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Financial Reform Playbook

Our Financials Sector Head Josh Steiner sent the note below to his subscribers yesterday.  Given the importance of financial reform as factor in the market currently, we thought it was important to highlight, specifically relating to the potential catalysts in the calendar relating to reform over the coming weeks.  As you are positioning and thinking about how the next few weeks could play out on the financial reform front, this note is worth more than a crackberry minute to read.


Daryl G. Jones

Managing Director

04/20/2010 06:32 AM

With Financial Reform "Part One" now potentially just a few weeks away, and in light of the SEC's fraud allegations directed at Goldman Sachs, we thought it a worthwhile time to get investors back up to speed on what to expect.

First, our take on what's going on.

Financial Reform "Part One" is seemingly now moving full steam ahead, made possible largely by the curiously opportune timing of the SEC Goldman case. What had been a reasonably high probability of a filibuster of the current Dodd Bill just days ago will now likely not stand up in the face of blistering sentiment in the court of public opinion around the Goldman situation. The GOP position will only be made more difficult by the Administration removing the $50bn bank tax, which Senate Minority Leader Mitch McConnell (R-KY) likened to a government-approved future bailout - the one, already-bent arrow left in the GOP quiver.

The two key events to watch for will be (a) the Senate Agriculture Committee vote on whether to ban bank trading of derivatives (this Wednesday) and (b) whether republican Senator Collins will vote in favor of Senator Dodd's Financial Reform bill - likely to play out in the near future as Treasury Secretary Geithner met with her just yesterday afternoon.

Financial Reform "Part Two" deals with the implementation and enforcement of Financial Reform once passed into law. We address this later in the report.

Second, a timeline and list of upcoming catalysts/key dates relevant to Financial Reform.

1) Yesterday afternoon - Treasury Secretary Geithner was meeting with Senator Collins (R-ME) to try and get her to break ranks with her GOP colleagues and support the Senate reform bill as proposed. 

Update: Susan Collins is no longer on the fence / she has sided with the rest of the GOP on this issue.

2) This morning (4/20/10) - GS reports before the open / conference call at 11am. All eyes will be directed their way looking for any incremental information in light of the SEC's recent fraud accusations.

3) Wednesday (4/21/10) - Senate Agriculture Committee will hold a markup of its comprehensive OTC derivatives regulation bill with the goal of passing the measure out of committee on Wednesday.

4) Thursday (4/22/10) - Senate likely to begin debate on Senator Dodd's (D-CT) Financial Reform bill.

5) Thursday (4/22/10) - UK general election debate between PM Brown and Conservative Candidate Cameron will likely focus heavily on the GS/Financial Reform issue. US politicians may watch closely to gauge voters response to different posturing around this issues.

6) Thursday (4/22/10) - President Obama will visit Manhattan to deliver a speech on the importance of Financial Reform at Cooper Union; an interesting choice of location, for it was there that President Abraham Lincoln galvanized New Yorkers for the first time in his quest to become President with one of his most famous speeches decrying slavery. 

7) Thursday (5/6/10) - UK general election for Prime Minister.

8) Memorial Day (5/31/10) - This is the Date President Obama has given to Congress to have a Financial Reform bill on his desk. After Memorial Day, Congress will go into full swing campaign mode, and passing any meaningful legislation will become difficult.

Third, a summary of the key developments of late and what to watch for.

1) Dodd's Odds. Senate Banking Committee Chairman Chris Dodd (D-CT) announced prior to the recent legislative break that he was abandoning efforts to strike a bipartisan compromise after separate attempts to negotiate with committee republican Shelby (R-AL) and committee republican Corker (R-TN) failed to yield an acceptable compromise. Senator Dodd chose a go-it-alone strategy, which will require a 60-vote filibuster-proof majority in the Senate. With the election of Scott Brown (R-MA), there are now 57 Democrats plus 2 Independents (who caucus with the Democrats), and 41 Republicans currently in the Senate. The Democrats are short one vote to avoid a filibuster. Enter Senator Susan Collins (R-ME).

Update: The GOP is now saying that they’re close to a deal. Senator Shelby is putting forward an optimistic tone for the first time since 2009.

2) Senator Collins. Senator Collins (R-ME) is perceived as the low-hanging fruit by the administration for the 60th vote in favor of Dodd's bill. While she has come out against the bill, and has signed the GOP letter to the Democrats calling for a reopening of bipartisan talks on the issue, she was the last republican senator to do so, and has a history of breaking with her party at times. As the following excerpts from her voting record show, Senator Collins has acted independently of the GOP many times, making her a plausible candidate to do so again on Financial Reform.

