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SBUX – FIRST LOOK

SBUX’s fiscal 2Q10 earnings came in at $0.29 per share, beating the street’s $0.25 per share estimate.  The company reported 7% same-store sales growth in the U.S and internationally, implying a 250 bp sequential acceleration in 2-year average trends in the U.S. and 150 bps internationally.   Traffic improved in the quarter.

 

Consolidated operating margins improved 540 bps YOY, reflecting the 740 bp margin expansion in the U.S. and 410 bp growth internationally.

 

Based on these better than expected results, SBUX raised its full-year 2010 guidance:

 

EPS: $1.19-$1.22 (from $1.05-$1.08)

Same-store sales: up mid single digits (from modestly positive)

Revenue growth: up high single digits (from mid single digit growth)

Operating margin:

U.S.: 15% to 17% implies 400 to 600 bps YOY growth (from 400 bps)

International: 8% to 10% implies 180 bps to 380 bps YOY growth (from 200 to 250 bps)

CPG remained the same at 35%

Consolidated: 12% to 13% (from 11% to 12%)

 

Howard Penney

Managing Director

 


Charting Inflation's V-Bottom

We’ve had plenty of mail on Q2 Macro Theme call, Inflation’s V-Bottom.  Some are convinced that Bernanke’s inflation calculations are right and that we should take the US government’s word for it when it comes to its inflation forecast. We are thankful that some people invest with that blind faith. Every liquid and transparent market needs the other side of a trade!

 

On Main Street, whether it be via a nasty consumer confidence reading this morning (ABC Washington Post weekly survey came in at minus 50 versus minus 47 last week) or via that nasty price consumers are paying at the pump, its all one and the same thing when measured by our proprietary Hedgeye Inflation Index – its inflationary.

 

Below we have attached the go forward expectations of inflation as measured by Treasury Inflation Protection (TIP). Wouldn’t you know, this chart looks suspiciously like a V-Bottom too…

 

Cheers,

KM

 

Keith R. McCullough
Chief Executive Officer

 

Charting Inflation's V-Bottom - TIP


GS: Risk Management Update

I’ve fielded plenty of mail on this name in the last 3 trading days. The end result has been lower immediate term lows.

 

The stock continues to breakdown on bearish volume and volatility factors. I have no support until the immediate term TRADE line in my model that I have highlighted with the green dotted line in the chart below down at $150.98.

 

Real-time risk management doesn’t occur in the vacuum of theoretical sell side estimates.

KM

 

Keith R. McCullough
Chief Executive Officer

 

GS: Risk Management Update - GS

 


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MCD – WHERE TO FROM HERE?

The stock’s performance today is somewhat surprising in light of MCD’s outstanding 1Q10 numbers.

 

The 1Q10 results out of MCD today were nothing short of outstanding.  Same-store sales in the U.S., which have struggle recently, came in strong in March, up 4.2% on top of a difficult 5.6% comparison last year.  Management stated on its earnings call, more than once, that top-line momentum across all segments has continued in April.  The stock’s performance today is somewhat surprising in light of these results. 

 

Management sounded extremely positive on the call and the results warranted that optimism.  Looking at MCD’s stock chart and considering MCD’s comment that the last time quarterly U.S. company operated restaurant margin exceeded 20.4% (the company reported 20.4% in 1Q10) was in the second quarter of 1994, nearly 16 years ago, investors may be concerned about where MCD goes from here.

 

MCD – WHERE TO FROM HERE? - mcd stock

 

MCD – WHERE TO FROM HERE? - mcd rop

 

Comparable Store Sales charts:

 

MCD – WHERE TO FROM HERE? - mcd us mar

 

MCD – WHERE TO FROM HERE? - mcd eu

 

MCD – WHERE TO FROM HERE? - mcd apmea mar

 

 

NOTES FROM THE 1Q10 EARNINGS CALL:

 

The momentum seen in comparable sales trends in March is continuing across geographies in April with positive sales momentum maintained in all markets

 

Sharing ideas with franchisees and building the brand.  Taking the business to the next level.

