Déjà vu all over again?

Just when you thought the financial sector was stabilizing, we get news of a US$2 billion and counting trading loss at JP Morgan Chase (NYSE: Symbol JPM, Friday’s close US $36.96). More disturbing was the fact that the loss was related to a hedge presumably designed to offload some of the risks associated with the banks credit default book.

What we know is that it will not require a bailout – always a concern because JPM is “too big to fail” – nor will it affect depositors at the bank. It does impact JPM shareholders and will cause investors to re-think the risks associated with financial institutions generally.

This latter point is especially poignant as the “hedge” was unrelated to risks that are apparent… such as sovereign defaults across the eurozone. On the surface, this appears to be a badly executed trade initiated in London presumably to circumvent US regulations.

If that were not enough, JPM’s CEO Jamie Dimon has been leading the lobby against undue US regulations for some time. But with this misstep, even if we were to assume that Mr. Dimon’s arguments have merit, it will be politically impossible to water down any regulation that does not error on the side of caution.

Unyielding regulations will do one of two things: 1) it will cause regulators to tighten their grip on US financial institutions which dampens profitability or 2) it will cause US institutions to move more of their risk offshore which gets in the way of transparency.

The more serious problem is that a gaffe of this magnitude causes investors to paint all banks with the same brush. Regardless where they are located or what their business model is. It will likely rein in any potential upside for Canadian banks which are probably the best of the best with significantly less coverage in the credit default market and only minor exposure to the kinds of risks associated with sovereign debt.

Repairing the damage will be time consuming. There will be the inevitable full court press from politicians who are certain to use it as the rationale for government oversight. Shareholders want to know the extent of the loss – the trade is still being unwound – and then be reassured as to the checks and balances that will be put in place to prevent it from happening again.

In the meantime one could make the case that best of breed Canadian banks may benefit as institutions shift their mindset away from a bigger is better strategy. Think of it as a risk off trade that allows a manager to maintain a position within the financial sector.

While I doubt that Canadian banks will see any short-term benefit there does not appear to be much downside. What traders might consider is entering a trade to short puts as a low risk alternative that takes advantage of the twin themes: minimum downside but, for the near term, limited upside.

Toronto Dominion (TSX: TD, Friday’s close $80.51) is one Canadian bank worth considering. Specifically look at writing the July 80 puts at $2.60 or better. With the sale of the puts you are obligated to buy TD shares at $80 until the July expiry. If you end up with the shares your net cost is $77.40 ($80 strike less $2.60 premium = $77.40). If the stock does stabilize or even rise between now and July, the put will expire worthless and you will retain the premium.

If you want to hedge against further downside you could also look at buying the July 72 puts for 70 cents. Your net credit is $1.90 ($2.60 received from the sale of the July 80 put less the 70 cent cost to buy the July 72 put) but with this spread you have limited your downside to the 72 strike.

The other advantage of this spread trade is that you are able to clearly define margin requirements, which eliminates any possibility of getting a premature margin call.