-end 2002 due to higher VAR for equity activities. In 2003, trading losses exceeded VAR on only one day, a result that is consistent with the 99% confidence level. Average, maximum, and December 31 nontrading VAR increased in 2003, primarily due to the increase in market volatility during the 2003 third quarter and to the rise in interest rates in the second half of 2003. There was an additional day in 2003 in which losses exceeded VAR; this was attributable to certain positions in the mortgage banking business.

The Firm is also committed to maintaining business practices of the highest quality. The Fiduciary Risk Committee is responsible for overseeing that businesses providing investment or risk management products and services perform at the appropriate standard in their relationships with clients. In addition, the Policy Review Office oversees the review of transactions with clients in terms of appropriateness, ethical issues and reputation risk, with

the goal that these transactions are not used to mislead investors or others.

During the year, the Firm revised its capital allocation methodologies for credit, operational, business and private equity risk. This resulted in the reallocation of capital among the risk categories and the business segments; the reallocation did not result in a significant change in the amount of total capital allocated to the business segments as a whole.

For a further discussion of Risk management and the capital allocation methodology, see pages 45-74 of this Annual Report.

Business outlook

Global economic conditions and financial markets activity are expected to continue to improve in 2004. While rising interest rates may negatively affect the mortgage and Global Treasury businesses; on the positive side, gains in market share, rising equity values and increased market activity may benefit many of the Firm’s other businesses.

The Firm expects to see a different mix of earnings in 2004. IB is targeting higher issuer and investor client revenue, but securities gains and net interest income may be lower. Mortgage earnings are likely to decline from the record set in 2003, and growth in other retail businesses may not be sufficient to offset the decline in mortgage revenue. Improved equity markets and increased M&A activity may provide increased exit opportunities in private equity and could result in higher fees in IMPB and in the custody business of TSS. Commercial net charge-off ratios may be lower, but credit costs may rise as the reduction in the Allowance for credit losses slows. The Firm expects stable consumer net charge-off ratios in 2004.

Business events

Agreement to merge with Bank One Corporation

On January 14, 2004, JPMorgan Chase and Bank One Corporation (“Bank One”) announced an agreement to merge. The merger agreement, which has been approved by the boards of directors of both companies, provides for a stock-for-stock merger in which 1.32 shares of JPMorgan Chase common stock will be exchanged, on a tax-free basis, for each share of Bank One common stock.

The merged company, headquartered in New York, will be known as J.P. Morgan Chase & Co. and will have combined assets of $1.1 trillion, a strong capital base, 2,300 branches in 17 states and top-tier positions in retail banking and lending, credit cards, investment banking, asset management, private banking, treasury and securities services, middle markets and private equity. It is expected that cost savings of $2.2 billion (pre-tax) will be achieved over a three-year period. Merger-related costs are expected to be $3 billion (pre-tax).

The merger is subject to approval by the shareholders of both institutions as well as U.S. federal and state and non-U.S. regulatory authorities. It is expected to be completed in mid-2004.

For further information concerning the merger, see Note 2 on page 87 of this Annual Report.



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Results of operations

This section discusses JPMorgan Chase’s results of operations on a reported basis. The accompanying financial data conforms with accounting principles generally accepted in the United States of America (“GAAP”) and prevailing industry practices. The section should be read in conjunction with the Consolidated financial statements and Notes to consolidated financial statements beginning on page 82 of this Annual Report.

Revenues

                         
Year ended December 31,                  
(in millions)   2003     2002     Change  
 
Investment banking fees
  $ 2,890     $ 2,763       5 %
Trading revenue
    4,427       2,675       65  
Fees and commissions
    10,652       10,387       3  
Private equity gains (losses)
    33       (746 )   NM  
Securities gains
    1,446       1,563       (7 )
Mortgage fees and related income
    892       988       (10 )
Other revenue
    579       458       26  
Net interest income
    12,337       11,526       7  
 
Total revenue
  $ 33,256     $ 29,614       12 %
 

Investment banking fees

Investment banking fees of $2.9 billion rose 5% from 2002. For a discussion of Investment banking fees, which are primarily recorded in IB, see IB segment results on pages 29–31 of this Annual Report.

