Marjorie E. Gross, Esq.
Managing Director and
   Associate General Counsel
J.P. Morgan Chase & Co.
Legal Department
270 Park Avenue
New York, New York 10017

Dear Ms. Gross:

This is in response to the request by J.P. Morgan Chase & Co., New York, New York ("JPMorganChase"), for an exemption from section 23A of the Federal Reserve Act that would allow The Chase Manhattan Bank, New York, New York ("Chase Bank"), to make certain guarantees on behalf of, and extensions of credit to, J.P. Morgan Securities Inc., New York, New York ("JPMSI"), in connection with the bank's securities lending program.¹

Chase Bank maintains custody and trust accounts for its customers. As part of this business, the bank offers customers that have "buy and hold" investment portfolios an opportunity to increase the yield on their portfolios by lending securities to others, typically securities broker-dealers ("Borrowers"), who need the securities to cover fails or short sales. Chase Bank actively engages in securities lending transactions with a number of unaffiliated securities broker-dealers.

In Chase Bank's securities lending program, the bank, as agent for a customer, lends securities in a customer's portfolio ("Borrowed Securities") to a Borrower. The Borrower may use the Borrowed Securities for its own purposes but must return the securities upon demand by the bank's customer. The Borrower provides collateral to Chase Bank, as agent for the customer, usually in the form of cash but sometimes in the form of other securities or letters of credit. The value of the collateral slightly exceeds the value of the Borrowed Securities.²

Three aspects of the program expose Chase Bank to credit risk in a manner that raises section 23A issues when the Borrower is an affiliate of the bank. First, in the agreement between Chase Bank and its customer, the bank undertakes to return the Borrowed Securities to the customer whether or not the securities are returned to the bank by the Borrower. This indemnity is limited, however, to the amount by which the value of the Borrowed Securities exceeds the value of the collateral posted by the Borrower. The bank limits its exposure on this indemnity by marking the Borrowed Securities and any securities collateral to market daily and calling for additional collateral in the event that the value of the collateral posted by the Borrower drops below the value of the Borrowed Securities.³

Second, during the term of a securities loan, the Borrower has an obligation promptly to transmit to Chase Bank's customer any dividends, interest payments, or other similar distributions made by issuers on the Borrowed Securities. Under the typical agreement, the bank is obligated to credit the customer's account with these distributions on the date the distributions are payable by the issuer, regardless of whether the Borrower has forwarded the distribution amounts to the bank for the account of the customer. Thus, the bank typically has a short-term credit exposure to the Borrower in the amount of any distributions that the bank has credited to a customer's account in advance of having received the distribution from the Borrower. Third, during the term of a securities loan, Chase Bank has discretion to advance funds to a Borrower, on behalf of a customer, in order to pay fees owed by the customer to the Borrower or to return excess collateral to the Borrower.

As noted above, Chase Bank engages in securities lending transactions on behalf of its customers with a number of unaffiliated securities broker-dealers. The bank proposes to engage in securities lending transactions with its broker-dealer affiliate, JPMSI, on the same terms and conditions that it lends customer securities to unaffiliated broker-dealers. Because these transactions would involve guarantees by the bank on behalf of JPMSI, and extensions of credit by the bank to JPMSI, JPMSI's participation in the securities lending program would be subject to the quantitative, collateral, and other requirements in section 23A.

Section 23A limits the amount of "covered transactions" between a bank and any single affiliate to 10 percent of the bank's capital stock and surplus, and limits the amount of covered transactions between a bank and all its affiliates to 20 percent of the bank's capital stock and surplus. "Covered transactions" include a bank's purchase of assets from an affiliate, a bank's extension of credit to an affiliate, and a bank's issuance of a guarantee on behalf of an affiliate. The statute also requires a bank to secure its extensions of credit to, and guarantees on behalf of, affiliates with prescribed amounts of collateral. In addition, section 23A has an "attribution rule" that treats as a covered transaction any transaction between a bank and a nonaffiliate to the extent that the proceeds of the transaction are used for the benefit of, or transferred to, an affiliate.

Section 23A specifically authorizes the Board to exempt "at its discretion . . . transactions or relationships from the requirements of this section if it finds such exemptions to be in the public interest and consistent with the purposes of this section."⁴ JPMorganChase has requested an exemption from section 23A in order to allow Chase Bank to conduct its securities lending program with JPMSI in the same manner as it conducts this program with unaffiliated securities broker-dealers.

Granting an exemption from the section 23A requirements for each of the three types of credit exposure generated by Chase Bank's securities lending program appears to be appropriate for several reasons. First, in the case of the indemnity given by Chase Bank to its customers on behalf of JPMSI, the risk of loss to the bank does not appear to be substantial. As noted above, the bank's exposure on the indemnity is limited to the amount by which the market value of the Borrowed Securities exceeds the amount of collateral posted by JPMSI. So long as the bank employs adequate daily mark-to-market and collateralization procedures in the securities lending program, the bank should rarely be exposed in any substantial amount to the credit risk of JPMSI. ⁵ On cash-collateralized transactions, the maximum credit exposure of Chase Bank to JPMSI on the indemnity is a two-day market move on the Borrowed Securities.⁶ On transactions collateralized by securities, the maximum credit exposure of the bank to JPMSI is the amount by which the value of the Borrowed Securities might exceed the value of the securities collateral over a two-day period.

