Future Financial Winners and Losers

Editor's note: This is the second of Scott Rothbort's two-part look at the future of the financial services sector.

Mortages: The Return of the S&Ls

The era of mortgages gone wild is over. The days of Countrywide (now owned by Bank of America ( BAC)) and Thornburg Mortgage (now traded over-the-counter) are behind us. When the real estate market returns to "normal," gone will be the standalone mortgage companies, which rely on credit default swaps or unsecured borrowing to fund their origination businesses.

When the dust settles from the current financial shakeout, mortgages will probably be sourced in a much more traditional way -- from deposits. This is going to benefit the smaller and localized savings and loan industry, which was destroyed by the S&L crisis of the late 1980s and crushed by the once mighty Wall Street asset-backed security machine.

Local S&Ls will also benefit from an increase in local deposits, as depositors become more leery of the large money center banks, such as Citigroup ( C), JP Morgan Chase ( JPM) and Bank of America.

The five largest S&Ls by market cap are: People's United ( PBCT), Hudson City Bancorp ( HCBK), New York Community Bancorp ( NYB), Capitol Federal ( CFFN) and First Niagara ( FNFG). I would note that all but First Niagara have spurned the government's TARP (Troubled Asset Relief Program).

(Don't miss: " Opinion: A Plan to Resolve the Banking Crisis")

Wondering what will happen with Fannie and Freddie? Fannie Mae ( FNM) and Freddie Mac ( FRE) will most likely have shackles put on their activities, in essence, forcing these GSEs (government-sponsored entities) back to lending according to their original mandates.

Additionally, Fannie and Freddie will fund and execute the Obama administration's foreclosure prevention plan. They will contribute more than $20 billion to the $75 billion loan modification program, which was unveiled last week. The funds will be used mainly to subsidize interest rates so troubled borrowers' monthly payments can be lowered to affordable levels.

Don't forget about the mortgage brokers. They will probably have to deal with increasing regulation that will require large infrastructure and capital to maintain their business operations. Eventually, a new, better organized and more transparent industry will emerge.

This new mortgage brokerage industry could evolve to include publically traded mortgage brokers that operate under spelled-out regulatory requirements. I see this akin to the insurance industry, which has insurance brokers such as Marsh & McLennan ( MMC) and Aon ( AOC) that operate independently from the actual insurers (that underwrite the insurance risk), such as American International Group ( AIG), Axa ( AXA) and Prudential ( PRU).

Finally, I expect "no-document," subprime and adjustable rate mortgage (ARM) loans will either be outlawed, strictly regulated or will wither away, as conventional mortgages become the rule not the exception.

(Don't miss: " Opinion: Paradigm Shift in Mortgages," " Opinion: Obama Subsidizes the Wrong People" and " For Mortgages, Paying Extra Doesn't Always Pay Off")

Rating Agencies: Get Ready for Judgement Day

Rating agencies are one of the biggest culprits in the current crisis. So far, they have not been taken to the woodshed but that is coming. Eventually, congressional hearings will take place and prosecutions will likely result. There are a few problems with rating agencies that need to be addressed.

Conflict of interest. An inherent conflict of interests currently exists, as the rating agencies are paid by the issuer to rate the bonds. This is akin to the Wall Street research scandals that took place several years ago. A possible solution is to create a pool of money through bond security transactions that will be utilized to pay the rating agencies on a deferred basis.

For example, if the fee to rate an issue is $100,000 for a 20-year note, the agency should receive $8,000 per year (accounting for time value of the annuity stream at a reasonable interest rate) over the 20-year period, if the rating has held up. Penalties would be applied if the financial condition of the issuer deteriorates or defaults, as the rating agency should have foreseen that occurring. This would be akin ( but not exactly similar) to the fees paid to the Options Clearing Corp. whenever a transaction is executed on the CBOE ( CME) for an options trade.

No real competition. Currently, the debt ratings business is an oligopoly dominated by Moody's ( MCO), Standard & Poor's (a McGraw-Hill ( MHP) property) and Fitch (majority-owned by Fimalac of France). Although some others do exist, we simply need to have more rating agencies. More competition will yield lower costs to issuers and improved end product. The barriers to entry must be torn down and new players should be motivated or enticed to enter the debt ratings industry.

