David Tepper of Appaloosa Management has plenty to celebrate this holiday season. This week, The Wall Street Journal reported that the hedge fund manager made a massive winning bet on bank stocks this year. The numbers are staggering:

  • Appaloosa produced a net gain after fees of 120% through early December.
  • Dollar gains amount to approximately $7 billion.
  • Tepper is set to earn more than $2.5 billion personally this year.

Betting against failure
Convinced that the financial system would avoid total failure, Tepper bought bank shares through February and March, when no one else wanted to own them; his average cost per share on Citigroup (NYSE: C) and Bank of America (NYSE: BAC) was $0.79 and $3.72, respectively. That equates to current gains of 316% on Citi, and 308% on B of A.

Tepper says he estimated that the risk of the U.S. nationalizing large banks such as Citigroup was 20%. One can attempt to put a number on this type of risk, but I think even Tepper would admit that that probability was fundamentally unknowable.A very small number of banking crises of similar severity to that of 2008-2009 offer few clues. Furthermore, the federal authorities have stepped in before, under less dire circumstances. Recall that Uncle Sam took an 80% stake in Continental Illinois in 1984 to halt a run on the bank. (Continental was ultimately sold to ... B of A.)

Owning "too big to fail" -- in bulk
Although Bank of America and Citigroup were Tepper's largest bets, Appaloosa Management's next five largest holdings at the end of September were also financials. By decreasing order of value, they were Wells Fargo (NYSE: WFC), Fifth Third Bancorp (NYSE: FTB), SunTrust Banks (NYSE: STI), AIG (NYSE: AIG) and Hartford Financial (NYSE: HIG). All but Hartford fall under the "too big to fail" category.

A good speculation
Appaloosa's returns on the Citi and B of A trade suggest it had a positive expected value, but it looks to me like a binary bet on an unusual situation, with a possible total loss of capital. That's not the sort of bet I find attractive, but I'm sure Tepper's investors will be filled with good cheer this Christmas.

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Fool contributor Alex Dumortier has no beneficial interest in any of the companies mentioned in this article. Try any of our Foolish newsletters today, free for 30 days. Motley Fool has a disclosure policy.