Trading revenue

Trading revenue in 2003 of $4.4 billion was up 65% from the prior year. Fixed income and equity capital markets activities drove growth in both client and portfolio management revenues. Portfolio management, in particular, was up significantly from 2002 as a result of gains in credit, foreign exchange and equity derivatives activities. Trading revenue, on a reported basis, excludes the impact of Net interest income (“NII”) related to IB’s trading activities, which is reported in NII. However, the Firm includes trading-related NII as part of Trading revenue for segment reporting purposes to better assess the profitability of IB’s trading business. For additional information on Trading revenue, see IB segment discussion on pages 29–31 of this Annual Report.

Fees and commissions

Fees and commissions of $10.7 billion in 2003 rose 3% from the prior year as a result of higher credit card servicing fees associated with $5.8 billion in growth in average securitized credit card receivables. Also contributing to the increase from 2002 were higher custody, institutional trust and other processing-related service fees. These fees reflected the more favorable environment for debt and equity activities. For a table showing the components of Fees and commissions, see Note 4 on pages 88–89 of this Annual Report.

For additional information on Fees and commissions, see the segment discussions of TSS for Custody and institutional trust service fees, IMPB for Investment management and service fees, and CFS for consumer-related fees on pages 32–33, 34–35 and 38–43, respectively, of this Annual Report.

Private equity gains (losses)

Private equity gains of $33 million in 2003 reflect significant improvement from losses of $746 million in 2002. For a discussion of Private equity gains (losses), which are primarily recorded in JPMP, see JPMP results on pages 36–37.

Securities gains

In 2003, Securities gains of $1.4 billion declined 7% from the prior year. The decline reflected lower gains realized from the sale of government and agency securities in IB and mortgage-backed securities in Chase Home Finance (“CHF”), driven by the increasing interest rate environment beginning in the third quarter of 2003. IB uses available-for-sale investment securities to manage, in part, the asset/liability exposures of the Firm; CHF uses these instruments to economically hedge the value of mortgage servicing rights (“MSRs”). For a further analysis of securities gains, see IB and CHF on pages 29–31 and 39–40, respectively, of this Annual Report.

Mortgage fees and related income

Mortgage fees and related income of $892 million in 2003 declined 10% from 2002. The decline reflects lower mortgage servicing fees and lower revenues from MSR hedging activities; these were offset by higher fees from origination and sales activity and other fees derived from volume and market-share growth. Mortgage fees and related income, on a reported basis, excludes the impact of NII and securities gains and losses related to Chase Home Finance’s mortgage banking activities. For a further discussion of mortgage-related revenue, see the segment discussion for Chase Home Finance on pages 39–40 and Note 4 on page 89 of this Annual Report.

Other revenue

Other revenue of $579 million in 2003 rose 26% from the prior year. The increase was a result of $200 million in gains from the sale of securities acquired in loan satisfactions (compared with $26 million in 2002), partly offset by lower net results from corporate and bank-owned life insurance policies. Many other factors contributed to the change from 2002, including $73 million of write-downs taken in 2002 for several Latin American investments.

Net interest income

NII of $12.3 billion was 7% higher than in 2002. The increase reflected the positive impact of lower interest rates on consumer loan originations and related funding costs. Average mortgage loans in CHF rose 32% to $74.1 billion, and average automobile loans and leases in Chase Auto Finance increased 32% to



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Management’s discussion and analysis

J.P. Morgan Chase & Co.

$41.7 billion. NII was reduced by a lower volume of commercial loans and lower spreads on investment securities. As a component of NII, trading-related net interest income of $2.1 billion was up 13% from 2002 due to a change in the composition of, and growth in, trading assets.

The Firm’s total average interest-earning assets in 2003 were $590 billion, up 6% from the prior year. The net interest yield on these assets, on a fully taxable-equivalent basis, was 2.10%, compared with 2.09% in the prior year.

