The Financial Reform Bill

THE GOOD, THE BAD, AND THE....WELL, YOU KNOW


Both Democrats and Republicans who voted for the bill say that it is not about "revenge" against Wall Street, but merely about prudent regulation and control. Are they right?

In this article, we review the details of the bill that changes everything.


The Good

No Compensation for Lies – Requires public companies to set policies to take back executive compensation based on inaccurate financial statements (if you have been cooking the books, you have to give back the money).

SEC Registration - Hedge Funds that manage over $100 million will now be required to register with the SEC and disclose financial data. This should lesson the amount of false disclosures and scams, common for hedge funds.

Skin in the Game – Requires companies that create securitized investment products (ex. buying crappy mortgages and selling them to others) to keep at least 5% of them on the books. If the product is awful, the company selling them will suffer too, even if just a little.

Consumer Protections – Various excellent amendments for consumers. For example, not allowing credit card companies to increase - without warning - interest rates on those who already carry balances.

Consumer Financial Protection Bureau – A board that watches for consumer scams and abusive financial practices, with the ability to autonomously write new rules and regulations.

UpFront Fund – Large institutions will pay into a fund, similar to deposit insurance, that will pay for the liquidation of a company should it fail (taxpayers will no longer pay). Until now, a financial firm could take out the equivalent of life insurance on a fellow firm, and then short-sell it to death. Now, the firm doing the killing will have to pay for it. Creating the fund will damage profits in the short term, but should enhance stability in the long term.

OTC Derivatives Clearing Houses – Former OTC derivatives will now be cleared on an exchange, similar to futures. That means fewer shady, under-the-table, interconnected deals. It also means fewer cases of institutions falling like dominoes.

Vote on Executive Pay – Gives shareholders a non-binding vote on executive pay, beyond the voting rights that shareholders currently have.


The Bad

SEC Review – Requires companies to provide a chart comparing their executive's compensation to stock performance over a 5-year period. This is a little unfair, since a company that is well run can still have mediocre stock performance. Having said that, I couldn't think of anything better myself.

Federal Reserve Oversight – The Federal Reserve will now oversee companies with assets of over $50 billion. Although the idea sounds good in theory, I’m leery of anything that causes the independent Fed to cozy up to large firms any more than they already do.

Tough to Get Too Big – Larger institutions (whose failure would create more of a threat to the overall system) will have stricter requirements for leverage, capital, and liquidity. This provision somewhat penalizes companies for getting large, which is something I don’t like. Many argue that it is a necessary evil.


The Ugly

Financial Stability Oversight Council – “Make Risks Transparent” mandate. The idea is that the council will identify systematic risks to the system before they occur. Yeah, right. If it were that easy, every financial crisis in history would have been avoided. The true crises are the ones you don’t see coming.

Office of Credit Ratings at the SEC – This office (more bureaucracy) is supposed to regulate the credit ratings agencies, and address poor performance. Good luck with that. No two analysts can look at a company and come to the same conclusion. Interestingly, the council actually has the authority to de-register a ratings agency for continued inaccuracy. Maybe in a few years all of today's ratings agencies will be gone.
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In all, I welcome the Financial Reform Bill. It is what consumers were demanding, much of it makes sense, and it could be a lot worse. Will it prevent another financial collapse? Of course not. But it should make a next one a little less disastrous.

For further information, see:
http://banking.senate.gov/public/_files/FinancialReformSummary231510FINAL.pdf

Thank you Sir, May I have Another?

It’s a terrible thing, to see a nice low limit order come tantalizingly close to being filled, only to see the stock market climb back up and away from your bid.

Financial news has been on a negativity-rampage for almost two weeks now (with a 2-day hiatus in the middle), and the markets have taken a good spanking.

Yesterday and today, news agencies pulled out all the stops, including interviews with Nouriel “Dr. Doom” Roubini, analyst Merideth Whitney (who called the market outlook “bleak,”) and even recycling frightening stories about housing from last year. Yet, the market retraced its decline today, with some financial stocks actually gaining.

Despite a stream of almost ridiculously negative headlines and advice (ex. “sell everything”), stock prices remain annoyingly unresponsive. The market is becoming desensitized. Stock news remains gloomy with stock prices to match, but another shock to the system is required.

With any luck, the U.S. financial reform bill will pass, creating enough anxiety for one more downward dive, and allowing the first tier of my low-ball orders to fill. In financial markets, one can only hope for the best of the worst.
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“You realize, you’re not in the analysis business, you are in the entertainment business.”
Fred Kittler of J.P. Morgan to analyst Andy Kessler, Wall Street Meat

Stay Away from U.S. Banks

Good advice, right?

