Market Wrap-up: the markets have had a couple of their worst days in recent memory after China announced monetary tightening and Obama targeted banks

2010-01-21

The big news today was Obama’s desperate populist attempt to put something substantive on the table that he can discuss at the State of the Union address to Congress on Jan 27.  He will be talking about what he has done so far.  The agenda would have revolved around his healthcare bill, but after losing the Massachusetts seat it is practically dead, so he had to scramble and find something that people can unite behind.  According to Washington Post polls, the public really hates Wall St. and blames it almost exclusively for the economic debacle.  The hatred is to a large extent misplaced, but it is easier for people that are suffering without jobs, facing foreclosure, etc. to offer them a scapegoat.  This scapegoat is, ironically, a group that contains the strongest banks in the US – albeit the characterization “strongest” is clearly a relative term. 

As we mused in our Opinion piece over the past weekend, there was risk that Obama would have to attack the banks sooner or later in some form or another in order to prove to the public that he has the upper hand, so we expected a near-term correction.  On the other hand, we also noted that the government is smart and understands the importance of supporting our very fragile economy, so despite putting on a tough front, the reality will prove much more benign.  Indeed, even though there are very few details on the new Obama proposal, which is also referred to as “the Volcker Plan” because it is reminiscent of a plan that Paul Volcker originally proposed a year ago and was rejected by the White House, it looks likely to end up having a minimal impact on banks.  Barney Frank spoke briefly after Obama and, even though he supports the plan, he explained that there would be a phase-out implementation period of 3-5 years. 

The plan right now calls for eliminating proprietary trading at banks, except for those positions that facilitate their clients’ trades.  This means that companies like JP Morgan – JPM, Bank of America – BAC, and Goldman Sachs – GS will not have their own sponsored hedge fund and private equity operations a few years from now.  However, these operations usually account for less than 10% of earnings, and the capital that will be freed up will be deployed elsewhere.  Perhaps not as profitably, but instead of 20% returns, redeployed capital should at least generate 10% returns.  So, the impact of the proposed plan – if and when it passes – will be to reduce banks’ earnings power from ~15% return on equity by 10% x 10% (at most, or in the worst case) to 14%.  It seems that Obama showed a strong hand by targeting one of the smallest bank operations and perhaps the only one that will have no meaningful impact on the economic recovery.  Regardless of the fact that proprietary trading was not the source of the financial and economic troubles we have been dealing with, perhaps this is a decent enough compromise between satisfying the public without cratering the economy, which is in line with the thinking that we mentioned last weekend.

Therefore, the market may have over-reacted.  What exacerbated the situation was that many hedge funds were caught in a precarious position: the popular trade has been to buy the stronger and larger banks, and to hedge that exposure by shorting smaller regional banks with commercial exposures.  As hedge funds started selling some of the big banks in reaction to the negative headlines, they also had to cover their short hedges, which resulted in a short squeeze in stocks like Fifth Third – FITB (up 10% at some point during the day, since it also reported strong results today), SunTrust – STI, KeyCorp – KEY, and Associated Bancorp – ASBC.  Still, since Obama will have to substantiate the plan and his actions until the State of the Union address, it will be a bumpy ride until that date at least.  An interesting place to look for opportunities might be some of the financial companies that do not have exposure to the proposed bill.

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