Banking-Stock Paired Trade: JPM, WFC

By Sean Hannon of Covestor.com.

(This column originally posted on Covestor.com Nov. 3 at 7:34 p.m. EST.)

As the credit crisis evolves, many steadfast rules have been discarded. Companies once thought too big to fail are gone and a free-market administration has expanded the government's role in the economy to a level not seen since FDR's New Deal.

With the market's constant shifts, investors must assess how the investment landscape has changed and look for the most prudent ways to profit. During this chaos, one constant has remained. In the banking sector, JPMorgan Chase (JPM Quote) stands alone as the trendsetting institution capable of profiting from others' misfortune.

JPM possesses advantages other firms lack. It has among the best management teams in the banking industry, one of the stronger balance sheets and the ability to manage risk that few others have mastered. These attributes have allowed JPM to play a key role during the crisis and absorb both Washington Mutual and Bear Stearns in government-assisted merger deals. By helping increase the deposit base and adding complementary lines of business, JPM is now a key competitor in every area in which it operates.

When acquiring Bear Stearns, JPM's risk profile was clear. With WaMu, the downside was unknown. WaMu possessed one of the worst balance sheets I have ever seen, littered with option ARMs in inflated housing markets. JPM faced a tough decision. If it allowed these loans to continue to negatively amortize (negam), JPM would be making a huge bet on the housing market. However, if it stopped the negam and modified these loans to current market rates, borrowers would be unable to afford the higher monthly payments and would be forced into foreclosure.

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