“It's a Wonderful Life” is truly a gift that doesn't stop giving.

It says something about the issue of investment selection. 

The posting entitled “Wall Street doesn’t run the world” used a Goldman Sachs (GS) “sell” recommendation for Kimberly Clark (KMB) to illustrate how Wall Street chatter creates opportunities for investors.  Kimberly-Clark was trading in the low 60’s at the time.  It's now trading in the mid 80’s, and it has paid a consistent and growing dividend.  Lest that comment be misinterpreted, the point of posting on Wall Street was that the advice for Wall Street was right for Wall Street.  By contrast, because it was right for Wall Street, it was wrong for many individual investors.  Investors could view the chatter from Wall Street as providing them with an excellent opportunity.  Washington chatter does the same thing.

A major plot line in “It's a Wonderful Life” is the conflict between Potter and two generations of Baileys.  

Potter wants to eliminate the competition that Bailey Building and Loan creates.  Eventually he ends up in concealing the fact that he has the Bailey’s deposit.  George Bailey, on the other hand, displays nothing but honesty even in the face of substantial adversity. 

In the end, one doesn't need to wonder who experiences the wonderful life.  Clearly, the movie’s theme is that leading an honest and trustworthy life yields results.  In the end, money comes pouring in from friends and associates to salvage George Bailey's organization and his reputation.  So, it isn't just nonmonetary rewards that George enjoys.  Sure, security, friends, family, and personal integrity are presented as more important than financial rewards; but, clearly, the movie implies a relationship between financial and nonfinancial rewards.

Trust is an important component in good investment decisions.  As will be explained, it is particularly important when it comes to investing in banks.  In that regard, the sort of Washington chatter that grabs my eye is illustrated by the excerpt from a WALL STREET JOURNAL Opinion piece quoted below:

“A persistent media-liberal lament—make that a cliché—is that too few financiers have been prosecuted for the financial crisis. But maybe that's because when the Obama Administration tries to prosecute a specific individual for a specific crime, it turns out there was no crime.

The government's latest embarrassments came this month, as one high-profile case collapsed and another was downsized by a federal judge. On November 16, the Securities and Exchange Commission dropped a civil lawsuit against Edward Steffelin. As an employee at GSC Capital, he helped create a synthetic collateralized debt obligation called Squared CDO 2007-1 that was offered by J.P. Morgan Chase (JPM).  It was synthetic because although it allowed investors to bet on the subprime housing market, it involved very little ownership of actual mortgages. Anyone investing in this deal knew he was simply gambling on a continued housing boom.

The government accused Mr. Steffelin of not informing Squared purchasers that another investor in the deal, a hedge fund called Magnetar, had helped select the mortgage pools to be wagered upon while it was simultaneously shorting some of them. Mr. Steffelin argued that Magnetar did not control which assets were in the deal. He also said he had done his job by accurately describing these assets to J.P. Morgan, which as far as he knew had accurately described them to investors. These would be sophisticated institutional investors who were eager to profit from the housing mania but are now cast as victims by prosecutors.

Since the Steffelin prosecution wasn't a criminal case but a civil suit, it presented a much lower bar for prosecutors to clear. But apparently not low enough. Last year U.S. District Judge Miriam Goldman Cedarbaum threw out the SEC's fraud charges, saying that it was a "big stretch" to say that Mr. Steffelin had a fiduciary duty to investors. That left only the accusation of negligence, and Judge Cedarbaum has now allowed the SEC to dismiss its case entirely.

It's true that J.P. Morgan Chase paid $153.6 million of its shareholders' money to settle a related SEC suit for its role in this transaction. But the bank admitted no wrongdoing and sees great value in avoiding adverse publicity. The problem for the government occurs whenever it has to prove that an actual human being has done something wrong.”

The interesting thing about this little excerpt is that the author completely misses the point of the government's accusations.  Often the government isn't interested in winning the cases.  They don't even care whether the accusations have a shred of truth.  They're interested in shaking down the employers for large amounts of money.  In this case, they were totally successful.  They got over $153 million out of J.P. Morgan Chase (JPM) despite the fact that nothing was ever proven. 

What isn't being reported in the general press is that the government's cases are often being disproven.  That would require the reporter do a little work and analyze the actual proceedings.  Besides, like the song says, “we like dirty laundry.”  So, the press has concluded that covering facts wouldn't help circulation, which one suspects is the real reason for not reporting factual information.

There is a nice thing about the press’s abandonment of any story when it starts to deviate from the planned storyline.  It creates wonderful investment opportunities.  For example, the article laments that the money J.P. Morgan Chase paid was “shareholders' money.”   But, the payment of that extortion with shareholder money is far from the most important aspect of the story. 

Investing is about character and trustworthiness. Not every charge results in a government failure to provide accurate evidence.  Thus, when individuals or organizations prove their honesty, it's a significant event.  Disproving charges that are supported by the tremendous resources of the government isn’t easy. 

When the scandal-hunting press loses interest, the opportunities abound.  The loss of interest doesn't eliminate the need for due diligence, but when one is not dealing with corporate representatives face-to-face, the government's failure to prove guilt provides a viable substitute for first-hand familiarity with the organization.  It's especially valuable when the defendant demonstrates honesty in their disclosures. That seems to be exactly what the article is reporting.  If anything, it should be taken as positive information by anyone considering investing in J.P. Morgan Chase or J.P. Morgan Chase offerings.  It makes due diligence somewhat easier when the nonsense coming out of Washington indicates that information J.P. Morgan Chase provides is probably reliable.

