For several weeks, a rotation has been underway in the U.S. market, with money moving away from some...
Why Banks Aren't Afraid of Reform
06/25/2010 8:57 am EST
Yes, banks led us to the edge of global financial collapse, and yes, lawmakers are determined to rein them in with new rules. So why do bankers seem so cocky?
So is it just standard-issue Wall Street arrogance, or does JPMorgan Chase (NYSE: JPM) know something?
The bank, which has emerged from the financial crisis as one of the strongest big banks in the United States, is pressing ahead with negotiations to buy a big Brazilian hedge fund and private equity group. JPMorgan Chase is in talks with Gávea Investimentos, which manages about $5.3 billion in assets.
Meanwhile, Congress is pressing ahead with a financial reform bill that includes the so-called Volcker rule, which would limit banks' own trading and limit their relationships with hedge funds and private equity vehicles.
JPMorgan Chase already controls Highbridge Capital Management, a $21 billion hedge fund, and private equity group One Equity Partners.
Does JPMorgan just have a lot of faith that the banking industry's army of lobbyists will once again prevail and remove anything truly dangerous to the status quo from the bill? (The bill is now in front of a joint House-Senate committee working to reconcile separate legislation from the two houses.)
Or does JPMorgan know that the fix is in and that no matter what our elected officials vote to do, when the rules are finally written by the folks who theoretically regulate the financial sector, the result will be change that banks can believe in.
I'd pick the latter.
Two Chances to Mute Reform
The financial industry knows it gets two shots at this. The first, in the halls of Congress, isn’t likely to prevent passage of something with a few teeth—enough so that representatives and senators can tell voters in November that they fought for them against big, bad Wall Street. (But not so many teeth, of course, that members of Congress will jeopardize their ability to fund their campaigns with Wall Street money or find work in the financial industry once they are out of office.)
The second shot, out of public view, will take place in the halls and offices of theregulatory bodies that write the rules that implement the often-vague laws that Congress passes. JPMorgan Chase and other big banks are betting that when the rules are written, they will permit the activities that banks deem crucial.
The track record suggests the big banks are almost certainly right. If that's true, it means there are some bargains out there among bank stocks that have been sold off because investors think financial regulation might have real teeth.
Let me start by explaining why financial regulation with teeth is unlikely. And then I will end this column by identifying three US bank stocks to put on your watch list for purchase during the summer doldrums to come. (To keep track of my watch list called, cleverly enough, Jim's Watch List, go here.)
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Minimal Exceptions That Add Up
The Volcker rule, first proposed in January by former Federal Reserve chairman Paul Volcker, an adviser to President Barack Obama, is a great example of why the damage to financial industry profits is likely to be less than many investors now fear.
The proposal would restrict proprietary trading by banks for their own accounts, unrelated to customers' needs. It would bar them from sponsoring hedge funds or private equity funds. The stakes would seem to be huge. More than a quarter of all private equity investments between 1983 and 2009 involved bank-affiliated private equity groups, a recent study from Harvard Business School and global business school Insead found.
Banking lobbyists are fighting hard for an exemption. Big banks such as State Street (NYSE: STT), Goldman Sachs (NYSE: GS), Morgan Stanley (NYSE: MS), and, yes, JPMorgan Chase want the rule changed to allow "de minimus" investments by banks in private equity deals.
No big deal, right? Allowing minimal investments by banks wouldn't add significant risk to the financial system, and it would allow banks to invest in deals alongside clients. And that would convince bank customers that such deals were safe because the bank had its own money at risk. The interests of customers and banks would be aligned, the banks argue.
It's hard to imagine that even the banks buy that argument. If the investment is truly minimal—so minimal that it wouldn't increase a bank's risk—then how could it possibly convince the participants in a deal that the bank had significant skin in the game?
But every exemption a banking lobbyist can get into the bill in stage one, the legislative process, the more room to maneuver banking lobbyists will have in stage two, the regulatory process.
Just to take this example, if legislators followed their usual practice, they'd leave it up to the regulators who write the rules to define de minimus. The definitions of de minimus in a legal context include "inconsequential, insignificant, meager, moderate, modest, negligible, of minor importance, of no account, paltry, petty, obscure, scanty, slight, trifling, trivial, and unworthy of serious consideration," according to Burton's Legal Thesaurus.
Lots of room for interpretation there. Exactly how would you set a limit for bank investments in private equity deals given that guidance? Should the investment be "modest" or "negligible," "moderate" or "trifling?" And what exactly, in dollars, is a "modest" or "trifling" investment for a Goldman Sachs or a JPMorgan Chase?