Noninterest expense

                         
Year ended December 31,                  
(in millions)   2003     2002     Change  
 
Compensation expense
  $ 11,695     $ 10,983       6 %
Occupancy expense
    1,912       1,606       19  
Technology and communications expense
    2,844       2,554       11  
Other expense
    5,137       5,111       1  
Surety settlement and litigation reserve
    100       1,300       (92 )
Merger and restructuring costs
          1,210     NM  
 
Total noninterest expense
  $ 21,688     $ 22,764       (5 )%
 

Compensation expense

Compensation expense in 2003 was 6% higher than in the prior year. The increase principally reflected higher performance-related incentives, and higher pension and other postretirement benefit costs, primarily as a result of changes in actuarial assumptions. For a detailed discussion of pension and other postretirement benefit costs, see Note 6 on pages 89–93 of this Annual Report. The increase pertaining to incentives included $266 million as a result of adopting SFAS 123, and $120 million from the reversal in 2002 of previously accrued expenses for certain forfeitable key employee stock awards, as discussed in Note 7 on pages 93–95 of this Annual Report. Total compensation expense declined as a result of the transfer, beginning April 1, 2003, of 2,800 employees to IBM in connection with a technology outsourcing agreement. The total number of full-time equivalent employees at December 31, 2003 was 93,453 compared with 94,335 at the prior year-end.

Occupancy expense

Occupancy expense of $1.9 billion rose 19% from 2002. The increase reflected costs of additional leased space in midtown Manhattan and in the South and Southwest regions of the United States; higher real estate taxes in New York City; and the cost of enhanced safety measures. Also contributing to the increase were charges for unoccupied excess real estate of $270 million; this compared with $120 million in 2002, mostly in the third quarter of that year.

Technology and communications expense

In 2003, Technology and communications expense was 11% above the prior-year level. The increase was primarily due to a shift in expenses: costs that were previously associated with Compensation and Other expenses shifted, upon the commencement of the IBM outsourcing agreement, to Technology and communications expense. Also contributing to the increase were higher costs related to software amortization. For a further discussion of the IBM outsourcing agreement, see Support Units and Corporate on page 44 of this Annual Report.

Other expense

Other expense in 2003 rose slightly from the prior year, reflecting higher Outside services. For a table showing the components of Other expense, see Note 8 on page 96 of this Annual Report.

Surety settlement and litigation reserve

The Firm added $100 million to the Enron-related litigation reserve in 2003 to supplement a $900 million reserve initially recorded in 2002. The 2002 reserve was established to cover Enron-related matters, as well as certain other material litigation, proceedings and investigations in which the Firm is involved. In addition, in 2002 the Firm recorded a charge of $400 million for the settlement of Enron-related surety litigation.

Merger and restructuring costs

Merger and restructuring costs related to business restructurings announced after January 1, 2002, were recorded in their relevant expense categories. In 2002, Merger and restructuring costs of $1.2 billion, for programs announced prior to January 1, 2002, were viewed by management as nonoperating expenses or “special items.” Refer to Note 8 on pages 95–96 of this Annual Report for a further discussion of Merger and restructuring costs and for a summary, by expense category and business segment, of costs incurred in 2003 and 2002 for programs announced after January 1, 2002.

Provision for credit losses

The 2003 Provision for credit losses was $2.8 billion lower than in 2002, primarily reflecting continued improvement in the quality of the commercial loan portfolio and a higher volume of credit card securitizations. For further information about the Provision for credit losses and the Firm’s management of credit risk, see the discussions of net charge-offs associated with the commercial and consumer loan portfolios and the Allowance for credit losses, on pages 63–65 of this Annual Report.

Income tax expense

Income tax expense was $3.3 billion in 2003, compared with $856 million in 2002. The effective tax rate in 2003 was 33%, compared with 34% in 2002. The tax rate decline was principally attributable to changes in the proportion of income subject to state and local taxes.



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Segment results

JPMorgan Chase’s lines of business 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. Revenues and expenses directly associated with each segment are included in determining that segment’s results. Management accounting and other policies exist to allocate those remaining expenses that are not directly incurred by the segments.

Overview

The wholesale businesses of JPMorgan Chase are known globally as “JPMorgan” and comprise the Investment Bank, Treasury & Securities Services, Investment Management & Private Banking and JPMorgan Partners. The national consumer and middle market businesses are known as “Chase” and collectively comprise Chase Financial Services.