Update: Susan Collins is no longer on the fence / she has sided with the rest of the GOP on this issue.

3) Senate Agriculture Committee. Senate Agriculture Committee Chairman Blanche Lincoln (D-AR) has proposed a ban on derivatives trading by banks. Specifically, her bill would require that financial firms spin out their derivatives business in order to remain banks - a modern day version of Glass-Steagall. In addition, it requires that derivatives be traded on an exchange and be approved by a clearinghouse. Further, firms would be required to disclose to regulators and the public their derivatives positions. This goes considerably farther than the Dodd bill, which would not require such a breakup or require public disclosure of positions. As we understand it, Dodd's view is more in-line with the administration's thinking on this issue. To reiterate, the Senate Agriculture Committee will hold a markup of its comprehensive OTC derivatives regulation bill with the goal of passing the measure out of committee this Wednesday (4/21/10). It is possible that the bill could be amended to the Dodd bill.

Update: The Senate Agriculture Committee will likely pass their bill today. The real question now becomes what elements of it get included in the Dodd bill.

4) Latest give and take. The latest concession being reported is that Dodd may, at the Administration's request, remove the $50 billion bank tax from the bill. This has been an area of heated recent exchange, where Senate Minority Leader Mitch McConnell (R-KY) has been using the bank tax as the basis for an argument that the Dodd bill will support future bailouts. Recall that the House version of financial reform has a similar provision calling for a $150 billion bank tax. 

5. Conference Committee. This may not be as challenging as many had anticipated. For those unfamiliar, the Conference Committee is the process in which the House and Senate bills are merged into one bill for the President to sign. Given the differences that were anticipated to emerge between the House and Senate bills for Financial Reform it was being speculated that the House would not acquiesce to the Senate's less stringent changes. However, now that Chairman Dodd's bill appears to have a higher likelihood of passage without broad Republican support, we think this may not be much of a challenge.

6. The UK Election. One interesting additional note is that the UK General Election will be held on May 6. Prime Minister Gordon Brown is set to lose by a wide margin according to Intrade.com, which has his contract for re-election priced at 20, while that of his competitor, conservative candidate Cameron is priced in the low 70s. This is significant for a few reasons. First, this could lead PM Brown to take off the gloves at their upcoming debate this Thursday and really lay into GS, among other Financial firms, in an effort to try and shore up his share of the populist vote. Second, politicians in the US will be paying careful attention to both the rhetoric and outcome of the UK election on this front as they devise their own political calculus heading into the November midterm elections. Finally, a surprise win by Brown would almost certainly represent an additional negative for the sector.

Fourth, Financial Reform Part Two.

The two bills proposed give regulators the option of breaking up firms deemed too-big-to-fail, but does not require it. Further, there is an element of this discretion woven throughout much of both the House and Senate bills, which is why we think it's again worth revisiting the role the Financial Services sector plays from a contributions standpoint, as it is a general truism that politicians rarely bite the hand that feeds them. Have a look at the following charts to get a sense for who is involved in this process, and where they receive campaign contributions.

The following chart shows Securities Industry contributions to Senators for the 2010 election cycle - the one underway right now. The interesting takeaways are that Democrats actually held 12 of the top 18 spots for donations, and the top four most heavily financed Senators were all Democrats: Senators Schumer (D-NY), Gillibrand (D-NY), Reid (D-NV), Dodd (D-CT). Interestingly, Senator Dodd has announced he will not seek re-election and Senator Reid is facing a 20-30 point gap in the Nevada polls, suggesting it may be unlikely that he'll seek to run again. The point is simply to show that the Securities Industry is a major Democratic contributor.

Financial Reform Playbook - Top Senatorial Contributions 2010

Source: opensecrets.org

In fact, overall, the Financial Services industry contributes 32% of all Washington donations, making it more than twice the size of its nearest competitor.

Financial Reform Playbook - overall industry contributions

Source: opensecrets.org

Here's a look at the contribution levels by recipient for a few of the senior Representatives and Senators who matter most to this process. Overwhelmingly, Financial Services is their principal source of campaign money.

