They Brought it Upon Themselves

Good Evening: U.S. investors spent a second consecutive day reacquainting themselves with the term “risk”. Since the past few months have mostly been tranquil, this renewed volatility might require an adjustment period, with most of the adjusting taking the form of lower securities prices. And while yesterday’s big concern was a potential cooling of the Chinese economy, today’s culprit was political heat on our nation’s largest financial institutions. President Obama proposed sweeping new regulations for the banking sector, including caps on deposit size, and bans on activities like proprietary trading and owning alternative asset managers. Financial shares slumped in response to this latest salvo directed at Wall Street, the timing and ferocity of which may not entirely be coincidental to Tuesday’s election results in Massachusetts. Predictably, there was considerable gnashing of teeth in the executive suites up and down Wall Street, but I believe top management brought these latest proposals upon themselves.

Obama Calls for Limiting Size, Risk-Taking of Banks

The gist of the story you see above was leaked last night, but global investors didn’t seem to react much to it. That they’ve seen similar promises in the past from the Obama administration come to naught may have been part of the reason, or perhaps investors just wanted to see the details before taking action. U.S. stocks actually opened only a little lower before it became clear that the President’s latest reforms are much more broad and sweeping than were previous attempts. Until Mr. Obama took to the podium, the indexes were somewhat mixed, with the NASDAQ actually rising due to some positive earnings results in the tech sector. I will save my thoughts about the wisdom of the President’s approach for another day, but market participants expressed their opinions on this day with sell orders.

An uneven set of economic releases (jobless claims and the Philly Fed survey were disappointing; leading indicators were strong) was quickly forgotten as the downside pressure mounted. The major averages dropped between 1.5% and 2% following Mr. Obama’s press conference. Though commodity-related stocks finished the day in worse shape, the vicious early selling in the largest financial names almost made it seem as if all the prop desks had in fact been shut down, that many bank-owned hedge funds and private equity shops were busy tacking “For Sale” signs to their doors, and that Glass-Steagall had once again become the law of the land.

Not quite. Most of the President’s reforms will require legislation, and those that do will require the blessing of retiring Senate Banking Committee Chairman, Christopher Dodd. Mr. Dodd’s promise to give these proposals “serious consideration” sounded like anything but a ringing endorsement. Investors paused to collect their wits after the initial selling was over, and stocks then essentially went sideways for the rest of the session before settling near the lows. The major averages declined between 1.1% (NASDAQ) and 2% (Dow). Treasurys were sought in this environment of risk aversion, and yields fell by 4 to 7 bps. Credit spreads — even swap spreads – widened. The dollar traded both higher and lower within a 1% range before curiously closing unchanged, while many commodities were once again drubbed. Weak oil and metals prices left the CRB index down 0.7% on Thursday.

Wall Street Hubris Soars as Crisis Goes to Waste: William Cohan

President Obama could not have been happy to see articles like the one above circulating in recent weeks. His healthcare initiatives were struggling, his financial reform proposals had gone nowhere, and his poll numbers were slipping. His entire first year agenda of change had little to show for it. And then Tuesday’s election results hit, threatening to altogether scuttle his plans for healthcare. Though it’s been on his mind to do so for a while, I’m guessing he decided some time yesterday to vent his frustration on the easiest target he could find — Wall Street. The wrenching financial changes Wall Street had been thus far successful in avoiding suddenly became an urgent priority for the administration. Inaction no more; this crisis would not go to waste without populist change.

Morgan Stanley Allots 62% of Revenue to Pay Employees in 2009
Goldman Sachs Sets Aside $16.2 Billion to Pay Staff

Executives at our nation’s largest financial firms reacted with shock and dismay this afternoon, but they brought these policy proposals on themselves. They’ve successfully gamed the legislative and regulatory systems so well and for so long that they literally cannot understand why so many people are angry enough to side with the President on this issue. Maybe their memories are a little foggy, so let me try to list just some of the change Wall Street firms themselves were able to effect during the past 15 years. It’s a Top 10 checklist of memorable achievements only a bank executive could love:

(1) Preventing OTC derivatives from being listed on exchanges and keeping them in a “regulation-free zone” during the mid 1990’s so they could become today’s multi-hundred trillion dollar business of intertwining counterparty risks — check.
(2) Tearing down the Glass-Steagall act during the late ’90’s so financial firms could take more risk and enter almost whatever business they pleased — check.
(3) Prevailing upon SEC Chairman Chris Cox during the early 2000’s to let firms lever up by exempting large financial institutions from regulations that had effectively capped their balance sheet leverage at levels just above 10 to 1– check.
(4) Finding (or creating) loopholes that would enable large financial firms to take on even more leverage through off balance sheet vehicles like SIVs — check.
(5) Boosting ROEs during the last decade by acquiring illiquid, higher yielding investments with this newfound leverage — check.
(6) Letting lending standards slip so badly during the middle of the last decade that almost anyone who could fog a mirror could now receive whatever financing they needed to buy a home — check.
(7) Allocating huge amounts of the resulting ersatz profits to themselves as compensation — check.
(8) Negotiating and then accepting relatively cheap, taxpayer-backed funding from the TARP — with few strings attached — when their levered business models threatened to bring down the entire financial system in late 2008 — check.
(9) Negotiating their way back out from under the TARP with relatively little pain during 2009 — check.
(10) Lobbying Congress to thwart the type of financial reforms that might prevent taxpayers from having to bail them out again some day — check.

By helping to bring about the changes listed above, executives in the upper echelons of our largest financial firms have, in the eyes of most of the public, pulled off the perfect caper: Private profits and socialized risks. Until now. Now these firms will reap the political whirlwind of antipathy blowing in the wake of the changes these firms foisted upon our financial system since the mid 1990’s. Yes, there many others — like the Maestro, who gave his official nod to numbers 1-7 above — who deserve blame. But if Wall Street and its army of lobbyists hadn’t been so successful in preventing even sensible reform in recent months, then they might have escaped the type of populist proposals put forth by the President this morning. In so many ways, they brought this mess upon themselves.

— Jack McHugh

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