The Following note was published by Joshua Steiner Head of Financials at Hedgeye Risk Management.

With Healthcare reform taking up all the oxygen in the District, we thought it worthwhile to point out that there is significant progress being made behind the scenes on Financial reform. After weeks of delay, the Financial Times reports that Senate Banking Committee Chairman Dodd (D-CT) and Senator Corker (R-TN) seem to be winding down their backroom horsetrading, and a financial reform bill may be introduced later this week. The latest iteration holds that the Federal Reserve will cede regulatory oversight of all but the top 23 bank holding companies (those with >$100B assets) to a new agency to be born out of a merger of the OCC and OTS. This will affect some 4,950 banks. Separately, the Fed will also cede oversight of all state chartered banks to the FDIC (a further 874 banks). Our take? The Office of Thrift Supervision (OTS) is known in the industry for being a weaker regulator than the Fed. From a systemic risk management standpoint, we think this move is incongruent with the goal of imposing stronger industry regulatory oversight. In other words, in the long run this is a bad idea. That said, the Office of the Comptroller of the Currency (OCC) is a strong regulator, so it's unclear what this new, merged super-regulator will look like. While Fed Chairman Bernanke cannot be pleased about losing such a significant portion of his organization's mandate, he must be breathing a sigh of relief that he gets to keep the too-big-to-fail banks under his purview - a clear compromise by Chairman Dodd. Conclusion: this represents no change for the big banks, and a potential positive for the rest of the sector (softer regulator).

Regarding the so-called Volcker rule, Senator Dodd has been a staunch roadblock to its inclusion in any legislation coming out of his committee. He's acquiesced to include some vague language around proprietary trading that will give regulators some theoretical power to curb banks proprietary trading activities on the margin, but we think it amounts to little real change on this front. Conclusion: a positive as this is unlikely to inhibit proprietary activities by any banks.

The Consumer Financial Protection Agency, arguably the single most important element of the reform legislation has been reduced from being a standalone agency to being the Bureau of Financial of Protection within either the Fed or Treasury. Clearly the banks would prefer if it were housed within the Fed. Chairman Dodd, as recently as last week, had indicated a willingness to house the division within the Fed, however pushback from House Financial Services Committee Chairman Barney Frank (D-MA) may result in a compromise whereby the division is housed within the Treasury - not as good for banks as if it were at the Fed, but not nearly as bad as if it were a standalone agency. For reference, Senator Shelby (R-AL) would like to see consumer protection manifest as a watchdog agency within the FDIC. Conclusion: a modest negative for the banks, but relative to expectations a neutral to positive development.

Separately, we think it's also worth pointing out that republicans have been quietly gaining steam in the polls ahead of the midterm elections this November. While it's still more likely than not that Democrats retain majorities in both the House and Senate, we think the following charts capture the changing momentum pretty well. The first chart shows the Intrade contract on Democrats maintaining a majority of the House of Representatives, while the second chart shows the contract for Democrats maintaining a majority of the Senate. For the House, odds that Democrats will remain in the majority after this Fall have fallen from 85% to 55% since early last year. For the Senate, odds of Democrats maintaining a majority have fallen from 95% to 65% in just the last few months.




While we're not yet calling for a change in control of Congress this Fall, the probability of it happening is clearly rising. With that in mind, here's a look at how Financials performed (and the market more generally) on the heels of the last time Republicans took control of both Houses of Congress while a Democrat was President.




Joshua Steiner, CFA