Why the Banks Are Plunging

As I write this, the Dow (INDEX: ^DJI) is almost exactly flat for the day.

Meanwhile, most of the country's biggest banks are plunging:

Banking is the only down sector today. The reason? What's being called JPMorgan's "bombshell."

Last night, we learned that JPMorgan lost $2 billion on supposed hedge positions in credit default swaps. Although JPMorgan is large enough to easily withstand that loss, it is troublesome beyond the capital hit (JPMorgan's core capital under Basel III will fall from 8.4% to 8.2%) for a number of reasons:

1. It happened at JPMorgan under Jamie Dimon's watch. Dimon has been praised by people from Buffett to Obama to just about every person following the banks as an especially talented bank CEO. He has been given credit for guiding the bank through the financial crisis in much better shape than most of its peers. As Simon Johnson was quoted as saying in a Wall Street Journal article: "If Jamie Dimon can't manage risk of this nature, then no one can."
2. Given this, the timing for big banks trying to avoid regulation is awful. The terms of the Volcker Rule are expected to be finalized by the end of July. That rule will put restrictions on proprietary trading at banks that take in deposits. In other words, it seeks to restrict banks from making bets with customer money. The current JPMorgan hedging snafu may not even count as proprietary trading for Volcker Rule purposes, which makes it all the more scary.
3. Credit default swaps were a cause of the financial crisis. The fact that they're still causing problems is a testament to the big banks being able to lobby against truly meaningful reform.

In the short term, additional regulation would hurt the big banks' bottom lines, but over the longer term, smart, common-sense regulation (e.g., breaking up banks that do both Wall Street banking and regular deposit-based banking) would make the industry more stable and likely allow for increased dividends and share-price multiples.

The JPMorgan bombshell highlights the very real black-box risk that comes with buying shares in the heavily discounted big banks. For more on the banking industry, check out our free report: "The Stocks Only the Smartest Investors Are Buying." It details a smaller bank that's been more impressive than the big boys. Just click here to access it.