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This column originally appeared on Real Money Pro on May 14.


Real Money

) --

"We simply attempt to be fearful when others are greedy and to be greedy only when others are fearful." -- Warren Buffett

Recently, I have written about the risks and rewards of

contrarian investing


While the crowd usually outsmarts the remnants, a well-timed contrarian view (especially at important turning points) can provide an excellent entry point to an attractive long-term investment.

Roy Neuberger once told me that investors should buy cyclicals when the factories are closed and sell cyclicals when companies are thriving and the P/E multiples appear preposterously low.

To me, the banking industry's factories (or in its case branches) are now padlocked, as the pressure of historically low interest rates (

JPMorgan Chase's

(JPM) - Get JPMorgan Chase & Co. (JPM) Report

loss underscores the risks associated with overreaching in its attempts to enhance yield and net interest income/margins in a near-zero interest rate backdrop), sputtering (and subpar) economic growth and a still-weak U.S. housing market combined with the banking industry's role as piñata of political and public scorn have conspired to put pressure on bank stocks.

And, of course, the revelation of the JPMorgan/Jamie Dimon blunder has put a black eye to the perception of (and a dagger through the heart of) the industry's valuations. It will likely hasten regulatory reforms (specifically the Volcker rule) and tip the balance of power back to the politicians and regulatory authorities.

The Smartest Man in the Room Looks Dumb (Part Deux)

"In hindsight, the new strategy was flawed, complex, poorly reviewed, poorly executed and poorly monitored." -- Jamie Dimon

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The facts surrounding JPMorgan Chase's loss are slowly being uncovered.

Under the knowledge and watchful eye of Jamie Dimon ("the smartest man in the room"), JPMorgan's London-based CIO engaged in an aggressive attempt to enhance its portfolio's returns by shorting massive amounts of insurance on large investment-grade credit in in 2012.This bullish bet on the markets soured when signs of worldwide economic growth surfaced in Apri and when the sovereign debt crisis in Europe escalated.

(Note: Banks with a large deposit-gathering apparatus around the country do not make as many loans as deposits they receive; the balance is made up in the investment in both government-backed and non-government-backed securities.)

What was undertaken this year out of JPMorgan's London-based CIO (shorting insurance on investment-grade debt) was a risk-increasing strategy, not a risk-reducing (and hedging) strategy. There is nothing illegal with JPMorgan's strategy. At the time of these investments, the bank was not yet subject to the

Volcker rule

(which is set, at the earliest, to be enforced in July 2012), prohibiting certain activities such as proprietary trading (which does not benefit depositors).

To state the obvious, however, the monitoring of the bet was poor and the resulting optics of the disclosed loss couldn't come at a worse time for the bank (and industry), which has been lobbying for some relaxation in the rules governing hedging in the still hotly debated Volcker rule legislation.

Last year, JPMorgan had taken the opposite (and bearish) bet in buying insurance. The strategy was enormously successful, and the bank took in huge profits at the expense of hedge funds, which experienced losses on the other side of the trade last year. JPMorgan accumulated sizeable reported profits in the three-year period ending 2011, and the principals of JPMorgan's CIO were handsomely rewarded as was Jamie Dimon (in reputation and salary).

In time, JPMorgan's short selling of insurance on investment-grade debt in 2012 grew more aggressive, and its portfolio expanded in size --

JPMorgan became the market

. So, if the slightest interruption in worldwide economic growth occurred -- if the European sovereign debt contagion showed signs of spreading or even if JPMorgan stopped short-selling insurance on investment-grade debt -- the firm would be in jeopardy of the trade going against it.

As the bank's portfolio bet grew in size in early 2012 and as more troubling events in the eurozone emerged (in Greece, Italy and Spain), senior bank management's directive was to increase the portfolio's hedge (and to reduce risk). That was done, apparently in a poorly executed manner that failed to correlate with the intended strategy, and, to some degree, it backfired. I suspect that the bank, again, was too aggressive and paid up for protection, but it is not yet clear. The same hedge funds that got hurt in 2011 on JPMorgan's trade started to prosper from the trade. And when JPMorgan reversed and started to hedge its bets, those hedge funds pressed their bets and JPMorgan suffered expanding losses.