No oversight. All rating agencies need to be accountable for their actions. The best way to do this is to create or designate a supervisory agency to oversee the agencies and enforce regulations. Another idea is to create a uniform rating system.

Insurance: Back to Basics

Traditionally, insurance companies would insure against straightforward risks, such as death, casualty and liability. However, over the last few years insurers started to write complex insurance in the form of credit default swaps, which are derivative contracts that, essentially, are options-like bets on the default of a debt issuer, but done so in the form of a swap contract.

Furthermore, insurers, which traditionally invested in real estate or mortgages as part of their investment portfolios, took on greater risk by entering the world of subprime debt. All told, we have seen insurance giant AIG take a large federal bailout and now many other insurance companies are in trouble.

What will likely happen to this once conservative business? I see a few emerging solutions and trends.

  • Credit default swaps will become regulated under the CFTC (Commodity Futures Trading Commission), thus removing their safe harbor exemption from regulation. This will come either through regulatory or legislative action.
  • Credit default swaps and other over-the-counter derivative transactions will have to be cleared through a central clearinghouse -- much akin to the OCC for options and DTC for stocks and might have to be transacted on an exchange. Transaction processing banks (like Bank of New York Mellon (BK)) and exchanges (like CME Group) could be beneficiaries of these requirements.
  • At-risk capital requirements will be placed upon the insurers -- much like that of broker-dealers and banks. Off-balance sheet obligations will incur capital charges under this model. This will cause insurers to prioritize risk rather than return.
  • Finally, there will be some companies that face potential solvency issues as annuity liabilities will not be covered by investment income. This is particularly true in the life insurance segment. Insurers could see a round of takeovers, where the stronger insurers with better balance sheets and investment portfolios gobble up the weaker ones.

    The weak members of the herd (based on current analysts' commentary, market actions and news reports), seem to be Hartford (HIG), Prudential and Principal Financial (PFG), while the strong insurers appear to be MetLife (MET) and Allstate (ALL). However, the lack of transparency within the insurance industry is so great that, to be honest, separating the potential winners from losers at this point, is really difficult until we have more oversight of the industry.
  • Your Homework

    There are risks and opportunities in investing in the financial services sector. Identify those risks and opportunities and take advantage of them.

  • Look at some of the smaller local S&Ls which have not accepted TARP money and consider them as a possible long term investment.
  • Consider some of the companies that will benefit from stronger derivative regulation as long term investments.
  • If you have a life insurance contract, your biggest concern is whether that company will be around when it has to pay off your death benefit in the future. Try to align your insurance with the best-run and financially strongest companies. Personally, my two major policies are with Northwestern Mutual Life and Guardian. Both of these insurers have very strong credit ratings according to AM Best, which specializes in insurance company ratings. (Don't miss "Outdated Home Insurance Can Cost You")
  • At the time of publication, Rothbort was long BAC stock and short BAC calls, although positions can change at any time.

    Scott Rothbort has over 20 years of experience in the financial services industry. In 2002, Rothbort founded LakeView Asset Management, LLC, a registered investment advisor based in Millburn, N.J., which offers customized individually managed separate accounts, including proprietary long/short strategies to its high net worth clientele.

    Immediately prior to that, Rothbort worked at Merrill Lynch for 10 years, where he was instrumental in building the global equity derivative business and managed the global equity swap business from its inception. Rothbort previously held international assignments in Tokyo, Hong Kong and London while working for Morgan Stanley and County NatWest Securities.

    Rothbort holds an MBA in finance and international business from the Stern School of Business of New York University and a BS in economics and accounting from the Wharton School of Business of the University of Pennsylvania. He is a Term Professor of Finance and the Chief Market Strategist for the Stillman School of Business of Seton Hall University.

    For more information about Scott Rothbort and LakeView Asset Management, LLC, visit the company's Web site at www.lakeviewasset.com. Scott appreciates your feedback; click here to send him an email.

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