by Doug Ehrman
While the bulk of coverage that will be given to the most recent in a long line of "questionable" trading decisions by a major Wall Street firm will be focused on the poor judgment of upper management, the real tragedy of this event is that it may tip the debate over the so-called "Volcker Rule" in favor of those who wish to remove the control from the professionals.
While a $2 billion loss is not immaterial, when CEO Jamie Dimon called the event a "tempest in a teapot," he was dead right. Over the weekend, however, Mr. Dimon has taken the advice of his PR department, and probably his lawyers, reversing his position. He now claims that he was dead wrong when he made the statement. If one looks at the reality of the situation, however, the whole media fiasco makes sense. Mr. Dimon is a very smart man, clearly realizing that investment truth and political truth are often different. Sometimes they are at opposite ends of the spectrum.
The Investment Ramifications
While no trader would ever aspire to lose $2 billion dollars, the entire context of the trade is what should be considered and discussed. JP Morgan Chase (JPM) has a trading portfolio in the realm of $150 billion dollars. The trade in question, therefore, represents less than 2% of the total book. This is a big drawdown for a single trade, but it is hardly catastrophic.
The idea that the CEO of an organization the size of JP Morgan should track every trade made on the company's books is typical of the naiveté of the press, politicians and often the public. If Mr. Dimon watched ever trade that carefully, he would be better off serving as a trader. He should be aware of the company's overall positions, risk controls and other details, but a dose of reality is in order. Maybe a position of this size should have been on his radar, but without a full review of the company's portfolio and trading activity, there is no cogent way to know.
In addition to the relative size of the trade, there is no reason to doubt that the trade was, in fact, a hedge. As such, the idea of discussing the size of the loss without considering the other side of the trade is also naïve. For the record, a good hedge will lose money when the trade, or trades, it protects make money. It is in place to protect against a catastrophic loss.
This protection has a cost, usually lowering the return of the trade, but serving as protection or insurance. It is likely that in this case, the hedge went very bad and lost more than was anticipated, but little has been written about that piece of the puzzle. What has been repeated over and over again by Mr. Dimon is that the company will make money. It would have made more money without the hedge, but it will make money. This should help to underline the contextual importance of this story - the company lost $2 billion and is making money. There is no reason to panic.
The Political Ramifications
If there is no reason to panic why is everyone politician racing for the nearest camera to squawk about evil Wall Street again? Aside from the fact that it is an election year, the simplest way to bend public opinion is to convince people that they need to be protected. Despite the fact that Jamie Dimon and JP Morgan behaved exactly as we would like them to, holding a special conference call to keep everyone in the loop, they will be partially vilified to serve a political end.
If the great Mr. Dimon cannot be trusted, we must have Dodd-Frank and the Volcker Rule to keep us all safe. God forbid the professional traders and asset managers should be responsible for running their own portfolios, much better to have the politicians and regulators involved, with all of their training and incentives to get things right. The plan is really quite brilliant and simple - Wall Street, and therefore the Republicans, are not trustworthy.
If we do not rally behind those trying to protect us, who knows where we may end up, but a return to the dark ages and the feudal system seems probable. Not that the "conservative" party is without its share of prophets. Even the party of small government is likely to join this crusade. It's a sexy political issue and everyone wants a piece.
How to Play The Stock
The safest play is to simply skip this stock until things stabilize. However, the selloff of over 10% last week presents an interesting opportunity. If one is willing to accept a somewhat elevated level of risk, the upside potential in the stock is significant. If one believes that this information is simply the proverbial tip of the iceberg, stay away. Otherwise, remember that this company was the jewel of the financial sector a week ago. It may be slightly less attractive, but only slightly.
Compared to peers, the company has fallen back in line on a valuation basis. JP Morgan has a price-to-earnings ratio of 8.2 relative to 13.7 for UBS AG (UBS), 8.4 for Barclays PLC (BCS), 8.2 for Citigroup (C), and a negative earnings number for Bank of America (BAC). While this is but one metric, it demonstrates that given JP Morgan's attractive position within the market, it represents a good value and a strong play at current levels. One should proceed with caution, but this may be a great profit opportunity.