Financial Reform - Bullet Dodged

Posted by jeff

Sun Jun 27th, 2010 11:49 AM

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Since March 2010, Mr. Bernstein has served as Senior Vice President, Research, for AH Lisanti Capital Growth, LLC, a registered investment adviser. This commentary solely represents Mr. Bernstein’s views and opinions as of June 27th, 2010, does not constitute investment advice and does not depict the views of AH Lisanti Capital Growth, LLC.



At Urban Digs we have been proponents of the idea that "as Wall Street goes so goes the New York City residential real estate market". We are not believers that the month-to-month or even year-to-year fluctuations in the market track the stock market averages. It's much too complex of a market with many other inputs to value for that to be the case. But like it or not the New York City economy is dependent on Wall Street profits (The Ax Man Cometh: Can the Tax Man Be Far Behind) and for this reason among many reasons we monitor the goings on in financial markets and the health of the Street.

As we all know dire predictions of Wall Street's demise have proven premature due to the TARP bailouts and Wall Street's central role in raising money for other financially stretched companies including high yield issuers of all sorts, REITs, and regional and local banks among others. The spritely rebound in the stock, bond and commodity markets and nascent economic recovery have also put Wall Street in a "done firing" mood.

As night follows day, after all financial debacles there are calls for increased regulation (Regulator Revenge: There's a New Sherriff in Town) There is always a threat that such regulation will cause a recapitulation (double entendre intended) of the markets and or asset classes that were involved in the original financial debacle. The financial reform effort going on in Washington carried just such a threat and it is no wonder that financial markets have been weak as this process came to a head. It is an old Wall Street saw that financial stocks tend to lead the stock market and if they are at all predictive of market and economic conditions to come the charts of stocks like Goldman Sachs(View image) and Morgan Stanley (View image) were a wary commentary on the potential pitfalls of the reform legislation.

I was fortunate enough to be on a conference call hosted by FBR Capital Markets, with their Washington Policy Analyst Edward Mills, who summarized the "Dodd- Frank" financial reform bill for listeners after spending the night attending the drafting session. The following are my interpretations of the key takeaways with my commentary in italics.

Consumer Protection Bureau - A consumer protection bureau will be established. It will be run by one individual with a large budget. Payday lenders, check cashers and those providing student loans will be regulated under this bureau in addition to the expected banks, thrifts, credit unions et al. The new regulations that will eventually be promulgated will likely raise compliance costs for these various institutions, but it seems unlikely that the establishment of consumer protections will significantly impact the depth and breadth of financial products available to American consumers. My guess is that the impact on economic growth will be deminimus in the near-term and small in the intermediate term. The development of products with the potential for abuse will be curtailed and with that the opportunity for ill gotten gains, but this shouldn't wreck any major players' business and you can expect cost increases to be transmitted to the consumer in one form or another.

Derivatives - Derivatives will be segregated into two types plain vanilla/low volatility products and complex/more volatile products. Banks will be allowed to continue dealing in interest rate swaps, foreign exchange, gold, silver and investment grade bond derivatives, through their regulated subsidiaries which utilize consumer deposits as a funding mechanism. In contrast, the broking of agricultural commodity, energy, other metals and non-investment grade derivatives and CDS, will be limited to seperate operations under the bank holding company structure, which do not put consumer deposits at risk. There will also be a code of conduct for derivative dealing with certainy types of clients like municipalities.Changing where within the holding company structure the derivatives books lie and requiring a seperate capital base supporting them will have very little effect on how these businesses are run. It is my understanding that Morgan Stanley and Goldman Sachs already run these operations under un-regulated subsidiaries.

Volker Rule - Banks will forced to curtail and modify some of their investment activities as a result of the new "Volker Rule" which will include conflict of interest standards. Investments by banks in hedge funds, private equity and venture capital funds will be limited to 3% of Tier I Capital (strangely all capital related limitations in the bill reportedly refer to Tier I requirements rather than the Tangible Capital measure which investors have come to depend on during times of trouble as the true dollars available to offset losses). Banks will have up to 7 years to divest themselves of stakes in these funds above mandated levels as there will be 2 years of rule making and they will be given 3 years to liquidate their holdings, with 5 years allowed for particularly illiquid partnership interests. Prohibitions on proprietray trading will be the purview of regulators. My guess is that proprietary positions assumed during the course of market making will be allowed, but pure proprietray desks or books may not. Certainly conflict of interest rules which forbid banks from selling products that may be deliterious to their clients health, and/or betting against products they are selling to customers, wll reduce profit making opportunities that may not otherwise exist. It is of course high time for some reduction in these kinds of conflicts, which are bad business in the long-run anyway. All in, the Volker rule is unlikely to have a big impact on bank profitability, recent media reports put Citi's proprietary trading at 2 - 3% of revenue and Goldman Sachs at approximetaly 7%.

Systemic Risk Regulator - "Too big to fail" institutions will be monitored and regulated by a systemic risk regulator, a position sorely needed due to the tangled web of leverage, derivatives, counter-party risks and insurance contracts that have come to underpin the entire financial system. Banks with assets over $50 billion and the largest hedge funds (assets > $10 billion) will be required to pay in about $19 billion over 5 years to pay for their regulator. This is perhaps the biggest cost of the bill to banks, even if one includes indirect impacts like limitations on profit making opportunities. It is certainly the most tangible at this juncture, yet here again, things coule have been worse.

Trust Preferred Securities (TRUPS) - These securities, which were issued by banks and utilized to meet capital requirements more easily, were also purchased largely by other banks and in a massive daisy chain effect, became a potential source of systemic risk in a "run on the banks" environment. Big banks (> $50 billion in assets) will be forced to replace TRUPS as a source of capital over a 5 year phase in period. Smaller institutions will have currently outstanding issues of these securities grandfathered in. This is eminently sensible in an environment where bank capital is already tight, continued loss taking is assured over the next couple of years, and the authorities would like to encourage banks to lend out capital, albeit wisely, rather than hoard it.

As one can surmise from the subject matter involved in this bill, there were any number of ways the legislation could have led to severe damaged to the currently anemic banking system. If anything, the bill lets banks off too easy, except for one crucial factor. This bill relies heavily on future rulemaking, largely slated for the next 2 to 2 1/2 years, which will mold the concepts outlined above into actual law. It is anybody's guess how that regulation will eventually fall out and what potentially perilous unintended consequences could result. That said, the government's restraint in this matter shows a regard for the importance of the financial systems and it's still fragile state in the face of a popular call for heads on pikes, indicating a wisdom I have not often witnessed from our elected officials....maybe ever. Don't get me wrong, the financial reform that is coming virtually assures that Wall Street peak returns on equity won't be seen again for a generation, but this process could have been much worse for the overall economic outlook and health of New York City.

As of Friday's close, a composite of larger banks and brokers including Bank of America, Goldman Sachs, Morgan Stanley, J.P. Morgan, Deutsche Bank and Citigroup was expected to see their earnings per share rise an average of 30% in 2011 (with a median of 22%). This despite Wall Street analysts' grave concerns about the financial overhaul. Now, it is possible that analysts were waiting to see the final bill, before slashing their numbers, so I will report back any significant change. However, if these numbers are even close to the real growth in earnings that these institutions will see in the early years of financial reform, it is good news indeed for the economy of the City of New York as well as New York city residential real estate.