Will derivatives reform kill bank stocks?
The newly passed financial reform bill includes plans for the derivatives market that could create huge costs for the banking industry and the economy.
By Lauren Tara LaCapra, TheStreet
Bank investors are freaking out, and with good reason: The companies they own have gotten hammered recently and may see up to 36% in additional losses in the weeks ahead, according to one estimate.
The bad news? Financial reform may slash revenue by at least 25%, profits by as much as 75% and force the industry to raise $200 billion in fresh capital. The good news? Things may not turn out quite as bad as those dire, doomsday predictions. The recovery will offset some of the downside, the capital burden may not be placed on shareholders, and bank stocks have already taken a big hit.
The outcome depends on lawmakers. Let's break it down.
The bill: The financial reform bill was approved by the Senate late Thursday after months of back-room negotiations and weeks of public debate. Sen. Chris Dodd (D., Conn.) first unveiled it in mid-March, but has gone through several iterations since then. In the past few days alone, lawmakers added a significant amendment regarding derivatives, doubted its prospects, touted its prospects, tried to water it down, then went back to square one.
Senate Majority Leader Harry Reid (D., Nev.) couldn't get his colleagues to vote "yes" on holding a vote until Thursday afternoon, when 60 senators voted to move the bill forward after the cloture vote failed by a margin of 57-42 on Wednesday. The Senate bill will now be reconciled with the House version, which was approved in December.
The financial industry and its corporate clients have been sweating bricks. In their view, the derivatives measure is perhaps the single most important item in the reform package. The direct and indirect costs to the industry and the economy could be huge, depending on whether that amendment, sponsored by Sen. Blanche Lincoln (D., Ark.) is adopted, and how it is interpreted. They are so significant that the estimates outlined so far are ballpark guesses at best.
A line item in a report on Thursday by Rochdale Securities analyst Richard Bove outlining all the costs related to financial reform may have captured it best: "For no definable reason, I am setting aside another $20 billion in possible losses due to the unknown."
Most of the reform bill's 1,500 pages relate to costs that have been well-known for some time. For example, Bove estimates deleveraging will cost the industry $2.3 billion, liquidity measures will cost $5.6 billion and an interchange fee will cost $3 billion.
Last year, financial firms individually outlined costs of rules implemented outside of the Dodd bill, such as Regulation E, the CARD Act and higher regulatory fees. Bove estimates those three items will chop roughly $10 billion off industry revenue.
In other words: All that stuff's been priced in. The real uncertainty lies in the impact of derivatives reform.
The Dodd bill initially proposed putting derivatives trading on an open exchange, with clearing, capital and margin requirements. Lincoln went a step further to propose that banks be forced to place derivatives operations into an affiliate that is separate from the bank holding company. That would mean the business couldn't rely on funds from a bank's existing balance sheet, nor would it have support from the Federal Deposit Insurance Corp., nor would it be eligible for taxpayer-financed bailouts.
Overall, the derivatives business would be undercapitalized, riskier and therefore more costly. A worst-case scenario would make the US derivatives industry unviable. Here's why:
Potential outcomes: Banks with large consumer operations such as JPMorgan Chase (JPM) and Bank of America (BAC) would have to decide whether there's enough demand for the costlier products. If so, they would have to find a source of capital -- probably from customers. If not, they'd have to wind down the business entirely. If the process becomes simply too cumbersome, they may opt to spin off derivatives operations into separate entities.
Banks such as Goldman Sachs (GS) and Morgan Stanley (MS), which still operate like investment banks but became federally chartered banks to be eligible for taxpayer support, may have to give up their charters to continue existing. Those firms, their foreign counterparts and any spun-off entities from consumer banks might also move operations to friendlier markets offshore.
"This could significantly restrict credit availability, increase the cost of borrowing for businesses and consumers, place US banks at risk of losing significant share in global financial markets as Europe, Asia and Canada gain share, and drive the Fed to be reliant on non-US banks as financial intermediaries of the US dollar," writes Morgan Stanley analyst Betsy Graseck, outlining the worst-case scenario.
What it means for bank stocks: Graseck says the Lincoln amendment alone could hurt earnings by 3.5%, 4.5% and 6.2% by 2012 for Bank of America, JPMorgan Chase and Citigroup (C), respectively. That's $12 billion less in revenue, $2.7 billion less in earnings collectively, or 11 cents less per share for Bank of America, 3 cents less per share for Citigroup and 27 cents less per share for JPMorgan Chase. (Lower spreads related to other reform measures were already "baked into" her estimates.)
Kian Abouhossein, an analyst with JPMorgan-Cazenove, says return on equity for global investment banks would drop to 12% from 19% if the Lincoln amendment -- also known as "section 716" -- is adopted in its current form. He estimates that the eight investment banks he covers may require $85 billion in capital. (A trade association has pegged the overall industry estimate at $200 billion.)
UBS (UBS) is the only one with excess capital, according to Abouhossein. Other companies would need $500 million to $26 billion more in capital, with Deutsche Bank (DB) being most at-risk for requiring fresh financing.
Abouhossein says he doesn't know what the derivatives measure means for the stocks he covers. Goldman, Morgan Stanley, UBS, Deutsche Bank, Credit Suisse (CS), Societe Generale (SG), BNP Paribas (BNP) and Barclays (BCS) may now be trading at anywhere from a 7% discount to a 36% premium, depending on whether their derivatives businesses are left intact or completely dismantled.
"Until we have clarity about section 716, we are unable to make a very strong case for global investment banks," says Abouhossein.
Banks had been rebounding from lows hit in March 2009 before regulatory crackdowns came to the fore. Most of those efforts have targeted derivatives.
The Securities and Exchange Commission kicked off the wave of bank-stock selling on April 16, when it accused Goldman Sachs of derivatives fraud. Since then, Goldman has shed 26% of its market value. The top five US swaps dealers, including Goldman, Morgan Stanley, JPMorgan, Bank of America and Citigroup, have lost an average of 22%.
Graseck notes that the Federal Reserve doesn't seem keen on the instability that would ensue from such a strict crackdown on derivatives. Nor would the government be thrilled with handing over the US' leading position in financial services to competitors across the Atlantic. Nor would it necessarily trust non-US banks -- those that it doesn't regulate that could still trade derivatives -- to handle currency transactions.
Bove says that even if the Lincoln amendment passes, it can't possibly stop banks from earning more money. In a report titled "Buy Bank Stocks," he does some back-of-the-envelope calculations to make the case.
Loan losses peaked at $248 billion last year and are poised to drop from 92% of pre-tax, pre-provision earnings to a more normal 12.5% during the next couple of years. He pegs the overall costs of financial reform at roughly $68.5 billion per year.
"The mathematics are clear," says Bove. "While the impact of the new legislation will be quite severe, it will not stop a meaningful recovery in bank earnings."
Abouhossein, whose report included some startling estimates, says "prices are attractive." If the reform bill leads to the worst-case scenario, though, the benefits won't go to any publicly traded firms: "Hedge funds will be the ultimate winners," Abouhossein says.
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