Basis of presentation

The Firm prepares its consolidated financial statements, which appear on pages 82–85 of this Annual Report, using U.S. GAAP and prevailing industry practices. The financial statements are presented on a “reported basis,” which provides the reader with an understanding of the Firm’s results that can be consistently tracked from year to year and enables a comparison of the Firm’s performance with other companies’ U.S. GAAP financial statements.

In addition to analyzing the Firm’s results on a reported basis, management looks at results on an “operating basis,” which is a non-GAAP financial measure, to assess each of its lines of business and to measure overall Firm results against targeted goals. The definition of operating basis starts with the reported U.S. GAAP results and then excludes the impact of credit card securitizations. Securitization does not change JPMorgan Chase’s reported versus operating net income; however, it does affect the classification of items in the Consolidated statement of income. For a further discussion of credit card securitizations, see Chase Cardmember Services on page 41 of this Annual Report.

Prior to 2003, the Firm excluded from its operating results the impact of merger and restructuring costs and special items, as these transactions were viewed by management as not part of the Firm’s normal daily business operations or unusual in nature and, therefore, not indicative of trends. To be considered a special item, the nonrecurring gain or loss had to be at least $75 million or more during 2002. Commencing in 2003, management determined that many of the costs previously considered nonoperating were to be deemed operating costs. However, it is possible that in the future, management may designate certain material gains or losses incurred by the Firm to be “special items.”

The segment results also reflect revenue- and expense-sharing agreements between certain lines of business. Revenue and expenses attributed to shared activities are recognized in each line of business, and any double counting is eliminated at the segment level. These arrangements promote cross-selling and management of shared client expenses. They also ensure that the contributions of both businesses are fully recognized.

Prior-period segment results have been adjusted to reflect alignment of management accounting policies or changes in organizational structure among businesses. Restatements of segment results may occur in the future.

See Note 34 on pages 126-127 of this Annual Report for further information about JPMorgan Chase’s five business segments.

Capital allocation

The Firm allocates capital to its business units utilizing a risk-adjusted methodology, which quantifies credit, market, operational and business risks within each business and additionally, for JPMP, private equity risk. For a discussion of those risks, see the risk management sections on pages 45–74 of this Annual Report. The Firm allocates additional capital to its businesses incorporating an “asset capital tax” on managed assets and some off–balance sheet instruments. In addition, businesses are allocated capital equal to 100% of goodwill and 50% for certain



(FLOW CHART)

JPMorgan is the brand name.JPMorgan ChaseChase is the brand name.Investment Treasury &InvestmentJPMorgan Chase Financial BankSecurities Management &PartnersServices ServicesPrivate BankingProduct type:Businesses:Businesses:Business:Businesses:•Advisory• Institutional Trust• Investment• Private equity• Home Finance•Debt and equityServicesManagementinvestments• Cardmember Services underwriting• Investor Services• Private Banking•Auto Finance•Market-making,• Treasury Services• Regional Banking trading and investing:• Middle Market — Fixed income - Treasury — Equities•Corporate lending

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Management’s discussion and analysis

J.P. Morgan Chase & Co.

The accompanying summary table provides a reconciliation between the Firm’s reported and operating results.

                                                         
    2003 2002
Year ended December 31,   Reported     Credit     Operating     Reported     Credit     Special     Operating  
(in millions, except per share data and ratios)   results(a)     card(b)     basis     results(a)     card(b)     items(c)     basis  
 
Consolidated income statement
                                                       
Total revenue
  $ 33,256     $ 1,870     $ 35,126     $ 29,614     $ 1,439     $     $ 31,053  
Noninterest expense:
                                                       
Compensation expense (d)
    11,695             11,695       10,983                   10,983  
Noncompensation expense (d)
    9,993             9,993       10,571             (1,398 )     9,173  
Merger and restructuring costs
                      1,210             (1,210 )      
 
Total noninterest expense
    21,688             21,688       22,764             (2,608 )     20,156  
Provision for credit losses
    1,540       1,870       3,410 (e)     4,331       1,439             5,770 (e)
 
Income before income tax expense
    10,028             10,028       2,519             2,608       5,127  
Income tax expense
    3,309             3,309       856             887       1,743  
 
Net income
  $ 6,719     $     $ 6,719     $ 1,663     $     $ 1,721     $ 3,384  
 
Earnings per share – diluted
  $ 3.24     $     $ 3.24     $ 0.80     $     $ 0.86     $ 1.66  
 
