The Beginning of the End for Wall Street

06/10/10 - 03:31 PM EDT

WASHINGTON (TheStreet) -- As Congress enters conference negotiations to come up with a final version of a controversial financial reform bill today, folks on Wall Street and Washington alike have indicated that it's unlikely to emerge quite as tough as it once seemed.

Still, it's undeniable that over the next couple of years, the U.S. banking industry will become smaller, safer and more confined than it has been in decades.

"I will tell you that we're now facing a new paradigm in the banking industry," says Harley Lance Kaplan, a financial adviser with Beta Industries. The dramatic turn to harsh regulation, after a long period of de-regulation comes "as a result of the banks' vertical integration into different businesses - lending and brokerage and hedge-fund management, all the things they've been able to do because of the Glass Steagall Act," he adds.

Or, as veteran bank analyst Nancy Bush puts it: "Wall Street is over."

"At least the Wall Street that had existed since 1982," she continues, "the year that the latest and greatest Bull Market of All Time began and the year that I first came into the business."

Their sentiments reflect the reality of the 2010 finreg bill, even if bankers and analysts are still trying to paint silver linings among the clouds. The initial bill crafted by Sen. Chris Dodd (D., Conn.) was thought to be harsh on its own. Broadly speaking, it had strong consumer protection measures, new powers to rein in big banks, new delegation of those powers and derivative regulation for the first time.

But the most worrisome measures for the financial industry have come instead from a handful of the more than 300 amendments that were added to secure votes for the bill's passage.

Sens. Richard Durbin (D., Ill.), Blanche Lincoln (D., Ark.), Susan Collins (R., Maine), Jeff Merkley (D., Ore.) and Carl Levin (D., Mich.) have added four provisions that have particularly frightened the pants off of management at banks large and small.

Durbin's interchange amendment threatens to cap the billions of dollars in fees that payment processors and credit/debit-card issuers receive from merchants that accept plastic. It would cut into the bottom line for Bank of America (BAC), JPMorgan Chase (JPM), Citigroup, Capital One (COF), American Express (AXP) and Discover (DFS). In a sign of just how much the rule could affect the system, Wells Fargo (WFC) - which has relatively little exposure to cards - has joined the industry in lobbying against changes as well.

Lincoln's amendment has been portrayed as a death-knell not just for the profits of Wall Street firms and banks with big swaps desks, but for corporate America's risk-management, for the mortgage industry and for consumer prices as well.

Dodd's bill was portrayed by banks and end-users as onerous on its own. But Lincoln's amendment goes a step further, forcing banks to effectively spin-off their derivatives operations into separate affiliates. That, in turn, would leave the businesses undercapitalized, riskier and more costly than Dodd's initial proposal. It would have the most significant impact on the five big banks that dominate all but a sliver of the U.S. swaps industry: JPMorgan, Goldman, Citigroup, BofA and Morgan Stanley (MS)

The Collins amendment would require stricter enforcement of new capital rules. Though wise on the face of it, one seemingly arcane component has stirred a lot of controversy among banks that are the opposite of "too big to fail." It would prevent the use of trust-preferred securities as a Tier 1 capital component. The change would have a disproportionate impact on smaller banks that rely heavily upon those assets for balance-sheet support.

The Merkley-Levin amendment is essentially the legislative version of the so-called Volcker rule, named after a proposal by Paul Volcker, the former Federal Reserve Chairman and current economic adviser to President Obama. Whichever surname one wants to associate with the idea, it would effectively reinstate a Depression-era rule that would prevent FDIC-insured banks from engaging in Wall Street activity. No prop-trading, no speculative investments, no associations with hedge funds or private equity.

The amendment would require higher capital levels for investment banks allowed to engage in those activities as well. It also seeks to limit "conflicts of interest" between proprietary investments and positions a firm takes for its clients. (For reference on the origin of that idea, see the profane cage match between Goldman Sachs (GS) and Sen. Levin c. April 27.)

The bill may emerge with softer language -- if not softer rhetoric -- than it entered conference with. Oliver Ireland, a partner at Morrison & Foerster who works with financial firms, suspects that may be the case. He also notes that the rules will take time to implement, and ultimately be meted out by regulators' judgment rather than political whims.

"You really don't know what the final rule's going to look like and in a number of areas, a lot depends on what the regulatory agencies or the council do down the road," says Ireland. "...If you're implementing it a year and a half from now, you're going to follow what the words say, but how you shade that and how you carry it out in a healthier [economic] environment will be different."

Still, the direction of the bill still seems very up in the air. For instance, some doubted that Lincoln's measure would remain in its initial form, since it faced opposition from key lawmakers like House Financial Services Committee Chairman Barney Frank (D., Mass.), as well as from Federal Reserve Chairman Ben Bernanke and the Obama administration at large. Lincoln's own future was in doubt, since she faced a tough nomination battle this week, ahead of her re-election battle in the fall.

