JPMorgan's Bad Bet on Derivatives Is Not an Isolated Case

NEW YORK ( TheStreet) -- The consensus on Wall Street in Friday's trading was that the $2 billion loss in derivatives trading at JPMorgan ( JPM) is an isolated situation, and that the stock was a buy on share price weakness. At ValuEngine, we have JPMorgan rated a hold, as it was before CEO Jamie Dimon's confessional. JPMorgan's chief investment officer in London is nicknamed the "London Whale" and he started to feel the harpoon well before the U.S.'s biggest bank reported quarterly results earlier in the quarter.

The first ever mortgage-backed derivative was a collateralized mortgage obligation (CMO) created in 1983 by Salomon Brothers and First Boston for Freddie Mac. I was heading the Government Bond Department at LF Rothschild at the time and we were in the Selling Group. I am an engineer by education with a Master of Science in Operations Research, Systems Analysis, and as the use of CMOs exploded I was skeptical that the mathematical models that created even more complex structures could be trusted long term.

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Fast forward to 2005. This was when I began to focus on the housing market and banking system. In 2006, I began to study the FDIC Quarterly Banking Profile (QBP) which I consider the balance sheet of the U.S. economy. Here's where I found the data that helped me predict the decline of community banks at the end of 2006 and the decline of regional banks in February 2007. In analyzing each QBP I have been tracking the trends in key risk categories that continue to plague the banking system today including derivatives.

At the end of 2007 the Notional Amount of Derivatives shown on the FDIC QBP totaled $164.8 trillion. As banks began to fail and the U.S. economy fell into the "Great Credit Crunch," the notional derivatives continued to rise and stood at $231.9 trillion at the end of 2011, up 40.7% when the banking system was supposed to be de-leveraging. The data has shown that JPMorgan was the biggest creator of derivatives in the U.S. banking system.

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The Troubled Asset Relief Program (TARP) was supposed to clear the banking system of toxic securities but the regulators and Wall Street could not figure out how to mark to market, so the Treasury used TARP money to bail out the banks with capital infusions instead. These bad financial assets have not gone away, and most are off balance sheet, some imbedded in derivatives.

One fortunate situation is with the $2 trillion on the Fed's balance sheet. The Fed does not mark to market -- liquid securities on their books can be sold to the primary dealers. The toxic stuff is just held to maturity.

The structure that failed to perform as expected by JPMorgan is called the CDX NA IG 9 Basis. To help JPMorgan hedge risk, this graph was supposed to decline from left to right, but obviously it has been rising. With all my experience, I cannot explain or understand what this mumbo jumbo means.

The problem with derivatives is that you cannot put Humpty Dumpty back together again. Here's a simple example:

U.S. Treasury Strips are a derivative that separates the interest payments from the principal of a U.S. Treasury note or bond, as separately traded securities. You can reconstruct the underlying bond after buying all the components, interest payments plus the principal. With the complex structures that have choked the banking system, this is next to impossible.

In my opinion, the "Great Credit Crunch" was not caused by too much proprietary trading. It was caused by allowing Wall Street to create derivative structures that were next to impossible to mark to market. Derivative structures are the product of Wall Street greed. It's time to disband many of the structural designs that we did not have before 1983 when this whole mess slowly began.

With regard to the Volcker Rule, there is a grey differential between proprietary trading and market-making. When you mix in "mark to myth" for derivatives, you have the "time bombs" that are ticking today. Evaluating the risk in a mix of toxic and liquid assets cannot be prudently accomplished.

Do you still want to buy JPMorgan?

JPMorgan -- ($36.96) was just below my annual pivot at $41.66 on Thursday when the news broke about the $2 billion loss. On Friday, the stock traded down to and held its 200-day simple moving average at $36.66. The intra-day volatility centered on my monthly pivot at $37.46 with the day's close below that level. My quarterly value level is $35.13, with my annual risky level at $41.66.

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