House Financial Services Chairman Barney Frank (D-MA)

Financial Reform Playbook - 1 Barney Frank by industry

Source: opensecrets.org

Senate Banking Committee Chairman Chris Dodd (D-CT)

Financial Reform Playbook - Dodd

Source: opensecrets.org

Influential Democratic Senator Chuck Schumer (D-NY)

Financial Reform Playbook - 2 chuck schumer by industry

Source: opensecrets.org

Potential Swing Voter Senator Susan Collins (R-ME)

Financial Reform Playbook - collins

Source: opensecrets.org

Interestingly, the one Senator who seems to have no reservations about breaking the banks apart in so far as prohibiting them from trading derivatives is Senator Blanche Lincoln - Chairman of the Senate Agriculture Committee, who has not one major financial campaign supporter. In fact, her only quasi-financial contributor is the Intercontinental Exchange, which is a potential beneficiary of forcing the OTC derivatives market to clear through either CME or ICE.This was clearly a major oversight on the part of the Financial industry not contributing to Senator Lincoln.

Senator Lincoln's top campaign contributors for the 2008 election cycle.

Financial Reform Playbook - Senator Blanche Lincoln   SAC Chairman

Source: opensecrets.org

Finally, a look at Goldman's contributions to the 2010 Senate election cycle relative to other companies within the Securities Industry. Clearly, GS stands at the top of the list. What's interesting is that GS actually allocated 75% of its contributions in this cycle towards Democratic candidates - a higher percentage than virtually any other firm on the list.

Financial Reform Playbook - GS relative to others for 2008

Source: opensecrets.org

It's our view that such substantial campaign resources generate considerable influence, and that influence has been years in the making and represents significant inertia that will be difficult to overcome, most notably in Financial Reform Part Two. In other words, we expect Congress to pass Financial Reform Part One, but the Devil will be in the details, as it most often is. In this case we would expect to see little follow-through support for any excessively punitive measures once "reform" is passed, and candidates can campaign solely on the passage, rather than the merits, of that reform.

Fifth, a summary of the key points of the two bills.

A few of these provisions are in flux, but the following are a good representation of the Bills as they stand now.

Senate Bill

  • Consumer Financial Protection Bureau:
    • The agency will be housed within the Federal Reserve and the agency's Director will be appointed by the President and confirmed by the Senate.
    • The bureau will have a dedicated budget paid by the Federal Reserve Board and will be tasked with autonomously writing rules for consumer protections governing all entities offering consumer financial services or products.
    • The agency will examine and enforce consumer rules for banks and credit unions with assets above $10B and will also have authority over mortgage-related businesses and large nonbank financial firms.
  • Systemic Risk:
    • The bill sets up a 9-member council of regulators, chaired by the Treasury Secretary, to oversee systemic risk in the financial system.
    • The measure empowers the systemic risk council, by 2/3 vote, to assign high-risk nonbank financial firms to fed oversight and says the council, by 2/3 vote, may approve a Fed decision to order the break-up of large firms that threaten the economy's stability.
    • Large bank holding companies that have received TARP funds will not be able to avoid Federal Reserve supervision by simply dropping their bank status.
  • Ending Too Big To Fail:
    • The Financial Stability Oversight Council will monitor systemic risk and make recommendations to the Federal Reserve for increasingly strict rules for capital, leverage, liquidity, risk management and other requirements as companies grow in size and complexity.
    • Creates an orderly liquidation mechanism for the FDIC to unwind failing systemically significant financial companies. Shareholders and unsecured creditors will bear losses and management will be removed.
    • Requires Treasury, FDIC and the Federal Reserve all agree to put a company into the orderly liquidation process. A panel of 3 bankruptcy judges must convene and agree within 24 hours that a company is insolvent.
    • Charges the largest financial firms $50 billion for an upfront fund, built up over time, that will be used if needed for any liquidation.
  • Volcker Rule:
    • Requires regulators to implement regulations for banks, their affiliates and bank holding companies, to prohibit proprietary trading, investment in and sponsorship of hedge funds and private equity funds, and to limit relationships with hedge funds and private equity funds.
    • Nonbank financial institutions supervised by the Federal Reserve will also have restrictions on their proprietary trading and hedge fund and private equity investments.
    • Regulations will be developed after a study by the Financial Stability Oversight Council and based on their recommendations.
  • Banking Regulations:
    • The Federal Reserve will regulate bank and thrift holding companies with assets of over $50B. The Vice Chair of the Federal Reserve will be responsible for supervision and will report semi-annually to Congress.
    • The FDIC will regulate state banks and thrifts of all sizes and bank holding companies of state banks with assets below $50B, whle the OCC will regulate national banks and federal thrifts of all sizes and the holding companies of national banks and federal thrifts with assets below $50B.
    • The Office of Thrift Savings is eliminated, existing thrifts will be grandfathered in, but no new charters for federal thrifts.
  • Executive Compensation and Corporate Governance:
    • Provides shareholders with a say on pay and corporate affairs with a non-binding vote on executive compensation.
    • Gives the SEC authority to grant shareholders proxy access to nominate directors.
  • Derivatives:
    • Requires central clearing and exchange trading for derivatives that can be cleared.
    • Provides the SEC and CFTC with the authority to regulate the OTC derivatives market.
  • Hedge Funds:
    • Raises the assets threshold for federal regulation of investment advisers from $25M to $100M so that those funds that manage over $100M will be required to register with the SEC as investment advisers and to disclose financial data needed to monitor systemic risk and protect investors.
  • Credit Rating Agencies:
    • Creates a new Office of Credit Rating Agencies at the SEC and requires NRSO to disclose their methodologies, their use of third parties for due diligence efforts, and their ratings track record.
  • Securitization:
    • Requires companies that sell products like mortgage-backed securities to retain at least 5% of the credit risk, unless the underlying loans meet standards that reduce riskiness.
    • Requires issuers to disclose more information about the underlying assets and to analyze the quality of the underlying assets.

