Will Blanche Lincoln Kill Bank Stocks?

NEW YORK ( TheStreet) -- Bank investors are freaking out, and with good reason: The companies they own have gotten hammered recently and may see up to 36% in additional downside in the weeks ahead, according to one estimate.

The bad news? Financial reform may slash revenue by at least 25%, profits by as much as 75% and force the industry to raise $200 billion in fresh capital. The good news? Things may not turn out quite as bad as those dire, doomsday predictions. The recovery will offset some of the downside, the capital burden may not be placed on shareholders, and bank stocks have already taken a big hit.

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The scary news? The outcome depends on the whims of lawmakers.

The Bill

The financial reform bill was approved by the Senate late Thursday after months of back-room negotiations and weeks of public debate. Sen. Chris Dodd (D., Conn.) first unveiled it in mid-March, but it went through several iterations since then. In the past few days alone, lawmakers added a significant amendment regarding derivatives, doubted its prospects, touted its prospects, tried to water it down, ridiculed the guy with the hose, then went back to square one.

After all that, Senate Majority Leader Harry Reid (D., Nev.) couldn't even get his colleagues to vote "yes" on holding a vote until Thursday afternoon, when 60 senators voted to move the bill forward after the cloture vote failed by a margin of 57-42 on Wednesday. The Senate bill will now be reconciled with the House version, which was approved in December.

Meanwhile, the financial industry and its major corporate clients have been sweating bricks. In their view, the derivatives measure is perhaps the single most important item in the reform package. The direct and indirect costs to the industry and the economy could be huge, depending on whether that amendment, sponsored by Sen. Blanche Lincoln (D., Ark.) is adopted, and how it is interpreted. They are so significant, in fact, that even the estimates outlined so far are ballpark guesses at best.
Blanche Lincoln
Sen. Blanche Lincoln, Democrat from Arkansas.

A line item in a report on Thursday by Rochdale Securities analyst Richard Bove outlining all the costs related to financial reform may have captured it best: "For no definable reason, I am setting aside another $20 billion in possible losses due to the unknown."

Most of the reform bill's 1,500 pages relate to costs that have been well-known for quite some time. For instance, Bove estimates deleveraging will cost the industry $2.3 billion, liquidity measures will cost $5.6 billion and an interchange fee will cost $3 billion.

Last year, financial firms individually outlined costs of rules implemented outside of the Dodd bill, such as Regulation E, the CARD Act and higher regulatory fees. Bove estimates those three items will chop roughly $10 billion off industry revenue.

In other words: All that stuff's been priced in. The real uncertainty lies in the impact of derivatives reform.

The Dodd bill initially proposed putting derivatives trading onto an open exchange, with mandated clearing, capital and margin requirements. Lincoln went a step further to propose that banks be forced to place derivatives operations into an affiliate that is separate from the bank holding company. That would mean the business couldn't rely on funds from a bank's existing balance sheet, nor would it have support from the Federal Deposit Insurance Corp. nor would it be eligible for taxpayer-financed bailouts.

Overall, the derivatives business would be undercapitalized, riskier and therefore more costly. A worst-case scenario would make the U.S. derivatives industry unviable. Here's why:

Potential Outcomes

Money-center banks like JPMorgan Chase ( JPM) and Bank of America ( BAC) would have to decide whether there's enough demand for the costlier products. If so, they'd have to find a source of capital -- probably from customers. If not, they'd have to wind down the business entirely. If the process becomes simply too cumbersome, they may opt to spin off derivatives operations into separate entities.

"Banks" like Goldman Sachs ( GS) and Morgan Stanley ( MS) that still operate like investment banks but became federally chartered banks to be eligible for taxpayer support may have to give up their charters to continue existing. Those firms, their major foreign counterparts and any spun-off entities from the money-center banks might also move operations to friendlier markets offshore.

