The Long and Short of Financials

 | Aug 09, 2012 | 4:04 PM EDT
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Muni-bear market strategist Meredith Whitney made another splash on CNBC yesterday by repeating her prediction that shareholders, not lawmakers, will force the largest U.S. banks to become "a lot smaller." Her comments followed the hysteria over former Citigroup (C) CEO Sandy Weill's earlier statement that banks should probably be broken up.

Meanwhile, investors have seemed not to care, as shares of major banks have barely trailed the broader market's 4.5% rally that began, ironically, on the very day (July 25) that Weill opened Pandora's box.

After visiting Washington, D.C., this week, fellow truth seekers and I found a reason to keep an eye out for the Weill/Whitney theme, even as the DJIA signaled that abandonment of Citi, Bank of America (BAC) or JPMorgan Chase (JPM) might be premature. More broadly, we took away good news and bad news for the banks, as well as for exchanges, futures commission merchants and providers of creditor-placed homeowners insurance.


Large banks have lost further ground among conservatives on Capitol Hill. Despite deference to CEO Jamie Dimon during his hearing appearances in late spring, lingering misgivings about JPMorgan's "London Whale" trading losses and braced anticipation of U.S. banks' complicity in Libor manipulation have begun to soften even conservative Republicans' traditional laissez faire attitude toward the banks.

The latest evidence comes in the form of a joint letter by conservative Louisiana Sen. David Vitter (R-La.) and liberal Sen. Sherrod Brown (D-Ohio), lobbying the Fed to impose much higher capital buffers for systemically important financial institutions. Per Vitter and Brown, the Fed should increase its proposed surcharge on the "megabanks" until it is "high enough that it will either incent them to become smaller or will help to ensure they can weather the next crisis without another taxpayer bailout."

While the Fed is not likely to move in that direction, it is noteworthy that Vitter, one of the most conservative Republicans in the Senate, is teaming with Brown. The move raised eyebrows among senior GOP staff, who confirmed that such disaffection is spreading among defenders on the right who have heretofore seemed indiscriminate in their blanket calls for repeal of the Dodd-Frank Act.

And this seems to confirm that not only is the GOP unlikely to carry water for big banks should the Party retake Senate control next January but it might even give in to populism, putting the industry further on the defensive.

We broached the subject, noting that the breakup-or-further-leg-weights option (and incentives to employ it) really lies more with Mitt Romney at this stage than Barack Obama. After all, the President will probably have to stick with the bailout-and-reregulate hand he played when confronted with the financial crisis upon taking office; Romney is not so constrained, and might even benefit by belying stereotypes that he's a Wall Street toady.

This could beget strange noises in weeks and months ahead. And depending on how badly and broadly the Libor scandal evolves -- or new ones (such as money laundering) emerge to extend the trend -- it could also create at least two new post-election fears. Absent counter push from conservatives, regulators might follow through with Dodd-Frank regulatory implementation without the softening final touches that investors have presumed as recently as the spring. This could impact everything from the big four's future market making to capital levels. Meanwhile, the industry might even face the threat of further size-penalizing amendments in the context of Dodd-Frank Act corrective legislation that could be considered next year.

Add even a whiff of such sentiment from Romney in the last 90 days of the campaign, and investors will feel compelled to factor in further potentially negative change.

A small consolation prize, however, may be that, in the wake of the MF Global and Peregrine disasters, we're told to expect major consolidation among futures commission merchants, which could cede larger market share to über futures commission merchants such as Goldman Sachs (GS), Morgan Stanley (MS) and, yes, the large banks. Meanwhile, with investors climbing the wall of worry over European debt and the year-end fiscal cliff, they may be prepared to trample those who might fall back due to concerns over further erosion of large bank franchises.


Meanwhile, derivatives specialists in Washington have told us that a host of policy and market factors are favoring the futures market over the nascent cleared swaps market. Futures commission merchants are suffering in the current low-interest-rate environment, and the U.S. Commodity Futures Trading Commission's new Rule 1.25 restrictions on investments will further reduce their net interest margin. Moreover, the expected regulation to protect customer collateral will increase costs at a minimum, and potentially even remove customer funds as a source of income. The new initial and variation margin rules, as well as cross-margining provisions, could also further the consolidation trend. Greater futures volume would benefit CME Group (CME) and IntercontinentalExchange (ICE) to the detriment of the new swap execution facilities.

Force-Placed Insurance

Finally, despite some doubts about their willingness to move forward, it now appears that the Federal Housing Finance Agency will follow through in coming months with its bulletin restricting lender-placed insurance costs and a request for proposal soliciting private vendors for cut-rate force-placed insurance for loans guaranteed by Fannie Mae (FNM) and Freddie Mac (FRE). This could add to already welling-up state pressures against costs and margins associated with policies being underwritten by industry leaders Assurant (AIZ) and Australian insurer QBE Insurance Group.

These pressures will be front and center during a National Association of Insurance Commissioners hearing today in Atlanta, during which the impact on homeowners, insurer relationships with servicers, disclosures, premiums charged, loss ratios and other delicate issues will be discussed.

Meanwhile, shares of Arrurant, which fell 27% between February 21 and mid-June, have recovered almost 10% amid the broader rally that began in late July.

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