House Bill

Consumer Protections: Creates the Consumer Financial Protection Agency (CFPA),

a new, independent federal agency solely devoted to protecting Americans from

unfair and abusive financial products and services.

Financial Stability Council: Creates an inter-agency oversight council that will

identify and regulate financial firms that are so large, interconnected, or risky that

their collapse would put the entire financial system at risk. These systemically risky

firms will be subject to heightened oversight, standards, and regulation.

Dissolution Authority and Ending “Too Big to Fail”: Establishes an orderly

process for dismantling large, failing financial institutions like AIG or Lehman

Brothers in a way that ends bailouts, protects taxpayers, and prevents contagion to the

rest of the financial system.

Executive Compensation: Gives shareholders a “say on pay” – an advisory vote on

pay practices including executive compensation and golden parachutes. It also

enables regulators to ban inappropriate or imprudently risky compensation practices,

and it requires financial firms to disclose any compensation structures that include

incentive-based elements.

Investor Protections: Strengthens the SEC’s powers so that it can better protect

investors and regulate the nation’s securities markets. It responds to the failures to

detect the Madoff and Stanford Financial frauds by ordering a study of the entire

securities industry that will identify needed reforms and force the SEC and other

entities to further improve investor protection.

Regulation of Derivatives: Regulates, for the first time ever, the over-the-counter

(OTC) derivatives marketplace. Under the bill, all standardized swap transactions

between dealers and “major swap participants” would have to be cleared and traded

on an exchange or electronic platform. The bill defines a major swap participant as

anyone that maintains a substantial net position in swaps, exclusive of hedging for

commercial risk, or whose positions create such significant exposure to others that it

requires monitoring.

Mortgage Reform and Anti-Predatory Lending: Would incorporate the tough

mortgage reform and anti-predatory lending bill the House passed earlier this year.

The legislation outlaws many of the egregious industry practices that marked the

subprime lending boom, and it would ensure that mortgage lenders make loans that

benefit the consumer. It would establish a simple standard for all home loans:

institutions must ensure that borrowers can repay the loans they are sold.

Reform of Credit Rating Agencies: Addresses the role that credit rating agencies

played in the economic crisis, and takes strong steps to reduce conflicts of interest,

reduce market reliance on credit rating agencies, and impose a liability standard on

the agencies.

Hedge Fund, Private Equity and Private Pools of Capital Registration: Fills a

regulatory hole that allows hedge funds and their advisors to escape any and all

regulation. This bill requires almost all advisers to private pools of capital to register

with the SEC, and they will be subject to systemic risk regulation by the Financial

Stability regulator.

Office of Insurance: Creates a Federal Insurance Office that will monitor all aspects

of the insurance industry, including identifying issues or gaps in the regulation of

insurers that could contribute to a systemic crisis and undermine the entire financial system.

Conclusion. Democrats and the Administration may well have the needed ammunition to get Financial Reform legislation over the goal line on the heels of the SEC charging GS with fraud. The real question will be, once all the ink is dry, what will this mean for the sector. We remain somewhat simplistically convinced that the amount of campaign contributions the industry floods Capitol Hill with each year is likely to keep the wolves at bay to a greater extent than most assume. As such, we think there will be negative headline risk for the next month or so through Memorial Day, but after that the sector could lift on the realization that Congress' bark is worse than its bite.

Joshua Steiner, CFA

Allison Kaptur