Bank Bears Reawaken

Until late last week, the group which led the S&P 500 in gains for the year so far was the financial sector. This group of stocks was up nearly 15 percent for the year, nearly double the gain made by the broader market. But financial stocks fell sharply on Friday after JPMorgan (NYSE: JPM) stated it had made “egregious mistakes” and incurred significant ($2 billion) mark-to-market losses in credit derivatives since the end of March. And the company warned the losses “could get worse”.

This was terrible news for the shareholders of any of the investment banks as worries spread across the sector about the strength of banks' balance sheets and Wall Street's business model. Other stocks to suffer in the selloff include the investment bank poster child Goldman Sachs (NYSE: GS), Citigroup (NYSE: C), Morgan Stanley (NYSE: MS) and Bank of America (NYSE: BAC).

Broad investor sentiment to the JPMorgan announcement was summed up by Oliver Pursche, portfolio manager at Gary Goldberg Financial Services, “It is a reminder that when it comes to the financial sector, investors still have to be very guarded. There are still just too many uncertainties, way too many gimmicks within those balance sheets.”

Mr. Pursche is likely correct. Look at JPMorgan's $2 billion loss. Its 'chief investment office' is just a fancy name for a proprietary trading desk for the company. Since it is located in London, a question should immediately pop into investors' mind...was JPMorgan trading with their money or customers' money?

London is the place to be if you want to use other people's money to make money for yourself. Just think back to the MF Global scandal. They used a process called 're-hypothecation', which occurs when banks re-use the collateral posted by clients such as hedge funds to back the bank's own trades and borrowing. London is the center of re-hypothecated trades on the planet since there is no limit on the amount of client assets that can be re-hypothecated even if the client had an agreement with the bank that includes a ban on such practices.

Moving away from the murky world of shadow banking, the investment banks have another and more immediate worry on their hands – credit downgrades from the rating agencies.

Late on Friday, Fitch Ratings did downgrade JPMorgan's rating from AA- down to A+ and placed the bank on 'rating watch negative'. Standard & Poor's followed up by changing its outlook on the bank to 'negative' also.

A major talking point on Wall Street among the investment banks has been the recently announced Moody's upcoming review of the banks which is scheduled to be issued in June. Moody's had already put Morgan Stanley and several other banks on review for a downgrade in February. It is believed that JPMorgen may face as much as a three notch slide in its ratings while other banks including Citigroup and Goldman Sachs have a two-notch slide looming over them. Bank of America has the potential for a one-notch slide in its rating.

Morgan Stanley said last Monday that if such an event occurs, it would have to pony up another $7.2 billion in collateral if its rating was changed by Moody's and Standard and Poor's. That is more than an 50 percent increase from its last estimate. Other investment banks, if downgraded, will also face raised borrowing costs and increases in required collateral.

For a long time, the stock market has ignored the problems with the major banks which never really went away from the 2008 financial crisis. But that may be changing now. It looks as if the good times for the banks and their investors are over and it may turn out to be a long, hot summer for the sector.

This article was originally writtern for the Motley Fool Blog Network. Be sure to read my daily articles for the Motley Fool at http://blogs.fool.com/tdalmoe/.