A Potential Pothole on Rally Road

The stock market rallied big Thursday and was soaring again midday Friday. A continuation of the technical factors that contributed to Thursday's gains, along with a Lehman Brothers upgrade of IBM (IBM Quote) and relief that General Electric's (GE Quote) results weren't worse were fueling big gains for major averages Friday afternoon.

Everything may suddenly appear "okey-dokey" but a large number of market participants remain worried about the potential for some upheaval in the financial system.

"I will venture there is an outside chance that in the very near future, during a momentous market upheaval, a major financial participant will face complete and instant annihilation," Fari Hamzei of Hamzei Analytics in Los Angeles commented recently.

For some time now, J.P. Morgan (JPM Quote) has been the name most often cited as a potential trouble spot. In an interview Thursday, Hamzei said J.P. Morgan is on his short list of financial firms about whose "annihilation" he is concerned. Admittedly, that's a dramatic description for what others contend may be a forced sale or, at the very least, more pain for J.P. Morgan's stock and bondholders.

Specifically, concerns remain about the bank's exposure to derivatives, financial instruments that derive their value from other securities and are designed to offset risk -- although history suggests they often have the opposite effect.

As reported previously, J.P. Morgan is far and away the largest dealer of derivatives -- involved in $25.9 trillion, or 51%, of the $50.8 trillion notional value of contracts involving U.S. commercial banks and trust companies at the end of the second quarter, according to the Office of the Comptroller of the Currency. Given its dominance, J.P. Morgan is an obvious bogeyman for those concerned about derivatives in general.

A midweek downgrade by Moody's put those concerns back on the front burner. A J.P. Morgan spokesman said the bank doesn't comment on rating actions. But in a conference call after its profit warning last month, Dina Dublon, J.P. Morgan's head of finance, said a Standard & Poor's downgrade at the time would have but a "small impact" on J.P. Morgan's derivatives business. In cutting $42 billion of J.P. Morgan's long-term debt to A-1 from Aa3 and its bank subsidiary debt to Aa3 from Aa2, Moody's ratings are now in line with S&P's.