Return on average common equity (f)
    16 %             16 %     4 %                     8 %
 
(a)  
Represents condensed results as reported in JPMorgan Chase’s financial statements.
(b)  
Represents the impact of credit card securitizations. For securitized receivables, amounts that normally would be reported as Net interest income and as Provision for credit losses are reported as Noninterest revenue.
(c)  
There were no special items in 2003. For 2002, includes merger and restructuring costs. For a description of special items, see Glossary of terms on page 131 of this Annual Report.
(d)  
Compensation expense includes $294 million and $746 million of severance and related costs at December 31, 2003 and 2002, respectively. Noncompensation expense includes $336 million and $144 million of severance and related costs at December 31, 2003 and 2002, respectively.
(e)  
Represents credit costs, which is composed of the Provision for credit losses as well as the credit costs associated with securitized credit card loans.
(f)  
Reflects the return on average common equity as it relates to the Firm. Return on allocated capital is a similar metric used by the business segments.

other intangibles generated through acquisitions. The Firm estimates the portfolio effect on required economic capital based on correlations of risk across risk categories. This estimated diversification benefit is not allocated to the business segments.

Performance measurement

The Firm uses the shareholder value added (“SVA”) framework to measure the performance of its business segments. To derive SVA, a non-GAAP financial measure, for its business segments, the Firm applies a 12% (after-tax) cost of capital to each segment, except JPMP – this business is charged a 15% (after-tax) cost of capital. The capital elements and resultant capital charges provide each business with the financial framework to evaluate the trade-off between using capital versus its return to sharehold-

ers. Capital charges are an integral part of the SVA measurement for each business. Under the Firm’s model, economic capital is either underallocated or overallocated to the business segments, as compared with the Firm’s total common stockholders’ equity. The revenue and SVA impact of this over/under allocation is reported under Support Units and Corporate. See Glossary of terms on page 131 of this Annual Report for a definition of SVA and page 44 of this Annual Report for more details.

JPMorgan Chase’s lines of business utilize individual performance metrics unique to the respective businesses to measure their results versus those of their peers. For a further discussion of these metrics, see each respective line-of-business discussion in this Annual Report.



(PIE CHART)

Contribution of businesses in 2003 Operating revenue (loss)Consumer 42%Wholesale and other 58%Consumer includes:Wholesale and other includes:Chase Home Finance12% Investment Bank41% Chase Cardmember Services 18% Treasury & Securities Services 12% Chase Auto Finance2% Investment Management & Private Banking8% Chase Regional Banking7% Chase Middle Market4% JPMorgan Partners(1)% Other consumer services(1)% Support Units and Corporate (2)%

(PIE CHART)

Operating earnings (losses) Consumer 37%Wholesale and other 63%Consumer includes:Wholesale and other includes:Chase Home Finance20% Investment Bank55% Chase Cardmember Services 10% Treasury & Securities Services 8% Chase Auto Finance3% Investment Management & Private Banking4% Chase Regional Banking1% Chase Middle Market5% JPMorgan Partners(4)% Other consumer services(2)% Support Units and Corporate —%


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Investment Bank

JPMorgan Chase is one of the world’s leading investment banks, as evidenced by the breadth of its client relationships and product capabilities. The Investment Bank has extensive relationships with corporations, financial institutions, governments and institutional investors worldwide. The Firm provides a full range of investment banking and commercial banking products and services, including advising on corporate strategy and structure, capital raising in equity and debt markets, sophisticated risk management, and market-making in cash securities and derivative instruments in all major capital markets. The Investment Bank also commits the Firm’s own capital to proprietary investing and trading activities.