Financial stocks are, once again, the scourge of Wall Street. There is talk of new financial regulation, rumors that the big banks will be broken up and sold, criminal investigations, and concerns about bad debts in Europe - all of which are making headlines daily. Will the horrors never end?

Professional money managers have been busy writing articles with frightening headlines, warning you that financial stocks are dangerous and to avoid them "at all costs." Yet, at the same time as they have been telling you to stay clear, they have been buying a lot for themselves.

Institutional ownership of Bank of America is 56%, Wells Fargo 75%, Morgan Stanley 75%, and Goldman Sachs 72%. For comparison, institutional ownership of Wal-Mart is 36%, Exxon 49%, Proctor and Gamble 58%, and General Electric 50%. If you want to have some real fun, go to the disclosure section of any article that tells you to sell stocks, and check the author’s holdings. You may find that while the author is telling you to sell certain stocks, the disclosure reveals that he owns them all. So yes, he does indeed want you to sell your stocks - so that he can buy them from you.

Here are the major reasons why financial institutions are set to outperform long-term:

The U.S. housing market
In 2008 and 2009, the price of real estate was plummeting, taking the net worth of the average American down with it. But prices have now stabilized, and at extremely low levels. The painful de-leveraging of America is over. The U.S. now has some of the most affordable housing in the industrialized world, and it won’t stay that way forever.

Client Purges
In the previous two years, numerous clients of major banks received letters telling them, for example, that their line of credit would be cancelled if they did not use it within the next 90 days. Clients were outraged, and many cancelled their cards just out of spite - which is was exactly what the banks wanted. This was money that the banks could have been lending out for a profit, but that was instead locked into credit with customers who would never use it. The banks, from their perspective, got rid of a lot of dead weight. They also got rid of a lot of credit risk.

Restructuring
During the height of the financial crisis, the industry was shedding 39,000 jobs every month. Although layoffs can hurt good employees as well as bad, it can safely be said that the best, brightest and most necessary were not the first to go. In addition to the widespread layoffs, many financial institutions streamlined their processes, eliminated business segments not related to their core business, and just generally refocused. The financial industry is leaner and hungrier than it has been in a very long time.

Solid balance sheets
The balance sheets of U.S. financials have been heavily scrutinized by investors, the SEC, the government, hedge funds, and the Federal Reserve. Tier 1 Capital ratios (measures of bank safety) are well above normal. Citigroup, generally considered one of the weakest, has a Tier 1 capital ratio of 11.92% - almost double the level necessary to be called "well-capitalized." In addition, many banks are sitting on extraordinary amounts of cash and have large loan loss reserves.

Financial Reform
The proposed financial reform legislation is often portrayed as a capitalism killer in the conservative media, but it is nothing of the sort. The bill proposes larger capital requirements for those who take more risks, greater transparency in general, and a federal body for winding down companies that nonetheless fail. In other words, large financial institutions will be more subject to scrutiny, require more fallback as their risk levels climbs, and if they fail their operations will be wound down in a manner that is least disruptive to markets and paid for by the industry itself (not taxpayers). Accountability makes for good capitalism.

Valuations
Many financial institutions belong in the single digit forward P/E club. JP Morgan has a forward P/E ratio of 8.2; Goldman Sachs 7.0; Morgan Stanley 7.5, and Citibank 8.9. Citi also has $5.61 of book value per share. Imagine if someone came up to you and said, "I'll sell you this genuine $5 bill for $4 dollars." You would probably assume it was fake, since in the real world this never happens. In the world of Wall Street, however, it happens all the time. At the moment, you can buy $5.61 worth of Citibank assets for $3.81, and get all their clients, brand names, and worldwide businesses for free: Morgan Stanley, Bank of America, MetLife, Travelers, Capital One, and many others are the same.

For small investors to get significant coverage in the financial industry, you need only buy two exchange traded funds - the XLF (large institutions) and the KRE (regional banks). Due to the present worldwide housing bubble, I recommend buying mostly regional banks (KRE) first, until the full brunt of International problems hit their markets (in the short term, psychology trumps value every time). But for value investors, buying time is now.

Statistics (at time of writing):
KRE $27.32
XLF $15.35

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“You can’t make a baby in one month by getting nine women pregnant.”
Warren Buffett, 2009, explaining the importance of investment patience.
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Disclosure and Disclaimer
I own all companies listed here as individual stocks, in ETFs, or both.
Do not buy stocks, or take this or any other financial advice without doing your own analysis; including, but not limited to: reviewing business models, financial statements, management style and philosophy, recent developments, market macroeconomic analysis, and chart analysis. If you do not know how to do these things, you shouldn't be buying stocks in the first place. Seek the advice of professionals, as appropriate.