How Long Before Wall Street Stops Picking Up Nickels in Front of Steamrollers?


JP Morgan's stunning $2 billion trading loss, blamed on a hedging error, has renewed calls for tighter regulation on Wall Street. As a result, banking stocks are getting creamed as investors take risk off the table ahead of a period of regulatory uncertainty.

But let's be honest: The time has come for Wall Street to look itself in the mirror and make some big changes.

The main problem is that Wall Street has moved away from an investment-led model to a gambling-based model.

"This was exemplified by the failure of [1990s hedge fund Long-Term Capital Markets] which blew up unsuccessfully making huge interest rate bets for tiny profits, or 'picking up nickels in front of a steamroller,' and by Jon Corzine's MF Global doing practically the same thing with European debt (while at the same time stealing from clients)," writes the Azizonomics blog.

As Nassim Taleb described in his best-seller The Black Swan, the strategy of betting large amounts for small frequent profits is extremely fragile, because eventually (and probably sooner in the real world than in a model), losses will happen. And if you are betting big, losses will be big, especially if you factor in the magnifying effects of leverage.

A gambling analogy might be useful to describe these effects.

Imagine going to the roulette table in Vegas and placing a $100 bet on red (which pays out 2:1). If you lose, you double your bet to $200. If you win the second round, you receive $400 for a total of $300 invested. If you lose the second round, you double your bet again to $400, and so on.

The idea here is that you're increasing the size of your bets to keep making a small profit relative to your overall position. For example, if you lose the bet 10 times in a row, your 11th bet would have to be for $204,800 to win back your initial stake of $100. Azizonomics explains:

That might well exceed the casino table limits -- in other words you have lost your counter-party, and are left facing a loss far huger than any expected gains. ... The bigger point here is whatever happened to banking as banking, instead of banking as a game of roulette? You know, where investment banks make the majority of their profits and spend the majority of their efforts lending to people who need the money to create products and make ideas reality?

Business section: investing ideas
Luckily for investors, there are still many regional banks that are involved in more stable, traditional banking business models. What's more, it's quite likely these stocks will be unjustly dragged down by the overall sentiment affecting the financial sector.

All of the regional banks mentioned below have seen significant levels of insider buying over the last six months, which seems to counter the existing trend of significant insider selling in the broader market.

These banking executives seem to believe in the value of a more traditional banking model. Do you? (Click here to access free, interactive tools to analyze these ideas.)

1. National Penn Bancshares (NAS: NPBC) operates as the bank holding company for National Penn Bank, providing commercial banking products and services to residents and businesses primarily in eastern and central Pennsylvania. With a market cap of $1.39 billion, it most recently closed at $9.10. Over the last six months, insiders were net buyers of 1,122,160 shares, which represent about 1.15% of the company's 97.52 million-share float.

2. Cathay General Bancorp (NAS: CATY) is the holding company for Cathay Bank, which offers various commercial banking products and services for individuals, professionals, and small- to medium-sized businesses primarily in California. It has a market cap of $1.34 billion, with a most recent closing price of $16.99. Over the last six months, insiders were net buyers of 1,458,600 shares, which represent about 2.03% of the company's 71.8 million-share float.

3. Sun Bancorp (NAS: SNBC) operates as the bank holding company for Sun National Bank and provides a range of commercial and retail banking products and services in the U.S. Its market cap is $216.34 million, with its shares most recently closing at $2.52. Over the last six months, insiders were net buyers of 1,095,640 shares, which represent about 5.24% of the company's 20.91 million-share float.

4. Guaranty Bancorp (NAS: GBNK) is the bank holding company for Guaranty Bank and Trust Company, providing various banking products and services to both consumers and small- and medium-sized businesses. With a market cap of $201.67 million, its stock most recently closed at $1.90. Over the last six months, insiders were net buyers of 746,787 shares, which represent about 1.05% of the company's 71.32 million-share float.

5. Middleburg Financial Corporation provides banking, fiduciary, and investment-management services to individuals and small businesses. With a market cap of $115.24 million, its most recent closing price was $16.44. Over the last six months, insiders were net buyers of 189,751 shares, which represent about 3.69% of the company's 5.14 million-share float.

6. Cape Bancorp operates as the holding company for the Cape Bank, providing a line of banking products to retail customers and small- to mid-sized businesses, primarily in Cape May and Atlantic counties, N.J. With a market cap of $101.27 million, its most recent closing price was $8.10. Over the last six months, insiders were net buyers of 120,100 shares, which represent about 1.52% of the company's 7.89 million-share float.

Interactive Chart: Press play to compare changes in analyst ratings over the last two years for the stocks mentioned above. Analyst ratings sourced from Zacks Investment Research.

At the time thisarticle was published Kapitall's Eben Esterhuizen does not own any of the shares mentioned above. Insider buying data sourced from Yahoo! Finance. All other data sourced from Finviz.The Motley Fool has adisclosure policy. We Fools may not all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. Try any of our Foolish newsletter servicesfree for 30 days.

Copyright © 1995 - 2012 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.