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Banks Show More Regulatory Fear as Goldman Probe Begins

News of a criminal inquiry into Goldman Sachs comes just as investors are increasingly focused on the idea that financial regulatory reform may have sharper teeth for the industry than previously expected.

NYSE Traders
Oliver Quilla for CNBC.com
NYSE Traders

If the market wasn't pricing in the potential impact of financial regulatory reform, it's beginning to now, in part thanks to Goldman Sachs . Reports late Thursday that the U.S. attorney is looking into Goldman Sachs mortgage business drove Goldman shares sharply lower Friday, and pulled the rest of the major banks and stock market down with it.

Separately, the SEC has charged Goldman and one of its traders with civil fraud for failing to disclose that they created, then sold a complex financial instrument that was designed with the help of a client who was shorting it.

"When you're picking off the very top, when the the very best of the best in the industry is under siege, everyone automatically assumes the rest are worse," said Robert Albertson, chief strategist with Sandler O'Neill.

The Senate voted to debate the bill this past week, and now the Senate will take a first vote on amendments Tuesday. It is expected to then spend weeks getting through more than 100 amendments before actually voting on a final bill. The Senate bill must then be reconciled with a bill already approved by the House, so what will ultimately make it into the legislation is extremely unclear.

The S&P financial sector was down 3.8 percent for the week, and 2.5 percent Friday. While Goldman was down about 10 percent Friday, Citigroup fell 4.1 percent, and JP Morgan fell 3.2 percent.

Morgan Stanley though was up 3.5 percent. Regional banks, however, were higher as they could see some competitive advantage from regulatory reform as the big banks businesses could be crimped. Banks, like Keycorp , PNC and Fifth Third were all higher.

Albertson said there are aspects of the bill that would not help. "It's a canard that they can use to motivate passage of irrelevant things that would be highly damaging. There's no such thing as too big to fail...it's a question of how to fail," he said. He said Lehman's demise could have been avoided if regulators were able to put a safety net and structure under it, "which ultimately would have kept it alive in an economic sense without causing all the panic."

He said if the regulation results in the breaking apart of major banks, the system would then just be at the same risk from more institutions because of their interrelations. "The consumer protection part is truly going to pull credit out of the system," he said.

Rochdale Securities strategist Richard Bove also said the aspects aimed at helping consumers may instead hurt them and the economy. "If JP Morgan is not allowed to hedge interest rates then the cost of money will go up dramatically," he said.

Bove said there's some logic to reducing the size of the big banks. "The government's argument is 'too big to fail' puts the government at risk. My argument is consumer finance is no longer an attractive business for many reasons," he said. "Basically, it's a saturated market with no pricing flexibility left for the producer so therefore cutting off those businesses from big banks would seem to be more beneficial for the banks than keeping them."

Jon Najarian, co-founder of OptionMonster.com, said investors in the options markets are finally factoring in some fear of the potential reform. The amendment to be considered Tuesday involves the proposal to ban banks from participating in aspects of the derivatives business.

In the middle of the day Friday, he pointed to heavy trading in Financial Select Sector SPDR Fund puts. "Our system shows 70 percent of puts trading in the XLF are being bought on the offer, a VERY bearish indicator," he said in a note. Earlier in the day, there was a block of 20,000 June 10 XLF puts at the 15 strike. The XLF finished Friday at $16.159.

"Earlier this week it did seem that the market was not pricing in big changes by way of Financial Reform, but after the WSJ article about potential criminal charges, investors of all persuasions are scrambling for protection," Najarian wrote. "For the short term, until we get a better look at what will be in Fin Reg, I would sell when the sector gets overconfident and buy into days like today when the sector is fearful."

"The fact that the bill has been passed is not in the stock," said Bove, adding it's because the contents are unclear.

"The bills in front of the Congress have such a negative impact on all facets of the financial industry that nobody believes they would really do this. It literally could put us back to a recession of the same magnitude we were in in 2008 because of the cost of money, the cost of commodities...It would be a tremendous tax on the U.S. economy," he said.

Corporate bond strategists have been noting that the bonds of major banks could be downgraded as a result of fin reg, not something widely discussed in the stock market. However, they have mixed opinions on whether those possible actions are priced into the securities.

In a March 22 note, Standard and Poor's said a negative of the legislation would be less extraordinary support from the government. It said it includes varying degrees of "uplift to our ratings on highly systemically important banks" due to its expectations the government would prevent failure and default on the senior obligations. If the bill becomes law, it said it would reconsider that assumption.

Bove said the market is paying attention to its worst fears about Goldman Sachs, and those are that Goldman will go the way of Drexel Burnham Lambert, the firm that was shut down as a result of the sweeping federal insider trading case in the 1980s. Bove, however, does not believe Goldman will be indicted.

"The point was some dragon had to be slain in order to meet the political requirements," said Bove.

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