Large Banks and the Bernanke Put Option?

On March 10th of this year, Federal Reserve Chairman Ben Bernanke made a bold statement when he declared that large banking institutions will not be allowed to fail. What this has essentially done is put a temporary bottom in the financial market, and gave investors a reason to starting buying shares of some of the large banks. Up until this time, there was a good deal of uncertainty regarding whether or not some of the large banks would be nationalized. The government had already taken a 35% stake in Citigroup (C), one of the largest financial institutions in the country with over 7,700 branches, and investors thought other banks may also fall victim to the same fate.

The idea that Bernanke has basically purchased a put option on the large financial companies by making these comments is a fair assessment. In laymen’s terms, a put option is insurance against downward movement in a stock. A put option allows an investor to have a long position in a stock, with the option to get out if the stock falls to a certain level. Since Bernanke’s remarks, companies such as JP Morgan (JPM), one of the countries leading investment and commercial banking institutions, Bank of America (BAC), a leading financial holding company with over 6,000 banking centers, and Wells Fargo (WFC), one of the leading community and wholesale banking companies in the United States, have all seen their share prices increase by 15%-30%.

What Bernanke’s comments have done is instill confidence in the financial sector of the market and provide investors with some downward protection for their investment. If the Federal Reserve will not allow large banking institutions to fail, then there is little risk that shares of these companies will fall below their prices prior to his statement. However, if another shoe falls, so to speak, and these banks are not profitable like they have said they are, then this may create more volatility in the financial sector.

With that said, there will still be some consolidation in the financial sector, especially among the smaller, regional banks. It is also within the realm of possibility that some smaller banks will fail and be forced into bankruptcy. Banks such as Fifth Third Bancorp (FITB), which is a small regional bank which operates mainly in the Mid-Atlantic States, are still not out of the clear. Some of these banks, such as New York Community Bank (NYB), still offer very high dividend yields which have the potential to be cut in an attempt to free up more capital for the company. Almost all of the big banks previously mentioned have cut their dividends significantly over the past few months, so investors should not look at these stocks as safe dividend plays.

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In recent days, these bank stocks have soared upwards of 30%. If you missed this uptrend, I wouldn’t rush into these stocks at their current levels. Wait for them to pull back to a lower level before you start forming a position. While we don’t expect them to go all the way back to their lows, we do think they will pull back from their current levels. If you buy at these levels you are “chasing the trend” and this will leave you vulnerable to a downturn.

An investor investing in a bank stock trading position might also consider using a put option to protect from a downside fall in stock price. A put option can be considered “stock insurance“, similar to insurance for a car or house, etc.

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[tags] Federal Reserve Chairman, Ben Bernanke, banking, BAC, BankAmerica Corp., C, Citigroup Inc., FITB, Fifth Third Bancorp., JPM, J.P. Morgan Chase, NYB, New York Community Bancorp Inc., WFC, Wells Fargo & Co. [/tags]