Time to Buy JP Morgan

This is far and away the world’s premier banking institution. Estimates of the huge trading losses by the London “whale”, initially pegged at $2 billion, have since skyrocketed to $6 billion. I’ll ignore the Internet rumors that speculate about a $30 billion hickey. As you well know, almost everything on the net is not true, except what you read in my own newsletter.

Back in the 1980’s when I was at Morgan Stanley, the inside joke was to look for nice office space for ourselves whenever we visited clients at (JPM). The expectation was that they would take us over when Glass-Steagle ended, as they were both the same institution before the Securities and Exchange Act broke them up in 933. When the separation of commercial and investment banking finally came in 1999, Morgan Stanley had grown far too big to swallow and the egos too big to manage.

I’ll tell you another way to look at this trade. (JPM) lost 4.7% of its capital, so Mr. Market chewed 30% out of its capitalization. Sounds a bit overdone, no? The bad news is already in the price. A large part of the offending position has already been liquidated.

I have known Jamie Diamond for a long time, and can tell you that he is the best manager of a financial institution anywhere. I have been warnings him for years that his traders were understating risk and leverage in esoteric derivatives in order to boost their own bonuses. It was just a matter of time before they blew up. Presumably, by now Jamie has tightened up internal controls and in the future won’t pay so much attention to presentations by wet behind the ears traders pitching schemes that are too good to be true. As a result, you can now buy (JPM) at the blow up price.

I have analyzed the specific trade that got (JPM) into so much trouble, the now infamous “Investment Grade Series 9 Ten Year Index Credit Default Swap.” The chart of its recent performance and its hedge is posted below. It was in effect a $100 billion “RISK ON” trade that came to grief in early May.

The trader involved, Bruno Iksil, broke every rule in the trading Bible: too much leverage in an illiquid credit derivative with no real risk control and hedges that were imprecise at best. As I never tire of pointing out to hedge fund newbies, when your longs go down and your shorts go up in a hedge fund, you lose money twice as fast as a conventional long only fund. Play at the deep end of the pool, but be aware of the risks.

Few outside the industry are aware that this was a $6 billion gift to two dozen hedge funds who are now shouting about record performance. It is, after all, a zero sum game. Didn’t Bruno get the memo to “Sell in May and go away”? He obviously doesn’t read The Diary of a Mad Hedge Fund Trader either.

Even if the worst case scenario is true and the $6 billion numbers proves good, that only takes a 4.7% bite out of the bank’s $127 billion in capital. It is in no way life threatening, nor requiring any bailouts. These shares at this price are showing an eye popping low multiple of 7X earnings, and have already been punished enough. Getting shares this cheap in this company is a once in a lifetime gift, and twice in a lifetime if you count the 2009 crash low.

You don’t have to run out and bet the farm right here. Scale in instead, and if the market drops, you can always cost average down. If Greece forces us into major meltdown mode, we can also hedge this  “RISK ON” trade through taking more aggressive “RISK OFF” positions, like selling short the (FXE), (SPX), (IWM), (GLD), or the (SLV) by buying puts.



Short Red and Long Black Was Not Good

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