"This could significantly restrict credit availability, increase the cost of borrowing for businesses and consumers, place U.S. banks at risk of losing significant share in global financial markets as Europe, Asia and Canada gain share, and drive the Fed to be reliant on non-US banks as financial intermediaries of the US dollar," writes Morgan Stanley analyst Betsy Graseck, outlining the worst-case scenario.

What It Means For Bank Stocks

Graseck pegged middle-of-the-road estimates for the Lincoln amendment's impact on 2012 earnings for Bank of America ( BAC), JPMorgan Chase ( JPM) and Citigroup ( C) at 3.5%, 4.5% and 6.2%, respectively. That's $12 billion less in revenue, $2.7 billion less in earnings collectively, or 11 cents less per share for Bank of America, 3 cents less per share for Citi and 27 cents less per share for JPMorgan Chase. (Lower spreads related to other reform measures were already "baked into" her estimates.)

Kian Abouhossein, an analyst with JPMorgan-Cazenove, says return on equity for global investment banks would drop to 12% from 19% if the Lincoln amendment -- also known as "section 716" -- were adopted in its current form. He estimates that the eight investment banks he covers may require $85 billion in capital. (A trade association has pegged the overall industry estimate at $200 billion.) UBS ( UBS) is the only one with excess capital, according to Abouhossein, while others would need anywhere from $500 million to $26 billion, with Deutsche Bank ( DB) being most at-risk for requiring fresh financing.

But Abouhossein doesn't quite know what it means for the stocks he covers. Goldman, Morgan Stanley, UBS, Deutsche Bank, Credit Suisse ( CS), Societe Generale ( SG), BNP Paribas ( BNP) and Barclays ( BCS) may now be trading at anywhere from a 7% discount to a 36% premium, depending on whether their derivatives businesses are left largely in tact, or completely dismantled.

"Until we have clarity about section 716, we are unable to make a very strong case for Global IBs in terms of investments," says Abouhossein.

Indeed, investors had been pushing bank stocks higher from the lows of March 2009 until recently, when regulatory crackdowns came to the fore. Most of those crackdowns pertain to derivatives, and the selloff pertains to doubt about where it will all end up.

The Securities and Exchange Commission kicked off the wave of bank-stock selling on April 16, by alleging that Goldman Sachs had engaged in derivatives fraud. Since then, Goldman has shed 26% of its market value. The top five U.S. swaps dealers, including Goldman, Morgan Stanley, JPMorgan, BofA and Citi, have lost an average of 22%.

Uncertainty is the forest in which bears can roam. Yet analysts and some political observers are still skewing to the bullish side. The recent selloff has largely been characterized as a buying opportunity, not a reason for more panic-driven selling -- albeit with caveats.

Graseck notes that the Federal Reserve doesn't seem keen on the instability that would ensue from such a strict crackdown on derivatives. Nor would the government be thrilled with handing over the U.S.' leading position in financial services to competitors across the Atlantic. Nor would it necessarily trust non-U.S. banks -- those that it doesn't regulate, and are able to trade derivatives -- to handle currency transactions.
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For his part, Bove says that even if the Lincoln amendment does pass, it can't possibly stop banks from earning more money. In a report titled "Buy Bank Stocks," he does some back-of-the-envelope calculations to make the case.

Loan losses peaked at $248 billion last year and are poised to drop from 92% of pre-tax, pre-provision earnings to a more normalized 12.5% in the next couple of years. He pegs the overall costs of financial reform at roughly $68.5 billion per year. Even without that revenue, Bove estimates that PTPP earnings are set to climb to $200 billion -- eight times the current level.

"The mathematics are clear," says Bove. "...While the impact of the new legislation will be quite severe, it will not stop a meaningful recovery in bank earnings."

Even Abouhossein, whose report included some startling estimates, still thinks "prices are attractive." If the reform bill leads to the worst-case scenario, though, the benefits won't go to any publicly traded firms: "Hedge funds will be the ultimate winners," says Abouhossein.

-- Written by Lauren Tara LaCapra in New York.

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