Regulatory Corner

In this edition, we are pleased to provide an update on significant regulatory developments during the quarter. For more information, please contact your securities lending relationship manager.

On May 1, 2009 the U.S. implemented the Treasury Market Practices Group’s (TMPG) recommendation that settlement fails in U.S Treasury securities transactions be subject to a financial charge when interest rates are low. The new measure is designed to address a weakness in market practices when interest rates are close to zero that can lead to widespread and chronic settlement fails. The New York Federal Reserve adopted the trading practice in its own market operations and encouraged its adoption by all market participants. J.P. Morgan hosted several educational sessions to explain the policy and process for U.S. Treasury settlement fails to our clients. Please contact your securities lending relationship manager for more information.

The Technical Committee of the International Organization of Securities Commissions (IOSCO) published its final report on the regulation of short selling. J.P. Morgan participated fully in the consultation process and welcomed the Technical Committee’s findings. The report reaffirms the value of short selling with respect to price discovery, market liquidity, mitigating market bubbles, and risk management (including hedging), while also describing how certain types of short selling in combination with abusive strategies and in extreme market conditions may contribute to disorderly markets. To mitigate such risks, the report offers four principles for the effective regulation of short selling:

1. Short selling should be subject to appropriate controls to reduce or minimize the potential risks that could affect the orderly and efficient functioning and stability of financial markets.
2. Short selling should be subject to a reporting regime that provides timely information to the market or to market authorities.
3. Short selling should be subject to an effective compliance and enforcement system.
4. Short-selling regulation should allow appropriate exceptions for certain types of transactions for efficient market functioning and development.

The Federal Deposit Insurance Fund’s (FDIC’s) special assessment fee was lower than some expected. The second quarter special assessment fee was levied against all insured financial institutions in the U.S., and was calculated by taking total assets less Tier 1 capital. The one-time assessment took into account all liabilities – and not just domestic deposits. It was expected to raise approximately $5 billion for the FDIC, whose reserves have been depleted by bank failures.

U.S. financial institutions demonstrated decreasing reliance on Federal Reserve liquidity facilities with some programs set to end in October 2008. The Asset Backed Commercial Paper and Money Market Mutual Fund Liquidity Facility (AMLF) shrunk by nearly 50% from its spike in early May and the Commercial Paper Funding Facility (CPFF) declined for ten straight weeks, ending the quarter with the lowest balance since the program’s inception. The Federal Reserve (Fed) made an important modification to the AMLF, requiring money market funds to experience “material outflows” to be eligible (defined as redemptions of 5% in a single day or 10% over five business days). It is expected that the Fed will allow AMLF and CPFF to expire in February 2010. In addition, the Fed will allow the Money Market Investor Funding Facility (MMIFF) to expire at the end of October. The MMIFF, the only facility that was eligible for securities lenders, has not been utilized to date. With weak demand for collateral under the Federal Reserve’s Term Securities Lending Facility (TSLF), the Fed announced on June 25 the suspension of TSLF auctions backed by schedule 1 securities (Treasury, Agency debt, and Agency-guaranteed mortgage backed securities). The Federal Reserve also suspended the TSLF Options Program (TOP), effective on the maturity date of outstanding June TOP options. TSLF auctions backed by schedule 2 collateral (schedule 1 collateral and investment-grade corporate, municipal, mortgage-backed, and asset-backed securities) will now be conducted every four weeks, rather than every two weeks, and the total amount offered under the TSLF was reduced to $75 billion.

As additional evidence of normalization, select banking institutions, including J.P. Morgan, were granted permission by the U.S. Treasury in June to repay funds distributed under the Troubled Asset Relief Program (TARP). The announcement was made after the institutions successfully completed extensive stress tests to demonstrate sufficient capital strength without the government funding under various difficult scenarios. J.P. Morgan paid the funds in full in June, and expects a Tier 1 capital ratio above 9% for second quarter, reflecting our ongoing financial health. Overall, more than ten U.S. liquidity facilities and programs continued to operate in the second quarter, as part of the U.S. government effort to restore liquidity and stability to the financial markets. For more information on specific programs, please visit www.financialstability.gov or speak to your relationship manager.