The influence of lobbyists on senators and representatives gets all the attention—of the relatively meager amount of attention that we pay to how the legislative sausage is stuffed, anyway. And lobbyists at this level are immensely influential, both in dollar terms and in terms of personal connections.
The US Chamber of Commerce, to take just one example, spent $148 million on lobbying Congress in 2009 and the first quarter of 2010, according to the Center for Public Integrity, a nonprofit that produces investigative journalism. It's hard to get a precise estimate of how much is spent on lobbying on a specific issue, but the center calculates that the top ten lobbying companies in Washington collected $30 million in fees for lobbying on financial reform and other related issues. (The center's estimate is based on a study of lobbying companies' financial disclosure forms that contained key words or bill numbers related to financial reform legislation.)
The volume of personal connections between lobbyists and Congress is perhaps even more overwhelming. According to the Center for Responsive Politics, a nonpartisan research organization, and consumer advocacy group Public Citizen, 56 financial industry lobbyists once worked on the personal staffs of the 43 senators and representatives sitting on the financial reform conference committee. A total of 1,447 lobbyists for the financial industry once worked for the federal government; 73 are former members of Congress.
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The Rule-Writer’s Rule
But lobbying Congress is only part of the game. Congress writes the laws, but it leaves it up to regulators to write the rules. In a mid-June review of the text of the financial reform legislation, the Chamber of Commerce counted 399 rulemakings and 47 studies required by lawmakers.
Each one of these, like the proposed de minimus exemption of the Volcker rule, would be settled by regulators operating by and large out of the public eye and with minimal public input. But the financial industry lobbyists who once worked at the Federal Reserve, the Treasury, the Securities and Exchange Commission (SEC), the Commodities Futures Trading Commission (CFTC), or the Federal Deposit Insurance Corp. (FDIC) know how to put in a word with those writing the rules. Need help understanding a complex issue? A regulator has the name of a former colleague now working as a lobbyist in an e-mail address book. Want to share an industry point of view with a rulemaker? Odds are a lobbyist knows whom to call to get a few minutes of face time.
The regulatory battles range from issues like the precise way to calculate de minimus to membership on the list of banks that need extra regulation because they represent a systemic risk to the financial system. (Define that risk. Go ahead. I dare you. Best of luck to the Federal Reserve.)
It's no wonder one of the most contentious battles has been over amendments offered by Senators Jeff Merkley, D-Ore., and Carl Levin, D-Mich., to restrict the discretion that regulators would have in implementing the Volcker rule.
Estimates of the cost of the financial reform legislation are designed to terrify legislators and voters. We're in danger of destroying one of the few globally competitive US industries, the anguished cry goes. (Of course, that globally competitive industry played a key role in creating a financial crisis that took the world close to another Great Depression, but never mind.)
Some banking industry analysts have estimated that financial reform as now written could reduce profits at big banks by 12% to 35%. Earnings at Goldman Sachs would fall 23%, at Morgan Stanley 20%, at JPMorgan Chase 18%, and at Bank of America (NYSE: BAC) 16%, according to a June 16 investment report from Citigroup (NYSE: C).
Sorry, but I think those estimates completely overestimate the power of words in a congressional bill to produce actual change to corporate bottom lines. The words will have been lobbied over until they give maximum discretion to the actual rulemakers, who will then be lobbied some more, out of public sight, to bend the rules in the industry's favor as far as possible without breaking with the original congressional intent. Whenever it happens to be clear.
Three Bank Stocks to Watch
The current legislation gives rulemakers up to 18 months to finish their work. But rules in Washington are seldom completed on time. Count on 2012 to be well-advanced before the bulk of rules actually hit the industry.
By then, the banks that I'm adding to Jim's Watch List today, Goldman Sachs and Morgan Stanley—along with JPMorgan Chase, which I added to the watch list on June 8—will have massaged the rules so that they can live with them without major changes to their business models. And maybe their lobbyists will have even found a way to turn some of those rules into weapons to use against competitors.
It wouldn't be the first time that reform worked out that way.
At the time of publication, Jim Jubak did not own or control shares in any company mentioned in this column.
Jim Jubak has been writing "Jubak's Journal" and tracking the performance of his market-beating Jubak's Picks portfolio since 1997 on MSN Money. He is the author of a new book, The Jubak Picks, and he writes the Jubak Picks blog. He is also the senior markets editor at MoneyShow.com.
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