Both the trades in 2011 and 2012 were clearly proprietary trades and are difficult to justify as portfolio hedges, but I suppose in time (and in light of the large accumulated profits), the bank rationalized it as part of its investment portfolio. By that time, however, it was too late.

That said, in such a period of heated regulatory reform debate and in light of the size of the position, it is terribly disappointing that JPMorgan's management wasn't in closer control of the situation. The second trade (in April) was clearly a hedge made to reduce existing portfolio risk.

Back to Dimon.

Originally, I thought there were two ways of looking at Dimon's role (and in determining the possible impact to his reputation) on these trades.

I put very low odds that Dimon had been disingenuous or was even lying about the role of prop trading at JPMorgan. By all counts, Dimon is honest and forthright. (Look at his self-effacing annual report letters as an example of this.)

For months, Dimon had been arguing to the public and to the regulators that hedging was necessary since loans were a relatively small percent of deposits gathered -- the rest was investments, many of which were not government-backed and many were abroad. So credit, interest rate and currency risks, he argued, needed to be hedged. The problem, as some will note in the coming days, is that in a recent public interview in April, he was less than candid in fessing up to the portfolio's losses, as he cited that concerns about the CIO's large positions was "a tempest in a teapot."

Rather, I put the highest odds that Dimon ignored the risks of the 2011-2012 trades because "things were going well." In all likelihood, he simply took his eye off the ball and improperly monitored balance sheet risk until things deteriorated. At which time, it was too late. (Not surprisingly, on Sunday,

The Wall Street Journal


that several members of management will be fired from the bank.)

Frankly, I don't know which is worse -- being disingenuous (which I don't think he really was) or the poor management (which was reflected in the flawed strategy, shoddy execution and improper monitoring of such a sizeable investment).

Importantly, it is hard for me to understand how such a hands-on guy such as Dimon was inattentive to such a large bank investment.

The JPMorgan mess up is so

American International Group

(AIG) - Get American International Group, Inc. Report

-like and downright dumb in a


setting of reform.

I thought Dimon was smarter than those other banking and Wall Street goofballs and had learned from AIG's near-fatal mistakes (and those of the other Wall Street banks).

I admire that Jamie Dimon is an honest guy. His


on "Meet the Press" was refreshing in his candidness and willingness to accept responsibility.

Bottom line, though: I am sorry to say that it appears as though Dimon's screwup was a combination of one quarter hubris and three quarters poor management. His credibility has taken a big hit (and he freely admits it and takes the blame).

For now, Jamie Dimon is no longer the Superman of banking; he is Clark Kent (without the ability to turn into a superhero in a phone booth).

For now, he is just another one of those guys in banking and on Wall Street that has overreached.

Jamie Dimon's reputation will be regained -- and I am certain he has learned an important lesson in 2012 -- but not until he does a lot of heavy lifting (in delivering better JPMorgan profits) in the years ahead.

I wouldn't count him out.

Unmasking Upturns

How do we, as investors, uncover a turning point in a market sector?

Often a turn comes from a negative industry event, similar to the JPMorgan development, in which investors' trust is lost. (The portfolio-insurance-induced crash in October 1987 comes to mind as an illustration.)

Accordingly, let's put some perspective on JPMorgan's gaffe -- let's (ahem!) put some lipstick on that pig.

With total assets of $2.27 trillion and shareholder's equity at $185 billion, JPMorgan was leveraged 12.2x at year-end 2011. The bank has reported an estimated $2 billion loss ($0.52 per share pretax, $0.20 to $0.25 per share after tax). The sum total of JPMorgan's after-tax loss will reduce profitability by only about $0.15 a $0.17 a share in 2012, however, as we should assume a more aggressive buyback over the next several quarters as compared to previous expectations (when the stock was trading at higher levels).