Comparable sales, op income, and EPS all showed strength.

 

US

  • Later this summer launching smoothies, becoming more of a beverage destination
  • Continuing expansion of McCafe

 

Europe

  • Fourth tier
    • Snack offerings in UK/GER doing well
  • New sandwiches performing well across markets
  • Strong increases in extra value meal growth

 

APMEA

  • Launching ¼ lb in Singapore
  • Value lunch driving TC and sales

 

Consumer relying on MCD to deliver affordability

  • Driving traffic through new products and core products
  • Convenience and look of new restaurants are driving this too

 

Remodels

  • Australia and EU leading the way
  • 400-500 in the US this year, interior and exterior
  • China opening 150-175 new units this year

 

Improved perception across markets where critical mass exists

  • Strength of the brand is also dependent on great service
  • APMEA top customer satisfaction
    • China and Japan leading the way
  • US and EU also making progress in improving satisfaction scores

 In the US more than 1/3 of restaurants are open 24 hrs

 

 

APMEA

  • Convenience is a key driver of business
  • Continued expansion of 24 hr service driving sales in Japan
  • Breakfast available in 75% of APMEA stores

 

Momentum is continuing this year

  • Value, experience, product are in line
  • Keeping financial discipline
  • Highest graded company in the space
    • Returning FCF to shareholders – 1bn in 1Q
  • Confident of achieving continued success

 

Chief Financial Officer

  • Plan to win continues to drive sales, guest counts
  • 1Q operating growth of 20% to nearly $1.7bn
    • Combined operating margin increased 220 bps to nearly 30%
  • Lower food and paper costs have allowed the continued expansion of margins

 

United States

  • Lower food and paper costs (and refranchising) helped operating margins increase to 20.4%, by 210 bps
  • Basket of goods decreased 5% in 1Q
  • Commodity outlook for the U.S. is down 2%-3%
  • “remain focused on building traffic”

 

Europe

  • Company operating margins increased 200 basis points in 1Q, to 17.3% 
  • Strong comparable sales in France, Russia, the U.K.
  • Lower commodity costs were partially offset by higher labor and occupancy costs

 

APMEA

  • Company operated margins increased 200 bps
  • Lower commodity costs, operating efficiencies, positive comparable store sales
  • Benefitting from heavily franchised structure
  • The mix of APMEA’s margin was adversely impacted by the Aussie dollar strengthening

 

G&A

  • Improved as % of sales
  • Still expect full year 2010 G&A to be up slightly

 

Closing underperforming stores

  • Closing 430 stores in Japan
    • Negatively impacted EPS by $0.03
    • Expecting minimal charges for the remainder of the year

 

Reimaging

  • Timing is ideal
  • Investing on a scale that can’t be matched…
  • Reimaging over 2k units this year
    • Half in EU, 600 in APMEA, remainder in U.S.
  • Only 20% of exteriors globally are up to date
    • 40% of interiors
  • Rebuilding over 150 restaurants this year
  • Average sales lift above overall market performance of at least 6%-7%
  • Coinvesting with owner-operators
    • $150-200k
    • Remaining $250-500k from operators depending on what they need done to the units

 

Debt

  • 45% of total debt is in foreign denominated currency
    • Hedge vs volatility

Performance over the past quarter is a testament to the alignment of the system in a challenging environment.

 

 

Q&A

 

Q: In Europe and US, how does check break down? Was traffic above SSS and check below? You think that check can improve in the year? Any pricing this year?

 

A: Has been a fall off in check, particularly breakfast, due to how menu is being presented. Still holding the line on pricing. 

Seeing an even larger % of sales growth being attributable to guest counts, which are tremendous. That’s what the focus is. TC’s were 50% of the comp growth in Europe.

 

 

Q: US business and the acceleration in the comps in March, positive tone in April…is core consumer feeling better or is it MCD?

