Advisor Roundtable: The Passage of Financial Reform Legislation

It’s time once again for the Advisor Roundtable! This past Wednesday (July 21^st), President Obama signed into law the financial reform legislation.  As I wrote in It’s Time to Regulate the Investment Banking Psychopaths, my hope was that financial reform would pass and — lucky me — it has. But enough about me (for now). Let’s give the final word to KCI’s investment advisors, who are the real experts. Specifically, I asked KCI’s circle of financial phenoms the following:

What do you think of the recently passed financial reform legislation? How, if at all, does it affect the stocks that you cover?

As expected, given the different industry and country perspectives the experts focus on in their investment advisory services, their answers were all over the place, ranging from libertarian disdain to foreign indifference to cautious optimism to activist disappointment. Read on to find out the details:

Elliott Gue — Personal Finance, Energy Strategist, MLP Profits, Stocks on the Run

The financial reform legislation is a populist measure. The public is clearly angry at Wall Street and blames bankers for the financial crisis of 2008 – it has been obvious for more than a year that some form of regulation would pass and some of the reform proposals discussed were downright scary. The good news: on some of the headline issues such as the regulation of derivatives and investments in private equity firms, the compromise legislation is not as negative for the financials as had been feared. That’s a short-term positive.

However, the legislation is quite lengthy and extremely complex. Much like the healthcare reform package passed earlier this year, there are likely to be a long list of unintended and unanticipated consequences. We have already heard some of these fears from financial firms that have reported earnings over the past few weeks, and lingering uncertainty is negative for stocks. History suggests that hastily-passed populist measures represent poor legislation and I suspect that’s likely to be the case here.

More broadly, the financials represent a sizeable chunk of S&P earnings. While the legislation isn’t as negative as it could have been, it’s likely to slow the growth potential of the industry and depress profits. That’s a modest longer-term negative for the stock market.

Yiannis Mostrous — Silk Road Investor, ETF Global Profits, Stocks on the Run

I have not thoroughly read the 2,300-page law, but it should not really affect companies operating in the emerging markets that I cover in Silk Road Investor. My current regulatory focus lays not in Washington, D.C. but further east in Switzerland with the Basel Committee’s ongoing meetings on international financial regulatory reform. The Basel Committee, which is composed of representatives from more than 20 countries, is currently discussing whether to raise international bank capital standards.

David Dittman – Canadian Edge

Right now, U.S. financial reform has little impact on Canada and the income investing themes we’ve articulated in Canadian Edge. We’ll wait and see what happens during and after what promises to be a long implementation process.

Back-of-the-envelope estimates suggest that U.S. regulators will have to furnish more than 200 rules in the next two years. This alone is challenging. But the vagueness of the legislation also complicates the work of regulators directed to complete 67 one-off studies and establish 22 periodic reports. Here’s just a sampling of what must be done: creating a council to detect systemic risks; crafting capital and liquidity standards; building a consumer financial protection bureau; enforcing a ban on proprietary trading; and setting standards for derivatives.

Of these provisions, perhaps the most important is the creation of the Financial Stability Oversight Council. Its mission will be to identify and head off emerging threats. Left open are the criteria to define a systemic threat and to identify institutions that pose a risk to the broader economy. The statute directs the council to consider assets, leverage, size, liabilities and interconnectedness, but it will be up to the council to figure out how to quantify such factors.

Several Canadian institutions, most notably Toronto-Dominion Bank (NYSE: TD) and Royal Bank of Canada (NYSE: RY), operate in the United States. But the impact on them of U.S. financial reform, come what may from rule- and report-making process, will be minimal.

The Canadian banking system is dominated by five institutions that cover all corners of the Great White North. They engage in all types of financial activity. Canadian banks, all of them, are overseen by one regulator at the federal level, the Office of the Supervisor of Financial Institutions (OSFI), and zero at the provincial level. It’s a simple regulatory scheme. And, as Bharat Masrani, CEO of TD Bank, Toronto-Dominion’s U.S. arm, recently noted, it was sufficient to guarantee one simple, significant outcome for Canadian banks: “We were not in the subprime business.”

American banks are overseen by the Federal Reserve and what appears to be a confusing array of federal and state regulators, all with their own budgets and turfs to protect. With what lies ahead for the evolving saga of U.S. financial reform, this problem will get worse before it gets better.

In the meantime, stick to Canada and the best income investing story on the planet.

