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Months ago, when "the Whale" news was being bandied about, I said buying JPMorgan (NYSE:JPM) in light of the valuation and sentiment made sense. At the time JPM traded down to $32 and the losses from the London shenanigans were possible to be roughly estimated and were certainly much lower than what JPM had lost in market capitalization.

Since the logic was decent and the overall market helped, today JPM trades much higher -- above $48 as I write these lines. Due to recent developments, however, it is probably a good time to get rid of the shares.

The reason

The reason for dropping JPM here is tied to the headline risk which is increasing quickly for JPM. JPM's valuation remains reasonable, with the P/E floating between 8 and 9 and the stock trading at 0.95 times book. However, contrary to the "Whale" event, right now the headline risk is much harder to quantify.

The headline risk comes from the fact that JPM participated in the MBS frenzy during the credit bubble. It participated directly through its own operations and indirectly through its subsidiary Bear Stearns, which it bought during the credit crisis.

At the time, JPM bought mortgages that it packaged into MBS and sold. Obviously, it's well known that many of these mortgages were fraudulent, with inflated incomes (that was the era of "stated income" which was routinely inflated) and many other shenanigans taking place. It so happens that it seems likely that JPM had known of many deficiencies these mortgages had before packaging and selling them to Fannie Mae, Freddie Mac and many other investors, and the news of this knowledge are now coming out.

Knowing this, those investors are charging back and suing JPM for the losses they suffered. Just today we saw an article stating that there are e-mails pointing towards many wrongdoings at JPM and Bear Stearns. It is both likely that more of these articles will surface, and that JPM might lose, or be speculated to lose, some large lawsuits. Such will constitute the headline risk for JPM, as some of the lawsuits -- particularly those involving Fannie Mae/Freddie Mac -- should have the possibility of being large enough to make those relevant even for JPM.

Size of the problem

It's hard to estimate the size of the potential liability for JPM. JPM presently carries a $183 billion market capitalization and was certainly just one among many sellers of the type of products which ultimately produced losses for the investors.

The problem here is that the total market, which ultimately produced losses in the hundreds of billions of dollars, was up to around $2 trillion at the top of the credit bubble (chart below). Now much of the hundreds of billions lost then (for instance, it is estimated that the cost of supporting Fannie Mae and Freddie Mac will be up to $300 billion) will come back asking for satisfaction from the sellers of the securities. And the problem here is that fraud did take place massively at the time, so there will be a lot of proof that many of the securities were backed by fraudulent product.

(click to enlarge)

In short, the size of the potential problem appears relevant when compared to the size of the market capitalization of JPM, and even if ultimately JPM dodges the bullet it can still have market impact. This is different from the "Whale" problem, where the ultimate size was reasonably well known and not large enough to ultimately pose a problem.

Other banks at risk

Perhaps even more than JPM, Bank of America (NYSE:BAC) is at risk regarding this problem. The investors which took losses will turn every rock to find problems with the investments they made, and there are a lot of very obvious problems to be found regarding the underlying mortgages, lending strength to the investors' side.

Bank of America is at risk because in one of the most egregrious segments of the market, CDO issuance, it and especially Merrill Lynch (since bought by Bank of America) were among the largest issuers (Source: "The Story of the CDO Market Meltdown: An Empirical Analysis", Anna Katherine Barnett-Hart).

(click to enlarge)

Conclusion

Having had a giant run and now being faced with substantially increased headline risk of a material nature, it seems a good place to let go of JPM shares and BAC shares. The problem is both large enough and difficult to ultimately quantify, which makes it materially different from "the Whale" where the problem was not large enough and quantifiable within a range which made it less important.

Source: Headline Risk Increasing For JPMorgan