How to Hedge Your JPMorgan Investment

By Bill Edson - July 20, 2012 | Tickers: JPM, NTRS, USB, WFC | 0 Comments

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In 2012 investors in financial companies should know that they are investing in black boxes which could generate huge, sporadic losses. Firms like JPMorgan Chase (NYSE: JPM) will seem stable for years only to report a catastrophic loss which could never be forecasted from financial statements. This news should not come as a surprise. Yet somehow the market is punishing JPMorgan for "surprise" losses that it should come to expect from these firms. There is no excuse for this implied naivety and the dramatic overreaction in JPMorgan's stock price. In fact, the recent price drop in JPMorgan shares might be an attractive buying opportunity for bank investors. Below, I will explain why investors considering JPMorgan should also consider taking short positions in shares of Wells Fargo (NYSE: WFC), U.S. Bancorp (NYSE: USB), or Northern Trust (NASDAQ: NTRS) as hedges.

Ugly Media Attention for JPMorgan

JPMorgan made public that their bungled credit scheme could cost more than $7 billion, a loss which JPMorgan's traders may have tried to hush up. Using e-mails and taped calls, JPMorgan found that it had overvalued its first quarter performance by approximately $660 million. Much of the overvalued securities' worth had been assessed by the same trader who purchased them, a compliance measure based on the honor system which enables individuals to cover up or lowball losses. Four investors for JPMorgan's office in London have been implicated and have left the bank, but are being fined heavily with amounts that would equal approximately two years pay for each former employee. Although JPMorgan's second quarter profit was $5 billion, it decreased 9% and was lower than last year's performance in the second quarter. The controversy over trades correlates to the bank's decrease in market value.

The gigantic loss felt by JPMorgan is largely due to Bruno Iksil, the "London Whale" so named because of his tendency to go big or go home on investments. Iksil's choice to put all his chips on US corporate bonds expecting a big payout cost JPMorgan $5.8 billion, three times the bank's estimated risk.

Class action suits are being levied against JPMorgan by Louisiana, Oregon, Arkansas, Ohio, and a Swedish national pension fund for mismanaging public pension funds, causing these funds to sustain big trading losses. These cases rest on the fact that investors were given wrong information about the risk and financial condition of their investments.

Several organizations, including SEC, the Justice Department, the Commodity Futures Trading Commission, and different Congressional committees are now investigating JPMorgan Chase because of this fiasco.

Duh! Taming Tigers is Dangerous Business.

It is impossible to predict the date or extent of the next scandal which will result from a financial company's operations, but it is possible to expect such news to arise at these firms. This is the nature of their business: to push risk models and trading methods until losses must be made public.

This is like taming tigers. You and I know tigers are dangerous and that they infrequently turn on their masters and maul them. That's an occupational hazard. Siegfried and Roy had many safe years of taming tigers until one turned on them. Could I guess when? No. But if you ask me about working with tigers, mauling is a very real risk factor. It would be idiotic for me to think that this risk does not exist. JPMorgan tames financial tigers, and it got mauled recently. It will continue to tame tigers in its business, and will continue to embrace this risk. So will other financial companies. Their outlooks are roughly equally risky (and can't be distinguished because of opaque mark-to-model accounting conventions).

With this in mind, a long-short portfolio may be constructed using JPMorgan as a long position and other banks with similar past price movements as short positions to hedge JPMorgan's everyday business. This hedging will not hedge future mauling events, since the timing and severity of these incidents are uncorrelated. Instead, it will hedge industry-wide risks.

Several national and regional banks were analyzed over the five-year period from May 2007 to May 2012 to determine which, if any, move the most with JPMorgan's stock price movements prior to the current trading scandal. (Price movements were analyzed by taking the natural log of dividend-adjusted daily price changes and regressing them on JPMorgan's time series data.)

Higher R-squared values mean that the stock movements mimic the price movements of JPMorgan more closely. Higher slope values mean that the stock is more sensitive to JPMorgan price moves.

Investors who wish to buy JPMorgan as a special situation stock should consider taking short positions in shares of Wells Fargo, U.S. Bancorp, or Northern Trust as hedges. Wells Fargo is an attractive hedge because it most closely follows JPMorgan while trading at valuation multiples which are almost 50% more expensive than JPMorgan. U.S. Bancorp's valuations are higher, though its co-movement with JPMorgan is not as tight. Northern Trust's valuations are twice as expensive as those of JPMorgan, though it follows JPMorgan's price movements less closely. Either shorting these stocks or purchasing a put would balance a long position in JPMorgan. This strategy would attempt to capture alpha from a sensational media and market which fixates on the latest crisis rather than realizing that financial companies spawn crises systematically.

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