Banking-Stock Paired Trade: JPM, WFC

JPMorgan stands alone as the trendsetting bank capable of profiting from others' misfortunes.
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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) - Get Report

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.

Knowing that banks are in business to collect money, not own homes, neither option was appealing. Last week JPM unveiled the first step in a process that both limits negam and prevents further foreclosures.

Last Friday, JPM announced its intent to modify $150 billion of mortgage loans. While details are limited, we can expect some combination of lower interest rates and reduced principal balances to help homeowners obtain a monthly payment they can afford. The greater affordability will allow people to remain in their homes, will stem the tide of foreclosures and should eventually provide support to the housing market.

Personally, I do not like the path that massive loan modifications represent. By reducing loan balances and interest rates, bankers are penalizing prudence and rewarding speculation. While I could write pages on how this will only cause future problems, doing so would be a pointless exercise. As investors, our job is to predict actions, determine their effect and decide how to profit.

Looking back to the mortgage bubble, three main lenders were seen making questionable loans in mass size. These lenders were

Countrywide Financial

,

Golden West

and WaMu.

Today, Countrywide is part of

Bank of America

(BAC) - Get Report

, WaMu is part of JPM and Golden West part of

Wells Fargo

(WFC) - Get Report

via its merger with Wachovia. With JPM's modification intentions, we can expect that BofA and Wells will have to follow suit. Maintaining high mortgage payments when your competitors are reducing them is politically unpalatable.

Knowing other banks will follow suit, JPM has taken a proactive lead to weaken their competitors. BofA and Wells have weaker balance sheets and more pressing needs. Both these companies are undertaking transformative mergers outside of their areas of expertise. Combine the management uncertainty with the capital needs, a large-scale loan modification is an event they would rather not face. However, JPM has pushed these banks in that direction.

By dictating the pace of the conversation and having the capital needed to take action, JPM will emerge as the strongest bank. The end result will be increased market share and higher future profitability.

The Trade

Based on long-term earnings power, JPM could trade toward $55 in the coming months. With the stock trading near 1.6x tangible book value, we see a stock with strong upside potential, a nice level of current income (3.7% dividend yield) and a reasonable valuation that provides a margin of safety. All in, this is a stock to own for the future.

Buying JPM is a clear choice, but risk management remains a concern. A prudent investor will hedge their risk while attempting to profit from a move higher in JPM's stock price. Since option strategies are uneconomical, I recommend a short position in Wells.

While JPM trades at a reasonable 1.6x tangible book value, Wells trades at 3.1x tangible book value. Further, I believe there are risks in Wells' home equity portfolio that the market has not fully digested. This provides a rare opportunity where a pair trade can offer appreciation on the long side and profit from a short sale as well.

Over time, the valuation of Wells and JPM should converge. By shorting what is dear and buying what is cheap, an investor can manage their risk profile while skewing the portfolio for future gains.

At the time of publication, Sean Hannon was long BAC. Positions may change so

click here

to view his current portfolio. Sean Hannon has their investment record verified by

Covestor.com

. Visit Covestor.com to track the real investments of thousands of proven self-investors live for free.