A Dual Strategy to Balance Banking Sector Trade

As the credit crisis evolves, many steadfast rules have been discarded.  Companies once thought too big to fail are gone and a free market administration has expanded the government's role in the economy to a level last seen during FDR's New Deal. 

With constant shifts, investors must assess how the landscape has changed and what a prudent investor must do to profit.  During this chaos, one constant has remained.  In the banking sector, JPMorgan Chase (JPM) stands alone as the trendsetting institution capable of profiting from others' misfortunes.

JPM possesses advantages other firms lack.  They have among the best management teams in the banking industry, one of the stronger balance sheets and the ability to manage risk that few others have mastered.  These attributes have allowed JPM to play a key role during the crisis and absorb both Washington Mutual (WaMu) and Bear Stearns in government assisted mergers.  By helping increase the deposit base and adding complementary lines of business, JPM is now a key competitor in every area in which they operate.

When acquiring Bear Stearns, JPM's risk profile was clear.  With WaMu, the downside was unknown.  WaMmu possessed one of the worst balance sheets I have ever seen, littered with Option ARMs in inflated housing markets.

JPM faced a tough decision.  If they allowed these loans to continue to negatively amortize (negam), JPM would be making a huge bet on the housing market.  However, if they stopped the negam and modified these loans to current market rates, borrowers would be unable to afford the higher monthly payments and would be forced into foreclosure.  Knowing that banks are in business to collect money, not own homes, neither option was appealing.  Last week JPM unveiled the first step in a process that both limits negam and prevents further foreclosures.

This past Friday, JPM announced its intent to modifying $150 billion of mortgage loans.  While details were limited, we can expect some combination of lower interest rates and reduced principal balances to help homeowners obtain a monthly payment they can afford.  The greater affordability will allow people to remain in their homes, will stem the tide of foreclosures and should eventually provide support to the housing market. 

Personally, I do not like the path that massive loan modifications represent.  By reducing loan balances and interest rates, bankers are penalizing prudence and rewarding speculation.  While I could write pages on how this will only cause future problems, that is a pointless exercise.  As investors, our job is to predict actions, determine their effect and decide how to profit.

Looking back to the mortgage bubble, three main lenders were seen making questionable loans in mass size.  These lenders were Countrywide, Golden West and Wamu.  Today, Countrywide is part of Bank America or BofA (BAC), WaMu is part of JPM and Golden West is part of Wells Fargo (WFC) via the Wachovia merger.  With JPM's modification intentions, we can expect that BofA and Wells must follow suit.  Maintaining high mortgage payments when your competitors are reducing them is politically unpalatable.

Knowing other banks will follow suit, JPM has taken a proactive lead to weaken their competitors.  BofA and Wells have weaker balance sheets and more pressing needs.  Both these companies are undertaking transformative mergers outside of their areas of expertise. 

Combine the management uncertainty with the capital needs, a large scale loan modification is an event they would rather not face.  However, JPM has pushed these banks in that direction.  By dictating the pace of the conversation and having the capital needed to take action, JPM will emerge as the strongest bank.  The end result will be increased market share and higher future profitability.

Based on long term earnings power, JPM could trade toward $55 in the coming months.  With the shares trading near 1.6x tangible book value, we see a stock with strong upside potential, a nice level of current income (3.7% dividend yield) and a reasonable valuation that provides a margin of safety.  All in, this is a stock to own for the future.

Buying JPM is a clear choice, but risk management remains a concern.  A prudent investor will hedge their risk while attempting to profit from a move higher in JPM's stock price. 

Since option strategies are uneconomical, I recommend a short position in Wells.  While JPM trades at a reasonable 1.6x tangible book value, Wells trades at 3.1x tangible book value. 

Further, I believe there are risks in Wells' home equity portfolio that the market has not fully digested.  This provides a rare opportunity where a pair trade can offer appreciation on the long side and profit from a short sale as well. 

Over time, the valuation of Wells and JPM should converge.  By shorting what is dear and buying what is cheap, an investor can manage their risk profile while skewing the portfolio for future gains.

Comments

[1worldcurrency:]

All I have to say is that according to the Treasury Department JPM has $90,000,000,000,000 (trillion) notional exposure to derivatives.

Maybe they made the right bets, maybe not.

2008 Nov 04 05:51 AM

[Stealthmouse:]

I wouldn't touch JPM. The timing is uncertain, but with its derivative book and net exposure versus risk-based capital, it is a guaranteed zero sometime in this credit cycle. And unfortunately when JPM finally bites it, the government will be out of money (i.e., won't be able to print enough to make it happen).

2008 Nov 04 10:58 AM

[sumosama:]

Not sure you know how to read a balance sheet...you might want to re-read Wells' as well as the deal they are making with WB.

2008 Nov 04 12:10 PM

[I should know:]

Your quote: "Knowing other banks will follow suit, JPM has taken a proactive lead to weaken their competitors. BofA and Wells have weaker balance sheets and more pressing needs. Both these companies are undertaking transformative mergers outside of their areas of expertise."

**********************...

I would disagree with the above statement. Wells Fargo & Co has a great record for their merger and integration of other banks and financial institutions. When Norwest Bank merged with Wells Fargo, Norwest was the survivor. That merger is considered the best and smoothest major bank merger in history, masterminded by Dick Kovacevich who was CEO of Norwest at the time. He is still onboard and this merger is his baby. I DON’T disagree that with the acquisition of Wachovia, Wells Fargo took on a bunch of stinky loans originated by Great Western; now they are going to have to do something about them. However, I think they have planned a $71 billion write down on these loans. No bank is immune from meltdown in this volatile market, but Wells Fargo is up 12% from this day last year, while at the same time, the Dow is down 27%.

2008 Nov 04 12:57 PM