The Trouble with the Financials Today …

It is 2:00 am Eastern time as I write this and about 9 hours past since the JPM conference call. The bank with the self professed “fortress” balance sheet fessed up to a bit of binging on the synthetic credit derivatives. $2 B in losses have been realized in April and Dimon expects another $1 B or so to come.

Ironically, these losses have occurred in its Chief Investment Office, which is in charge of managing risks.

The thing is, the ultimate damage in terms of losses is pretty much up for speculation. It was reported last month that “London Whale” trader Bruno Iksil has been making bets so large that it might be impossible for the firm to unwind its positions without roiling the markets and his trades were regularly moving the prices in that market. Now that this is out in the open, it will be significantly more difficult to unwind these positions. Other traders scent an opportunity and know what the company has to do. It is not going to be a fair trade.

All this of course is a result of fairly recent activities in the firm. Nothing here indicates that the company has been hiding mortgage related losses from the housing bust. But it does underscore the point that the banks of today are not the high yielding coupon stalwarts of the yesteryears.

Here is the thing. Banks are meant to be utilities for the economy. That is their chief goal. They are not supposed to take undue risks and then find ways to hedge these risks that they are taking. Every bank in this country (and globally) believes that they are so smart, they can find ways to get rid of the risk and keep the rewards, but they all forget that in the overall grand scheme of things, the risk and rewards go hand in hand. In a game of musical chairs, there are always many losers.

The problem with derivatives and synthetics is that after a while and beyond a certain level of abstraction, all this makes less and less real sense to the people making these decisions and they have to trust their models and computers. As a result, the perspective on risk is blurred and wrong decisions are more likely. And when the bets become large, it starts impacting not only the portfolio in question, but even other firms and the broader economy. Banking and trading functions need to be separated again. Until this happens, financials will continue to be un-analyzable and therefore remain a sector I will continue to avoid.

Now the Wall Street’s case against the Volker rule is weakened and the proprietary trading ban will crimp the profits too.

Consider Bank of America (BAC). Dick Bove has pounded the table and Buffett seems to believe that the company is investment worthy. The fact is, we still can’t be confident that its balance sheet, as it is reported, accurately represents the facts with any level of confidence. As far as I am concerned, financials are still to be avoided. I am open to taking risks as long as I understand them and the rewards are greater than the risk taken. When the risks are not known, I avoid the investment.

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