The spectacle of Goldman Sachs executives being grilled before a Senate committee Tuesday, and the potential bite of regulatory reform could keep pressure on financial stocks.
The S&P financial sector fell 1.7 percent Monday. Goldman contributed a 3.4 percent decline, and Citigroup was down 5.1 percent, as the government was set to sell its 27 percent stake in the bank.
The Dow was up less than a point Monday, at 11,205 and the S&P 500 was down 5 at 1212.
Market winners were consumer discretionary, up 0.6 percent and industrials, up 0.2 percent.
Caterpillar results helped the market, after it reported better-than-expected earnings and said orders are significantly higher than last year.
Financials were the worst performing sector, followed by health care, which was down 1.1 percent.
The Senate late Monday failed to approve a cloture motion on the financial regulatory reform bill, as expected.
Dan Clifton, head of policy research at Strategas, said the bill will likely come back up before the end of the week. Sen. Harry Reid has indicated he will move to reconsider the bill in the next few days, and Sen. Christopher Dodd, D-Conn. and Sen. Richard Shelby, R-Ala. were expected to continue negotations.
Financial stocks may not yet reflect the potential impact of regulatory reform, according to Clifton.
"There's a great degree of complacency...When you start seeing the derivatives portion move from a long shot to a real idea, it's an indication that the debate is going in an aggressive route to the banking sector," he said.
Clifton was referring to an aspect of the proposed legislation that would prohibit banks from participating in the swaps business.
"There's a serious issue here. We're thinking maybe foreign banks aren't going to be subject to this, and then all of a sudden you have no U.S. banks doing swaps and then you have foreign banks doing it and hedge funds taking it up," he said. "We've been working on this for the past 18 months, and this one issue is happening fast, and I don't t think we've evaluated it enough."
The Wall Street Journal reported that the Fed objected to the plan to remove the swaps business from banks.
Clifton said regulatory reform for banks may have a similar affect on financial stocks as health care reform had on the health care sector, which is now down 3.5 percent in the past month.
Health care stocks had risen ahead of the adoption of legislation.
""Even when this bill passes, you're going to have three or four weeks before people see what's in this bill," he said. "It's very interesting to watch now that all of a sudden (health care) companies are saying this is material to them.
We're going to expect something similar with the banks." He said, for instance, banks could see their debt downgraded if the "too big to fail"/resolution authority provision becomes law, as it removes the idea of implicit government support.
Joel Levington, managing director in corporate credit research at Brookfield Investment Management, said, in a note, that spreads on bank debt widened by about 10 bps Monday on regulatory concerns.
"Headline risk around regulatory reform has been a drag on bank debt versus industrials over the past few days," he wrote.
Levington said a downgrade by rating agencies may not have much impact on the bank bonds.
"I think that at a given rating, the financials trade pretty wide of their industrial peers, so a notch downgrade, unless placing the bond in to a new category (for example, an A- moving to BBB+) should not have much of an effect on the value of the bond," he wrote.
The Senate's Permanent Subcommittee on Investigations begins its hearing on Goldman at 10 a.m. The Senate hearing is the result of a separate investigation from the SEC investigation that led to fraud charges against the firm.
Those testifying include Goldman Sachs CEO Lloyd Blankfein, CFO David Viniar, former mortgage head Dan Sparks and Fabrice Tourre, the Goldman trader accused of fraud.
Blankfein, in written testimony prepared for the hearing, said Goldman did not have a massive short position against the housing market, nor did it bet against its clients.
The SEC fraud case takes issue with Goldman in its role as underwriter of a complex financial product. The SEC claims the CDO was structured with the help of one hedge fund client that had wanted to short the product, and that Goldman did not reveal that in its offering documents.
Goldman, once the envy of Wall Street, is now becoming a punching bag for Wall Street excess.
Rochdale Securities analyst Richard Bove said he thinks Blankfein will have to resign.
"I think it's very bad in the sense the issue in my opinion is not the specific transaction. The issue is why did they pick on Goldman?" he said.
Bove said Goldman is by no means the biggest player in the CDO market.
"Why are they picking on the company that ranks sixth or seventh in the sector, and that is because the company hasn't protected its franchise properly," he said on "Squawk on the Street."
"It would appear to me you've got to bring in some kind of outside legal experts who write a new mission statement for the company," he said, adding he does not think Goldman is guilty of fraud. "There is an ethical issue that has to be brought and that ethical issue has to be dealt with by the company."
Bove said he is still a buyer of the stock. "There's no other company on the planet that offers the services that Goldman Sachs does," he said.
What Else to Watch
The S&P Case Shiller home price index is released at 9 a.m., while April consumer confidence is released at 10 a.m.
The Fed starts the first day of its two day meeting.
At 9:30 a.m., President Obama delivers remarks at the opening hearing of the 18-member commision established to tackle the budget deficit. Fed Chairman Ben Bernanke also testifies before that group.
The Treasury auctions $44 billion in 2-year notes Tuesday.
"The 2-year I think is probably going to be a little bit on the soft side," said David Ader, strategist with CRT Capital. "I think I'd rather buy the 2-year note after I hear the Fed is on hold and hasn't taken out the "extended period" language."
The Fed releases its statement Wednesday at 2:15 p.m. and is widely expected to leave in place the language that states it will leave rates extremely low for an "extended period."
There is a large number of corporate earnings Tuesday, including Ford, Dupont, 3M, UPS, McGraw-Hill, UAL, Under Armour, Valero, US Steel, Boston Scientific, Ashland Oil and Office Depot.
Aflac, Norfolk Southern, Broadcom, DreamWorks, and Boston Properties report after the bell.
The Milken Institute Global Conference is under way in Los Angeles, and once more has attracted CEOs, economists and leading scientists
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