Benjamin Shepherd – Global ETF Profits, Louis Rukeyser’s Mutual Funds

I’ve been recommending the SPDR KBW Regional Banking ETF (NYSE: KRE) in Global ETF Profits for several months now, largely in anticipation of financial reform legislation being formalized. Tracking a basket of 50 regional banks with an average market capitalization of about $1.1 billion, small-cap banks make up the bulk of the portfolio.

The large money-center banks will clearly see their top lines take a hit due to new limitations on investing for their own accounts and higher capital standards. But many — if not most — investors have been wrongly pricing a major hit into the share prices of many of the smaller regional players.

The majority of the banks in the fund’s portfolio have asset bases of less than $15 billion, leaving them immune to many of the reform legislation’s more stringent provisions on what can and cannot be counted towards Tier 1 capital — a key metric for regulators. Only a handful of the fund’s holdings were heavily involved in derivatives trading or ran proprietary trading desks of any size, so there shouldn’t be many sizable hits to cash flows.

In fact, once the dust settles, I strongly suspect that we’ll find that the new law has actually leveled the playing field for many regional and community banks. The new law caps the ability of the nation’s largest banks to continue expanding through a new limitation on the share of industry-wide liabilities that can be held by a single financial institution. That cap will curb the encroachment by money-center outfits such as Bank of America (NYSE: BAC) onto the turf of smaller players who are years — if not decades — away from bumping up against those limits, leaving them plenty of room for expansion. It will also allow many of the regional banks to conduct business on their terms without have to compete with the huge banks which in the past could always offer the lowest rates on loan products.

Jim Fink – InvestingDaily.com

Call me a member of the public that Elliott refers to in his answer. The 2008-09 financial crisis shook my confidence in laissez-faire capitalism symbolized by Adam Smith’s “invisible hand.” I’m also very angry at Wall Street and the rating agencies. Whereas I once believed that the private sector could self-regulate, I am now convinced that government must protect us from the reckless self-interest of corporations. Whereas Gordon Gekko in the movie Wall Street famously stated “Greed is good,” I say “Greed is dangerous.” It leads companies to take excessive risks that can blow up not only in their faces, but in the country’s (and our) face. I quoted Alan Greenspan in my psychopath article, but the quotation is so telling that I must offer it again below:

Those of us who have looked to the self-interest of lending institutions to protect shareholders’ equity are in a state of shocked disbelief.  I made a mistake in presuming that . . . they were best capable of protecting their own shareholders and their equity in the firms.

Greenspan is no liberal and neither is federal appeals judge Richard Posner, who wrote an analysis of the crisis entitled A Failure of Capitalism. Posner argues that the financial crisis was the direct result of financial deregulation. He concludes: “We need a more active and intelligent government to keep our model of a capitalist economy from running off the rails.”

The question remains whether the just-passed financial reform legislation will be effective in heading off another crisis.  I have serious doubts for the following reasons:

• Banks will remain “too big to fail.” I see nothing in the legislation that curtails the existing huge sizes of Bank of America, Citigroup, JP Morgan, and Wells Fargo.

• Regulation of non-bank financial firms is not guaranteed.  While the new Financial Stability Oversight Council has the authority to impose regulations on non-bank financial companies, it remains up in the air whether the FSOC will do anything. This uncertainty is disturbing since AIG and Lehman Brothers were prime contributors to the financial collapse and both were non-bank financials.

• Volcker Rule that aimed to prevent banks from making risky investments for their own proprietary account was watered down with a huge 3% of capital loophole.

• 80 to 90 percent of derivatives trades (interest rate, foreign exchange, and precious metals swaps) are exempted from the requirement that banks trade them in a separate entity. No hard capital requirements imposed on financial companies that write credit default swaps.

• Rating agencies (Standard & Poor’s, Moody’s, and Fitch) continue to be compensated and selected by issuers. The provision in the bill that would have had rating agencies randomly assigned was deleted prior to passage. The pervasive conflict of interest that caused the rating agencies to rate subprime junk debt as triple-A remains alive and well.

Come to think of it, the only real financial reform in the legislation involves limiting credit card fees, which had nothing to do with the financial crisis.

KCI Investing has an incredible collection of top-notch investment minds covering all aspects of the stock, bond, international, and ETF marketplaces. Whether you are interested in growth, energy, utility income, Canadian income trusts, emerging markets, ETFs, master limited partnerships, or short-term trading opportunities, KCI has an investment expert and service ready to help guide you towards wealth accumulation and financial independence.