Financial Reform's Endgame Now

With the financial reform bill now in conference, analyst notes and trader talk have heated up considerably over the weekend. We are now in endgame, and there is considerable speculation on the outcome of the key points.

1) Volcker Rule. Prohibits banks from proprietary trading and private equity trading. Betting seems to be that the Senate version, which merely mandates a Fed study to create guidelines on what activity will be banned, will likely prevail. That may be little comfort: there seems to be a strong movement toward pushing the banks out of prop trading altogether, as well as not allowing banks to invest in or house hedge funds.

This could have considerable impact on banks. Goldman Sachs, for example, has said it generates up to 10 percent of net revenues from prop trading and private equity. But margins are very high, so the impact to earnings will likely be greater.

2) Derivatives. Likely to be cleared and possibly traded on exchanges, though there are large numbers of "non-standard" derivatives that would have a hard time trading on exchanges. This is likely to narrow spreads and impact profits, particularly at GS and Morgan Stanley. What about the proposal from Sen. Blanche Lincoln (D-Ark.), which bans banks from engaging in derivatives? Unlikely to pass.

3) Too big to fail. The $150 billion bailout fund that was in the House version is eliminated in the Senate version, the Senate version seems likely to prevail. This may pose some risk to bank credit ratings, since there would be less chance of an overt bailout; S&P has explicitly stated this.

4) Skin in the game: requires underwriters to hold 5 percent of the face value of a new offering. This is a concern, as it would require banks to keep large holdings and may reduce activity in the securitization business.

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