Importantly, a significant, precipitous decline in the market value of the Borrowed Securities would not create Chase Bank exposure on the indemnity. The indemnity only covers situations where a Borrower fails to return the Borrowed Securities and the market value of the Borrowed Securities rises above the amount of the collateral posted. Accordingly, Chase Bank's obligations with respect to the indemnity generally would not increase in times of stress in the financial markets, when the bank would have a heightened need to preserve its capital.

In addition, section 23A accords special treatment to transactions secured by cash.⁷ Moreover, the Board has fully discounted the credit risk generated by certain cash-collateralized securities lending transactions in its Capital Adequacy Guidelines for bank holding companies and state member banks ("Capital Guidelines").⁸ Under the Capital Guidelines, if an organization provides an indemnity on a cash-collateralized transaction with terms and conditions similar to those of the Chase Bank indemnity in its securities lending program, the transaction generally is excluded from the organization's risk-based capital calculation.

The case for exempting securities lending transactions secured by U.S. government securities is also strong. Transactions secured by securities collateral pose more risk to Chase Bank than those that are cash-collateralized because, as noted, the bank's indemnity would cover any decline in the value of the securities collateral in addition to any increase in the value of the Borrowed Securities. Nevertheless, an exemption appears to be warranted when the collateral is U.S. government securities, in light of their low investment risk and the special treatment that section 23A and the Capital Guidelines accord to U.S. government securities.⁹

The case for exempting transactions collateralized by property other than cash or U.S. government securities is not as strong. Corporate, municipal, and non-U.S. obligations have a greater investment risk than cash and U.S. government securities, and section 23A does not provide any exemption for transactions secured by property other than cash or U.S. government securities.¹⁰

In light of all the facts of record, the Board believes that it would be appropriate to grant a limited exemption for transactions secured by property other than cash or U.S. government securities. Under this limited exemption, securities lending transactions with JPMSI secured by property other than cash or U.S. government securities would be exempt from section 23A to the extent that the total market value of Borrowed Securities lent to JPMSI by Chase Bank's customers against such collateral did not in the aggregate exceed the lesser of (i) 5 percent of the bank's capital stock and surplus; or (ii) 5 percent of the total market value of Borrowed Securities lent to JPMSI by the bank's customers. If the total market value of Borrowed Securities lent to JPMSI by the bank's customers against property other than cash or U.S. government securities exceeds this threshold, that marginal amount would be treated as a nonexempt guarantee by the bank on behalf of an affiliate under section 23A and, accordingly, would be subject to the quantitative limits and collateral and other requirements of section 23A.¹¹

The second type of affiliate credit exposure that Chase Bank faces in connection with lending securities to JPMSI arises from advances by the bank to customers of funds (such as interest payments or dividends) that are distributed by the issuer of the Borrowed Securities to JPMSI. These advances to customers on behalf of JPMSI are short-term and generally are repaid on an intraday basis. For U.S. equity securities and U.S. government securities, the Depository Trust Company would automatically pass distributions on the Borrowed Securities to the bank's customer by the end of the payable date. For U.S. corporate debt securities, accrued interest is part of the mark-to-market value of the Borrowed Securities; hence, the bank should be holding sufficient collateral to cover any interest payments that JPMSI fails to pass through to the customer. Uncollateralized, overnight (but still short-term) exposures typically are generated only with respect to distributions on foreign securities.

The third type of credit exposure arises from advances by Chase Bank to JPMSI on behalf of the bank's customers. These advances also are generally short-term and are secured by the investment securities in the customer's account.

In the case of each of the three types of exposure, as well as other aspects of the transaction that involve payments by Chase Bank to or on behalf of JPMSI, the bank would continue to be subject to the market terms requirement of section 23B. Section 23B requires that these exposures and payments be on terms that are substantially the same, or at least as favorable to the bank, as those prevailing at the time for comparable transactions with unaffiliated companies. Chase Bank has stated that JPMSI would be added to the list of eligible Borrowers in its securities lending program on exactly the same terms (including with respect to the indemnity and the advances) as those that apply to the numerous unaffiliated broker-dealers that participate in the program.¹²

Because numerous unaffiliated Borrowers participate in the securities lending program, examiners would be able to verify on an ongoing basis whether Chase Bank's covered transactions with JPMSI in the program are on substantially the same terms as those prevailing with nonaffiliates. Likewise, section 23B would prevent the bank from agreeing to indemnify or make an advance to a customer on behalf of JPMSI unless the bank would agree to make the same indemnity or advance on behalf of a similarly situated nonaffiliate, and would prevent the bank from making an advance to JPMSI on behalf of a customer unless the bank would make the advance to a similarly situated nonaffiliate on behalf of the customer.¹³

Granting the exemption would enable the bank's customers to obtain additional securities lending opportunities (and, as a consequence, an increased yield on their investment portfolios) and an increased ability to diversify the risks of securities lending.