But after securing the Democratic nomination on Tuesday, it appears less likely that Lincoln will back down. Dodd, who had initially issued tepid support for the measure, changed his stance this week by calling it "a strong provision."

Due to the uncertainty, investors have sought refuge in other areas of the market. For instance, King Lip, chief investment officer at Baker Avenue, was bullish on financials going into 2009, but reversed that position at the start of this year. He has taken cover in the safe havens of gold and cash, at least until first-quarter earnings are released.

"The financial reform bill is a net-negative for banks," he says. "It'll hurt the major banks, certainly, and I don't think the populist sentiment against the banks is going to end any time soon."

A report Thursday by FBR Research's Capitol Hill analysts -- titled "Will Derivatives Language Ever Die?" -- was rife with contradictory clues. They noted that newfound support for the Lincoln amendment "is in stark contrast to the message we heard from almost everyone we met with on the Hill, who believed this provision is coming out."

However, FBR was more certain about a "softening" of the Durbin amendment, a sentiment echoed by Bernstein Research. The analysts believe that, by the end of the conference process, Durbin will give more power to the Fed in determining fee restrictions. Since Fed management and staffers reportedly oppose the measure to begin with, that type of nuance would be a boon to the industry.
The FBR team also believes Collins will amend her proposal to phase in the TruPS component, thereby giving banks time to adjust their balance sheets or raise needed capital. As for Merkley-Levin-Volcker et al, this rule may actually be strengthened as a concession to oust Lincoln's measure.

But regardless of what language becomes stronger or weaker, which amendments come out and which ones stay in, the Restoring American Financial Stability Act of 2010 is sure to have a huge impact on the financial-services industry and its bottom-line - at least for the next several years.

"We're seeing the pendulum of compliance regulations swinging to the extreme side, which regulation usually does," says Beta Industries' Kaplan, with an air of c'est la vie. "This is usually what happens, all throughout history. It's a common scenario and it's happening now."

Ironically, some of the changes being mandated by the government had already been made by banks: They became more risk-averse in the aftermath of the crisis, simply because they lost too much money lending and trading.

On the matter of "too big to fail," it's true that consolidation is occurring, and some of the biggest firms continue to grow. The collective balance sheet of the six biggest U.S. banks has expanded by 7%, or $3 trillion, over the past year. But part of that reflects the transfer of off-balance sheet assets back onto the books and part of it reflects higher valuation in a better market environment.

Furthermore, their expanded balance sheets are a lot less risky and weighted far more in cash, low-yield deposits and Treasurys than the high-risk subprime loans and complex derivative products upon which their profits once relied. And while some firms, like JPMorgan, stubbornly refuse to scale back, others, like Bank of America, are selling noncore assets left and right. Citigroup and American International Group (AIG) are dismantling themselves, too.

Perhaps most importantly, size wasn't the issue that brought down the financial system. The S&L crisis of the 1980s was caused by a raft of failures of the type of small bank that Congress seems to favor. Hundreds of small banks have failed as a result of the current financial crisis as well. There's a good argument to be made that if 10 Lehman Brothers one-tenth the size of Lehman had failed on Sept. 15, 2008, the impact would have been just as dire.
Dick Bove, another veteran bank analyst with Rochdale Securities, also notes that, of the top 50 banks in the world, just four come from the U.S. American firms represent just 8.5% of global banks with over $100 billion in assets, and those 10 U.S. firms are "mostly at the bottom of the pack," according to Bove. If the government caps their size, and the rest of the world doesn't, "U.S. banks will simply fall off this list," he asserts.

"Since the government has displayed little knowledge as to how the financial markets have evolved in the past few decades, it has little idea as to how to change them," says Bove. "...It is believed that by forcing the banks to be over capitalized they will lend more. It is felt that by demanding the banks make more money available to liquid investments it will increase the money available for lending. It is felt that by placing onerous risk weightings on loans that it will decrease the price of those loans.

"None of this makes any sense."

Whether or not that view is correct, Bove believes the reform measures could sap nearly $70 billion from the banking industry's pre-tax earnings.

Nonetheless, the analyst community still has maintained a collective "buy" rating on big bank stocks, according to Thomson-Reuters. Their thesis appears simple: Cheap funding, an economic recovery ahead and breakneck growth in emerging markets around the world.

For instance, despite ongoing strains in the economy and global markets, the industry's pretax earnings in the first quarter were greater than those of the previous two years combined. In an optimist's view, banks may make less money than they would have without finreg in place, but they'll still make a lot of money going forward.

But it's hard to marry that view with the market's pummeling of bank stocks in recent weeks. The SPDR KBW Regional Banking ETF -- which includes stocks outside of the Big Six -- is down 18% since mid-April.

Kaplan, who has been advising private individuals for nearly 30 years, says this is just the way things go. And he's bullish nonetheless.

"I look at the market where it is now, and I see opportunity," he says.

-- Written by Lauren Tara LaCapra in New York.