On Friday, JPMorgan's shares lost $14.45 billion in market value, or $12.45 billion in excess of its $2 billion loss. In essence, the market is saying that JPMorgan's core earnings are being diminished by the risks of lost reputation and more onerous regulatory conditions.

At the very least, JPMorgan's Jamie Dimon (and his management team) badly took their eye off the ball as their positions became too large relative to the market and the bank stretched itself for returns in a low-interest-rate setting. Nevertheless, the market's reaction might have been too severe. (Here Jim Bianco graphically outlines JPMorgan's loss, hat tip

Barry Ritholtz


For me, however, specific industry group share price upturns (and sometimes even market upturns) are more likely an outgrowth of a combination of a bottom in fundamentals, extremely negative sentiment and undemanding valuations.

For the reasons listed below, we are probably at or are approaching an important buying juncture in bank stocks.

  • Short-term fundamentals: Apart from JPMorgan's one-off loss, banking industry profits are currently being pressured by historically low interest rates. As most subscribers recognize by now, I am of the view that interest rates are at cyclical lows. As a result, net interest margins are likely close to their nadir. Banking industry profits have also been pressured by an unprecedented 35% decline in nationwide home prices and by reduced sales activity. Here, too, I believe that we are at a cyclical low point and that a durable and multiyear recovery that continues throughout the decade is likely. As well, banking industry profits have been reduced by lower capital markets activity. Since I am expecting a huge reallocation out of bonds and into stocks, the capital markets may go from headwind to tailwind. Finally, industry profits are still being pressured by the residue of poor credit allocation decisions (and large credit losses) from the pre-2009 period. Credit quality has been on the mend for a few years, however, and the move toward normalization of loan losses is already upon us. That normalization moves us ever closer to the banking industry achieving its potential earnings power.
  • Intermediate-term fundamentals: Despite the implementation of limitations on leverage and on the mandate to reduce or eliminate some higher-margin businesses (e.g., proprietary trading), banking will remain a profitable sector capable of engineering reasonable returns on invested capital. (I still estimate that JPMorgan will print close to 15% ROI in 2013.) Over the course of economic and interest rate cycles, large deposit-gathering institutions such as JPMorgan Chase, Citigroup (C) - Get Citigroup Inc. Report and Bank of America (BAC) - Get Bank of America Corp Report benefit from a secure, predictable and low-cost deposit base. Moreover, one could argue that the offshoot of deleveraging and a greater regulatory presence should produce more consistent returns as well. This more steady profit stream may be seen, in the fullness of time, as valuation-enhancing.
  • Sentiment: Can sentiment get much worse?
  • Valuations: Can valuations get much lower? My 2013 estimates for Citigroup ($4.70a share) and JPMorgan Chase ($5.70 a share) represent P/E multiples of only 6.2x and 6.5x, respectively.

Looking at the Bright Side

Let's end with a real contrarian message that extends beyond buying bank stocks. It is an observation about a broader market that failed to buckle under the pressure of JPMorgan's late-Thursday afternoon announcement.

As an acquaintance emailed me over the weekend, could the JPMorgan trading losses be construed as a bullish event for the markets and lead to an

expansion in valuations

as (already sour) investors now recognize that our financial sector has been deleveraged and can now more readily absorb such events?

After all, JPMorgan's $2 billion mark-to-market loss pales in comparison to the near-fatal experiences of our financial institutions back in 2008 and 2009.



be looking up, as 2011-2012's banking screw-ups are less impactful, more manageable and not indicative of meaningful industry systemic risk.

The bright side is that despite JPMorgan's egregious and undisciplined loss and lack of focus, the U.S. banking industry is down but definitely not out.

At the time of publication, Kass and/or his funds were long JPM, AIG, C and BAC common/short JPM calls, although holdings can change at any time.

Doug Kass is the president of Seabreeze Partners Management Inc. Under no circumstances does this information represent a recommendation to buy, sell or hold any security.