That all sounds nice in theory, but what does it imply?  When the government decides to embark on a shakedown effort, the first step is a “Wells notification.”  Unfortunately, Wells notifications are also the first step in a serious investigation.  So, the thing to look for is when the follow-up to a Wells notification is an announcement of a decision not to file charges.  Basically, that's an admission on the government's part that they couldn't even find enough damaging material to pull off a decent shakedown.  For example, the government recently announced that one of their investigations of Wells Fargo (WFC) was not going to result in charges. 

Now, admittedly, the government's approach to pursuing shakedowns is to undertake a raft of investigations in order to intimidate their opposition.  Nevertheless, when they admit that they could not find any damaging information on one investigation, it often has implications regarding what they will find on other witch hunts.  

Wells notifications usually have a negative effect on a stock’s value.  When an organization like Wells Fargo or J.P. Morgan Chase have previously shown that the government is wasting money on many of its witch hunts, the resulting dip in the stock’s value often represents an opportunity to buy.  It's also worth noting the recovery in the stock of the company when a case is dropped or disproven, or when a Wells notification results in no charges.  The recovery is often slower and initially smaller than the drop in the stock that occurred when the investigation or charges were announced or the Wells notification was filed.  There is time to take advantage of the end of the witch hunt. 

So, one could do worse than starting 2013 owning Wells Fargo or J.P. Morgan Chase stock.  A series of witch hunts have probably depressed their stock.  The dropping of charges, notification that no charges will result from an investigation, and findings of not guilty would indicate that Washington has been barking up the wrong tree.

Both Wells Fargo and J.P. Morgan Chase are often viewed as best in class.  Their profiles are different, but as investments, both are subject to some of the same risks.  One common risk is implied by this whole discussion.  Specifically, filing charges against banks has become a very profitable endeavor for Washington.  Thus, both Wells Fargo and J.P. Morgan Chase are subject to considerable headline risk.  That headline risk could create more advantageous times to purchase either stock.  So, investors with some experience might consider selling cash covered puts on Wells Fargo or J.P. Morgan Chase.

The Hedged Economist already owns Wells Fargo stock acquired at a much lower basis during the financial crisis.  However, selling cash covered puts on banks is a strategy that seems particularly appropriate currently.  If one wants to take advantage of the witch hunts while they are still in progress, there is another name to consider.  There are ongoing investigations of The Bank of New York Mellon Corporation (BK).  Selling cash covered puts on Mellon would be a way to directly take on exposure to the headline risk. 

For those investors who like to avoid headline risk and recognize the destructive behavior that often emanates from Washington, The Hedged Economist would also recommend looking at financial institutions outside of the US.  Canadian banks represent a totally viable substitute for investors who want exposure to major financial institutions.

It's also worth keeping in mind that it is Potter, not George Bailey, who gets a phone call from the Senator.   Perhaps, the implication of “It's a Wonderful Life” is that investors are best served by avoiding organizations with high profile Washington ties regardless of whether those ties are currently considered positive or negative. 

Given that comment, one might logically ask: why consider any of the large banks in the US?  There are actually three components to the answer. 

First, consider this comment from the WALL STREET JOURNAL published on December 18, 2012.  The article is entitled “U.S. to Sell Bulk of TARP Banks.” It reports that:

“The Treasury in 2013 hopes to clear out its portfolio of banks that took bailout funds during the financial crisis, including scores of institutions that have missed dividend payments owed to the government.

Four years after TARP's launch, the government still owns stakes in 218 banks. Most are smaller institutions, and some are struggling financially—more than half have missed payments they agreed to make when they took bailout funds. Collectively, they owe taxpayers about $7.5 billion.

The Treasury invested more than $245 billion in 707 institutions under TARP's banking programs, most to companies like Bank of America Corp., Citigroup and others with assets of at least $10 billion. Overall, the government has recovered about $268 billion through repayments, dividends, interest and other income.

While big banks quickly exited, smaller ones have been slower to repay.”

What should be obvious from the quote is that large banks, for all their problems, have a risk profile that is markedly different from smaller banks.

Second, consider an article (“FICC or Treat for BankProfits?”) in the Heard on the Street section published the same day.  It notes “Big banks aren't just black boxes. They are black boxes within black boxes….That has always been the challenge for investors—exactly what their assets are worth isn't always clear, and just how they make their money is sometimes hard to discern.”

That is true of all banks and most financial service firms.  Investing in a bank is turning over the decision on the specific investments that will be made to someone else.  Anyone who has been following this blog is undoubtedly aware that The Hedged Economist is extremely reluctant to turn over investment decisions to a third-party.  It does not matter whether the third-party is a bank, a mutual fund, the investment committee of an insurance company, or a pension fund manager.  One could do worse than manage one's own money.

Third, the posting on January 9, 2011 entitled “Investing PART 9: One version of the ‘Unfinished symphony” introduced the concept of the widows’ and orphans’ stock portfolio.  It included large-cap names.  The rationale for the selections and why they were all large-cap stocks was explained in the introduction to the actual portfolio.  It noted that such a portfolio would be remiss in industry coverage and stock market coverage if it did not include a large-cap financial services company. 

So, to summarize the three reasons, 1) any large-cap bank is opaque, but no more opaque than other financial services firms, 2) large-cap financial services firms have a unique risk profile based upon their basic business activity, and 3) that risk profile is a desirable feature of a long run, minimal management portfolio. 

Consequently, one should seek out institutions where there is some basis for believing the company is trustworthy.  That's true of all investments, but particularly true of financial services firms.  Thus, when a financial services firm demonstrates integrity under the close scrutiny of a government’s effort to find an excuse to extort fines, it is important information and justifies considering them for investment.  In fact, the very opacity of the financial service industry makes it even more important to have an independent determination that the organization is trustworthy.