Bad Week For JP Morgan And Friends

Ongoing travails for JP Morgan (JPM) and other members of the financial sector yield opportunities for investors.

There was no shortage of speculation concerning the matters discussed in a secret meeting held on Thursday morning between United States Attorney General Eric Holder and JP Morgan Chase CEO, Jamie Dimon. Because no specific details of the matters discussed at the 50-minute meeting were disclosed “on the record”, a wide range of theories emerged. The more cynical among us assumed that Holder was simply interviewing for a job with the megabank, in the hope of landing a more comfortable and lucrative position in the private sector. Another theory focused on the notion that Dimon was negotiating with the shareholders’ money in attempt to buy his way out of serving time in prison. While being confronted by reporters about the substance of the meeting, Dimon became impatient with a reporter who raised a question on the subject of “prison time”.

The reluctance of the federal government to actually prosecute any of the Wall Street bankers for the malfeasance which led to the financial crisis has been a favorite subject of William Black, a professor of Law and Economics at the University of Missouri-Kansas City. On December 28, 2011, Professor Black characterized the failure to prosecute those crimes which led to the financial crisis as “de facto decriminalization of elite financial fraud”. This isn’t (just) about revenge.

Bruce Judson of the Roosevelt Institute wrote an essay last year entitled “For Capitalism to Survive, Crime Must Not Pay”. Judson emphasized that when the law is enforced in an unequal manner – by failing to prosecute executives of Wall Street financial firms for committing financial fraud while “perp walking” small-time accountants and bookkeepers who embezzle money from small businesses – some participants in the capitalist system are given a competitive advantage over others. Start-up businesses never develop because they are attempting to compete on a playing field which is not level.

The consensus of opinion concerning what the Justice Department is currently negotiating with Jamie Dimon and JP Morgan centers on several issues. It is believed that the government is attempting to force JP Morgan Chase to pay at least $11 billion in penalties for fraudulently packaging high-quality mortgages with dubious-quality subprime mortgages in collateralized debt obligations (CDOs) which were sold to JPM’s clients as “high quality” investments. The spin to this story involves the suggestion that JPM’s liability for such transactions would result solely from its corporate successor status as the company which “was forced” by the federal government to take over the failed Bear Stearns – the true culprit. Actually, many analysts and regulators believe that JPM itself was involved in the “toxic CDO” trade, regardless of its status as corporate successor to Bear Stearns. Federal prosecutors from New Jersey, Pennsylvania and California are after JPM for toxic CDOs packaged and sold by the bank before the 2008 financial crisis, going back to 2005.

In fact, the potential legal exposure arising from JPMs ownership of Bear Stearns is limited to the action being pursued by New York Attorney General Eric Schneiderman as well as the lawsuit brought by the Federal Housing Finance Authority (FHFA) on behalf of Fannie Mae and Freddie Mac concerning the sale of toxic CDOs to those GSEs by Bear Stearns and Washington Mutual. (JPMorgan is also a corporate successor to WaMu.)

No matter what happens, the bottom line on this is that an $11 billion fine isn’t small change, even for a behemoth like JP Morgan, and the chart clearly indicates Wall Street’s displeasure with the situation as the company’s stock is down more than 10% since early August.

Joining Dimon in the fun are Goldman Sachs (GS) and Lloyd Blanfein, and Wells Fargo (WFC) is also expected to find itself in the Justice Department’s cross hairs for its widely-criticized mortgage practices, which helped fuel the explosion of the housing bubble.

Meanwhile, investors are concerned about how to benefit from whatever develops from the legal wrangling. An impressive gauntlet run by Jamie Dimon could boost the entire banking sector because he will have established a template for other bankers to follow. If such a scenario unfolds, two ETFs you may want to consider would include:

Financial Select Sector SPDR ETF (XLF) – This ETF is designed to track the performance of the Financial Select Sector Index, which includes companies from the following industries: diversified financial services; insurance; commercial banks; capital markets; REITs; consumer finance; thrifts & mortgage finance; and real estate management & development.

ProShares Ultra Financials ETF (UYG) – This is a leveraged ETF, which is designed to obtain investment results corresponding to twice (2x) the daily performance of the Dow Jones U.S. Financials Index by investing in securities and derivatives which ProShares Advisors believes, in combination, should have similar daily return characteristics as two times (2x) the daily return of the index.

Investors who are expecting the crackdown by the Justice Department to wreak havoc on the profitability of the banking sector may want to consider these two ETFs:

ProShares Short Financials ETF (SEF) – This ETF is designed to obtain investment results corresponding to the inverse (-1x) of the daily performance of the Dow Jones U.S. Financials Index.

ProShares Short Financials ETF (SKF) – This is a leveraged ETF, which is designed to obtain investment results corresponding to twice the inverse (-2x) of the daily performance of the Dow Jones U.S. Financials Index by investing in derivatives which ProShares Advisors believes, in combination, should have similar daily return characteristics as two times the inverse (-2x) of the daily return of the index.

Bottom line: We live in a time of rapid change and great upheaval, and these conditions are ripe for great fortunes to be made or lost over short periods of time. The financial sector is more than 230% above its 2009 lows, certainly an impressive run, and now new opportunities await those who can be on the right side of the current travails of JP Morgan and its friends.

Disclosure: John Nyaradi holds a position in (SEF)

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