The Fed, The Bank, The Whale & The Street
Douglas is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
There can be no doubt that the financial environment has become significantly more complicated since the monetary version of The Emperor’s New Clothes required government protection for those banking juggernauts deemed too-large-to-fail. The Fed is on the verge of pumping even more money into the system, JPMorgan Chase & Co. (NYSE: JPM) is still trading its way out of large CDS positions initiated by the infamous “Whale,” and the Street is trying to sort through the mess and determine what it all means. In case that is not a sufficient amount of confusion, the often maligned Goldman Sachs Group (NYSE: GS) is helping to finance prisons as a part of a social-responsibility initiative. If one can manage to decipher all of the swirling motivations, it may be possible to stumble on just enough truth to make a shrewd investment.
The Federal Reserve
It is impossible to consider the position of Wall Street’s major financial companies without considering the backdrop of the Fed and its policies. While the release of the recent FOMC minutes sparked a small rally in stocks, real market experts understand that the August jobs report is likely to be the deciding factor that unleashes the next wave of quantitative easing. The important takeaway from the minutes is that the Fed acknowledged the pressure being exerted by the European debt crisis, the global economic slowdown and the fiscal factors at home.
Another critical Fed-related item is the impending release of the final version of the Volcker rule segment of Dodd-Frank. In addition to the Fed, the SEC, CFTC, FDIC, Officer of the Comptroller of Currency and likely some more Washington alphabet soup has been involved in crafting the rule. To oversimplify the current language, the rule drastically limits the amount of capital that major banks can invest in hedge funds and private equity funds; proprietary trading is completely banned. The goal of the legislation is to prevent another major financial crisis, but the residual impact is negative for those firms being regulated.
While history may have a tendency to repeat, the specific formula used is almost never the same, particularly on Wall Street. Keeping the public safe from evil hedge funds is likely to make banks less attractive investments, while doing little to prevent future problems. The next round of mistakes will come from a different arena. The false premise on which all of this regulation is built is the idea that everyone who works in finance is reckless, selfish and stupid. In a business in which risk is rewarded, there are incentives to ignore some risks, but the goal of a Wall Street financial firm is to consistently make a profit. Jumping off cliffs does not achieve these results.
The Bank & The Whale
JPMorgan has come under huge scrutiny and criticism as a result of a large loss announced by the firm several months ago. The trade was initiated by a trader, now dubbed “The Whale,” and since the announcement the situation has been flogged for every column-inch it could take. The facts of the case are very direct. The firm had a large trade in place that was a hedge against a variety of other positions. The trade, by itself and not evaluated as a side of the overall portfolio, generated a significant loss that was disclosed by the firm. If the loss ends up costing JPMorgan under the worst-case discussed by Janie Dimon, the total $150 billion portfolio will experience a $7.5 billion loss on the trade; that is a real loss, but not an unrecoverable one. During that same reporting period, JPMorgan was able to generate significant profits for shareholders. If firms like JPMorgan lose the ability to allocate capital to trading, profits may be significantly constrained. Zack’s equity research sums it up well: “we believe that until there is ambiguity surrounding the rule, investors will have a dim outlook on banks. They will expect the bottom line to be pressurized owing to the negative effect of the rule on banks.”
The impact of all this complexity has left an investment landscape that is more segmented than ever. Goldman Sachs, for example, has launched a program to invest in prisons while still maintaining social responsibility. Under the program, the investor –Goldman Sachs – earns a return based on the recidivism rates achieved in the prisons it pays to manage; high rates lead to low returns and vice versa. The theory is that the interests of the investor and society are aligned, which should yield more effective prisons. At the very least, it will be an interesting social experiment.
In more straightforward complexity, firms like Wells Fargo (NYSE: WFC) are embroiled in the housing climate. The company is attempting to turn the fact that it is involved in one in three U.S. mortgages into a positive. It stated in an internal memo, “Serving customers very well means that more customers and clients choose us and reward us with their business.” Whether this belief is accurate, the fact means that the firm is squarely in the middle of the interest rate dance, and thus the political theater approaching Election Day. Of equal political motivation, Bank of America (NYSE: BAC) recently announced that it will no longer be selling credit protection plans on its credit cards. The plans, which had represented a significant profit center for the bank, have come under political pressure as regulators have focused more on consumer protection. These twists exist for most firms on the Street.
The reality of investing in the banking sector these days is that one is buying significant exposure to politics. In such an environment, careful research is at a premium, as is solid management and public perception. Jamie Dimon has proven himself adept at managing such complex situations, meaning that significant dips can often be buying opportunities. Whether Goldman Sachs' experiment will succeed shall be seen, but it stands as a beacon of how bizarre the environment has become.
Mr. Ehrman has no positions in the stocks mentioned above. The Motley Fool owns shares of Bank of America, JPMorgan Chase & Co., and Wells Fargo & Company and has the following options: short OCT 2012 $33.00 puts on Wells Fargo & Company and short OCT 2012 $36.00 calls on Wells Fargo & Company. Motley Fool newsletter services recommend Goldman Sachs Group and Wells Fargo & Company. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. If you have questions about this post or the Fool’s blog network, click here for information.