                         
Selected financial data                  
Year ended December 31,                  
(in millions, except ratios                  
and employees)   2003     2002     Change  
 
Operating revenue:
                       
Investment banking fees
  $ 2,855     $ 2,696       6 %
Capital markets and lending revenue:
                       
Trading-related revenue(a)
    6,418       4,479       43  
Net interest income
    2,277       2,642       (14 )
Fees and commissions
    1,646       1,619       2  
Securities gains
    1,065       1,076       (1 )
All other revenue
    179       (14 )   NM  
 
                   
Total capital markets and lending revenue
    11,585       9,802       18  
 
                   
Total operating revenue
    14,440       12,498       16  
Operating expense:
                       
Compensation expense
    4,527       3,974       14  
Noncompensation expense
    3,596       3,451       4  
Severance and related costs
    347       587       (41 )
 
                   
Total operating expense
    8,470       8,012       6  
Operating margin
    5,970       4,486       33  
Credit costs
    (181 )     2,393     NM  
Corporate credit allocation
    (36 )     (82 )     56  
Operating earnings
  $ 3,685     $ 1,303       183  
 
                   
Shareholder value added:
                       
Operating earnings less preferred dividends
  $ 3,663     $ 1,281       186  
Less: cost of capital
    2,295       2,390       (4 )
 
                   
Shareholder value added
  $ 1,368     $ (1,109 )   NM  
 
                   
Average allocated capital
  $ 19,134     $ 19,915       (4 )
Average assets
    510,894       495,464       3  
Return on allocated capital
    19 %     6 %   1,300 bp
Overhead ratio
    59       64       (500 )
Compensation as % of revenue(b)
    31       32       (100 )
Full-time equivalent employees
    14,772       15,145       (2 )%
 
(a)  
Includes net interest income of $2.1 billion and $1.9 billion in 2003 and 2002, respectively.
(b)  
Excludes severance and related costs.

(BAR CHARTS)

Operating revenue Operating earnings (in millions)(in millions, except ratios)Return on allocated capital

Financial results overview

The 2003 performance of IB was positively influenced by a low interest-rate environment, a more favorable equities market and an improving credit market, partially offset by continued weakness in M&A activity.

In 2003, IB reported record operating earnings of $3.7 billion, an increase of 183% compared with 2002. Revenue growth of 16% far outpaced expense growth of 6%. Credit costs were negative $181 million in 2003, compared with $2.4 billion in 2002. Return on allocated capital for the year was 19%.

Operating revenue of $14.4 billion consisted of investment banking fees for advisory and underwriting services; capital markets revenue related to market-making, trading and investing; and revenue from corporate lending activities.

                         
Year ended December 31,                  
(in millions)   2003     2002     Change  
 
Investment banking fees
                       
Advisory
  $ 640     $ 743       (14 )%
Equity underwriting
    697       470       48  
Debt underwriting
    1,518       1,483       2  
 
Total
  $ 2,855     $ 2,696       6 %
 

Investment banking fees of $2.9 billion were up 6%. While Advisory fees declined by 14%, reflecting depressed levels of M&A activity, debt underwriting fees were up 2%. This 2% increase is primarily due to growth in high yield underwriting and structured finance fees and reflects a partial offset of lower loan syndication fees. The key contributor to the overall increase in IB fees was equity underwriting revenue, which was up 48%, reflecting increases in market share and underwriting volumes.



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Management’s discussion and analysis

J.P. Morgan Chase & Co.

Market shares and rankings(a)

            2003   2002
December 31,   Market share     Ranking     Market share     Ranking  
 
     
Global syndicated loans
    18 %     #1       23 %     #1  
     
Global investment-grade bonds
    8       #2       9       #2  
     
Euro-denominated corporate international bonds
    5       #6       6       #4  
     
Global equity & equity-related
    9       #4       4       #8  
     
U.S. equity & equity-related
    11       #4       6       #6  
     
Global announced M&A
    16       #5       14       #5  
 
(a)  
Derived from Thomson Financial Securities Data, which reflects subsequent updates to prior-period information. Global announced M&A based on rank value; all others based on proceeds, with full credit to each book manager/equal if joint. Because of joint assignments, market share of all participants will add up to more than 100%.

The Firm improved its ranking in global equity and equity-related underwriting to No. 4 from No. 8 in 2002. It also maintained its No. 2 ranking in underwriting global investment-grade bonds, its No. 1 ranking in global loan syndications and its No. 5 ranking in global announced M&A.

Capital markets revenue includes Trading revenue, Fees and commissions, Securities gains, related Net interest income and Other revenue. These activities are managed on a total-return revenue basis, which includes operating revenue plus the change in unrealized ga