In light of these considerations and all the facts you have presented, the transactions appear to be consistent with safe and sound banking practices and the purposes of section 23A. Accordingly, the Board hereby grants the requested exemption (subject to the indicated limits on securities lending transactions collateralized by property other than cash or U.S. government securities).¹⁴

This determination is specifically conditioned on compliance by JPMorganChase and Chase Bank with all the commitments and representations they made in connection with the exemption request. These commitments and representations are deemed to be conditions imposed in writing by the Board in connection with granting the request and, as such, may be enforced in proceedings under applicable law. This determination is based on the specific facts and circumstances of the securities lending program described in your correspondence and this letter. Any material change in those facts and circumstances or any failure by JPMorganChase or Chase Bank to observe any of its commitments or representations may result in a different view or in a revocation of the exemption.

Very truly yours,

(Signed) Jennifer J. Johnson

cc: Federal Reserve Bank of New York

1. 12 U.S.C. � 371c. JPMorganChase also has requested that the Board grant a broader exemption that would apply to securities lending transactions between any subsidiary bank of JPMorganChase, on the one hand, and any broker-dealer affiliate of the banks, on the other hand. Return to text

2. The amount of collateral that a Borrower must post is generally 102 percent of the value of the Borrowed Securities. A Borrower must post an amount of collateral equal to 105 percent of the value of the Borrowed Securities if the collateral is denominated in a different currency than the Borrowed Securities. Return to text

3. JPMorganChase has argued that the indemnity should be considered exempt under section 23A(d)(4) as a transaction fully secured by cash or U.S. government securities. See 12 U.S.C. � 371c(d)(4). The Board does not believe that the indemnity would qualify for the (d)(4) exemption because of the bank's unsecured indeterminate potential future exposure on the indemnity and because the bank would have an exposure on the indemnity during the period between the actualization of the potential future exposure and any collateral supplementation. Return to text

4. 12 U.S.C. � 371c(f)(2). Return to text

5. Chase Bank has represented that it would require the same collateral margins from JPMSI that it requires of other Borrowers and would value Borrowed Securities and collateral using the same mechanisms regardless of whether JPMSI or a nonaffiliate were the Borrower. Return to text

6. Chase Bank generally marks its securities lending portfolio to market on the morning of each business day, based on closing prices for securities from the previous business day, and makes collateral calls to Borrowers promptly thereafter. The agreements underlying the bank's securities lending program generally require the Borrower to meet collateral calls on the same business day as the calls are made by the bank. Return to text

7. Under section 23A, credit transactions fully secured by "a segregated, earmarked deposit account with the member bank" are exempt from the statute. 12 U.S.C. � 371c(d)(4). As noted above, the indemnity does not meet the terms of this statutory exemption. Return to text

8. See 12 C.F.R. Part 225, Appendix A, section III.D.1.i; 12 C.F.R. Part 208, Appendix A, section III.D.1.i. Return to text

9. Under the Capital Guidelines, claims like the Chase indemnity would receive a zero percent risk weighting if collateralized by securities issued by U.S. government agencies. See, e.g., 12 CFR Part 225, Appendix A, section III.C.1. Under section 23A, credit transactions fully secured by "obligations of the United States or its agencies" or "obligations fully guaranteed by the United States or its agencies as to principal and interest" are exempt from the statute. 12 U.S.C. � 371c(d)(4). As noted above, the indemnity does not meet the terms of this statutory exemption. Return to text

10. Under the Capital Guidelines, claims on corporate, municipal, and most other non-U.S. government entities receive a risk weighting between 20 percent and 100 percent. See, e.g., 12 CFR Part 225, Appendix A, section III.C. Return to text

11. If, notwithstanding the lack of contractual liability, Chase Bank makes JPMSI whole for the customer's failure to return collateral posted by JPMSI, the reimbursement would be subject to sections 23A and 23B and would not be protected by the exemption granted in this letter. Return to text

12. In particular, JPMSI would be given no preferential treatment in the allocation of bank customer securities, and fees paid by or to JPMSI in connection with securities lending transactions would be the same as those paid by or to unaffiliated Borrowers entering into comparable transactions. Return to text

13. Chase Bank has represented that it periodically reviews the credit quality of Borrowers in its securities lending program and would reduce a Borrower's credit line or remove a Borrower from the program (including JPMSI) if the Borrower's credit quality so warranted. Return to text

14. As noted, JPMorganChase has requested that the Board grant an exemption that would apply to securities lending transactions between any subsidiary bank of JPMorganChase, on the one hand, and any broker-dealer affiliate of the banks, on the other hand. The Board's grant of exemption to JPMorganChase's subsidiary banks other than Chase Bank is subject to the further conditions that (i) the securities lending program of any other subsidiary bank is structured in an identical manner as that of Chase Bank; (ii) the other subsidiary bank engages in securities lending transactions with a number of unaffiliated securities broker-dealers; and (iii) the other subsidiary bank includes affiliated broker-dealers in its securities lending program on exactly the same terms that apply to unaffiliated broker-dealers that participate in the program. Return to text