 

A:  Consumer confidence scores getting better, more spending in the marketplace. Unemployment is in a tough spot and spending won’t pick up meaningfully until jobs come back. Results are because of strategies around value – which remains the most important thing to MCD guests. As much about strategies as it is the improved state of the consumer.

 

 

Q: Commodities?

 

A: Probably seen the best quarter in the year in terms of the first quarter.  Expect it to continue to be favorable and that will allow us to wait to take price whereas others will be under pressure.

 

 

Q: Drive through in China? Outlook there?

 

A:  Development in China…beginning to understand how to develop drive thru’s in out rings where you have less density but where you have car traffic.  Tremendous opportunity to grow the business along with growth of free standing units.

Some of the best customer satisfaction scores in China and the structure of the organization there is performing well.

 

 

Q: How sustainable is the March pickup? On the smoothies, will they be ready in time for national advertising over the summer?

 

A: March was a good month.  Growth in all day parts for the entire month.  Momentum is continuing into April.  Broad based across the items…frappes were a part of it.

Frappes are in 9k restaurants and the performance expectations are exceeding what we thought they would.  Smoothies will be ready for national advertising.  Already in 2k units.  Hearing strong reports from operators.

 

 

Q: How do you guys manage the cost down so much with inflation in so many proteins…how does that give you a pricing advantage over time. 

 

A: Great supply chain at MCD. Some fixed price contracts, some options, some forward buying…and we can negotiate good pricing with the relationships we have.  Important for owner/operators to be clued into promotions coming in the next 6 months to mitigate impact on margins and be proactively prepared.   The product mix can be helped by higher margin products/promotions that support the company relative to the overall food cost

 

 

Q:  The cost of remodels…between 4 and 7 thousand?

 

A: This is the first time that MCD has given guidance on what the costs are going to be.  Hard to come up with an average cost across 6k US units of varying sizes, ages, and owner/operator preferences.  Doing interior and exterior gives a significant lift to sales.  Even at higher end of range, we’re seeing returns in the low double digits in the first year, cash on cash.  We feel confident in the level of investment and sales expectations will warrant that investment.

 

 

Q: April?

 

A:  Won’t be lower than the quarter – so the floor is 4.2%

 

 

Q: On the U.S., breakfast dollar menu, can you give mix on that…impact to margins? Competition? Also, in terms of returning cash to shareholders? Refranchising?

 

A: We’re at 80% in terms of franchising.  Optimizing portfolio around the world for how we perform.  On the breakfast mix…we’re selling more coffee.  $ menu is sausage biscuit, sausage muffin, hash brown, and coffee (then other menus that were already on there).   Low cost food and paper in these products. All in all we’re really pleased and the goal was to recapture guest counts.  Food at home down 2%, food away from home at 3%, we can’t take a lot of price.  Happy with breakfast TC’s.

 

 

Q: Metrics on beverage mix? How coffee has performed? Where was the beverage mix 3 or 4 years ago, today, and where is it going? Healthcare reform on corp and franchisee level?

 

A: On healthcare, 2014 is implementation.  Franchisees are a federation of small businesses.  It will vary by number of fulltime employees? 90 day waiting time to enroll, allowance, that helps when operators are evaluating whether someone is going to be fulltime.  $10-30k per store.  TBD.

Corporate level won’t be impacted. 

 

 

Q: On Japan, profitability of the stores that are being closed over the next year or so? Any guidance on how to think about contribution from Japan to equity income?

 

A: No real impact from the closures. 30 got closed so far.  While they were lower volume and return, there was no significant impact.  Not a significant drag.  There will be some sales transfer, higher performing operations to being with. 

 

The closures were restaurants that were size and logistically constrained.  Inhibits menu innovation. April 25, reopening some stores in Tokyo and those stores will be very iconic in Japan.  We will see that market begin to turn.  Got to get rid of some older constraints within system.

 

 

Q: 150-200k total on reimages? Talk about return…as you coinvest how does that impact franchise margin versus how it worked for older reimaging programs? Anything noticing in speed of service? Discounting levels compared with 6/12 months ago? Why would you push franchisees to let up on discounting when it’s defending traffic when they have margin risk?

 

A: Investment…we had a fixed amount during the older programs – 85k – we thought it would be 170k each total. Franchisees ended up spending 250k because they saw other stuff they wanted. Now we’re looking at 40 percentile of the lease hold improvement.  This time, there is a broad range; restaurants have different needs- inside, outside, signage…

Speed of service hindrances have not been observed.  Drive through capacity has been adjusted and service is still as fast as it ever was.  Doing well on that end.

 

Discounting level…we have consistent value across the year.  That allows us to ingrain it in customer and talk about frappes or smoothies or angus, we’re not jumping in with promotions here and there, we are consistent.

And on the coinvesting, where you will see that show up will be in additional depreciation on the franchise margin line

 

 

Q: McCafe expansion in Europe still doing well?

 

A: Pretty much…sales performance is strong.  Germany and France performing well.  France is reimaging exteriors in 2010.  In US, espresso drinks are given through drive thrus and over the counter…

 

 

Q: Plan to win has been a success…over the years we’ve heard about McGriddles, drinks…how do you guard against mistakes and increasing complexity in the back of the house with new promotions?

 

A: We stay focused on the future, focusing on food development protocols…innovation labs…very deliberate process. We don’t move forward with anything not completely tried and tested.

 

Investment in process and execution of operations has also picked up very much versus 8 years ago.  Plan to win focus is what’s helping today and the reinvestment and infrastructure that has been established is the difference that is often missed

 

 

Howard Penney

Managing Director


MACAU TRACKING UP 50% FOR APRIL

Gaming revenues tracked through April 19th of HK$8.1bn and other tidbits we picked up this week.

 

 

We think Macau gaming revenues were HK$8.1bn through April 19th which puts the full month on the pace of a little over HK$12bn.  On a year over year basis, Macau is looking at around a +50% month off of an easy -7% comp last year.  Total gaming revenue was up 66%, 73%, and 42% in January, February, and March, respectively.

 

April growth looks strong.  Foot traffic has been good.  One caveat is that we heard volumes at LVS were not as strong as win due to higher than normal hold percentages.  We are trying to get a feel for the luck factor at other properties.  Going forward, with a full Golden Week (9 days vs only 3-5 last year because of financial crisis) May should be another strong month.  Also, Wynn Encore opened this week which should boost volumes but potentially hurt same store results.

 

In conjunction with the Wynn Encore opening this week, the company announced the development of Wynn Cotai with an opening timeframe of early 2013.  The sense from people on the ground in Macau is that early 2013 might be a bit aggressive but Wynn may be trying to appease the government. 

 

Here are some initial thoughts on Wynn Encore:

  • Given the day of mourning in China they don’t expect PR to be as aggressive but volumes shouldn’t be impacted that much.
  • Claim that Encore isn’t assuming any dilution in win per table… taking some of Starworld’s VIP business – but it’s hard to know
  • Our guy thinks that win per table will be down though (although hold comps were easy last year). 
  • Margins should get thinner – since VIP will become a larger % of total profits at the property
  • Mass numbers should drop as a result of credit falling away for premium players – and a lot of Wynn’s Mass play is “premium mass.”  Unclear if the new offering will help them – a lot of that will be impacted by credit policy

Other tidings:

  • Grand Lisboa's head of table games and  VP casino manager are leaving and going to Galaxy Cotai.
  • No word on visa restrictions. There are talks of additional tightening on the mainland – but nothing has happened.

Financial Reform Playbook

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.

 

Cheers,

 

Daryl G. Jones

Managing Director

 

 

HEDGEYE
JOSHUA STEINER: UPCOMING CATALYSTS AROUND FINANCIAL REFORM/GS
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


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