And how.
We’ve got a range of analyst opinion for you on Friday morning, in reaction to President Barack Obama’s sweeping proposals to reform Wall Street. Opinion is still rather divided however.
To begin with, here’s that note from veteran banking analyst, now at Rochdale Securities, Richard Bove.
[Goldman Sachs] has provided a very loose estimate that businesses deemed to be unacceptable for banks under President Obama’s philosophy may contribute 10% of the Goldman’s Sachs’ profit. This number clearly swings widely depending on how well trading is doing and how well other proprietary investments are doing.
What is very clear, however, is that banks with large deposit bases have distinct advantages in certain sectors of the market. They can produce financial products at lower cost. If the banks are told they cannot use deposits in this fashion in the future, it “levels the playing field” for companies like Goldman Sachs. It should allow the company to gain market share and increase prices. This would increase profits and presumably offset the loss from proprietary investments.
However, there is a good chance that this speech is a political ploy. Having lost in the Massachusetts’ Senate race the 60 person majority in the Senate, the President needed a new bargaining chip. He just created one.
Conclusion
Investors are reacting sharply to the fourth quarter results at this company. However, all indicators – M&A, new financings, increasing volatility in a number of markets, growth in the money supply – all suggest that this quarter maybe a one-time event. The new proposals being put forth by the President are likely to benefit not harm the company. The adjustment of compensation lower leaves more money for shareholders. This is not a time to sell this stock it is a time to buy it.
And some comment from HSBC’s Van Hesser and Monica Parekh:
Taken together, we do not believe these two proposals present a material risk to bondholders. As for proprietary trading, specific units labelled as such are not really all that meaningful, even in the most markets-oriented firms. Goldman Sachs, which most market participants would assume has the most significant proprietary trading operations relative to its overall mix of business, sized its operation at roughly 10% of its net revenues. And we believe it could fold much of that somehow into its broader trading/balance sheet management functions if this law were to pass. The fact is, it is difficult to parse what is customer flow and what is proprietary. The vast majority of trades have a mix of both. But all the firm would need to do, presumably, is demonstrate that there is some sort of customer on the other side, and that becomes permissible.
Hedge funds? Private equity? While these businesses are important customers of the investment banking world, the financial commitment/dependence on firm owned/sponsored funds we believe is relatively modest. Again, Goldman is probably the most significant owner/sponsor of funds, and its private equity business is a key component of its business model. As of 30 September, it had USD145bn in alternative investments (hedge funds, private equity, real estate, currencies, commodities, and asset allocation strategies) under management (not on the books) in its asset management unit. The firm typically takes an interest in its funds, but that figure is not disclosed; if it were 10%, that does not amount to much on a USD900bn balance sheet. These businesses could easily be spun off to shareholders if need be.
We would also add that, while the White House made no mention of a timetable for enacting the proposal, should it pass, Barney Frank, chairman of the House Financial Services Committee, suggested that good policy would not trigger a fire sale of hedge funds or private equity businesses, but would be phased in over three to five years. That would help firms, and investors, adjust to whatever changes are coming down the pike.
. . .
If the average bank earning a 1.2% return on assets before the crisis falls to, say 1.0% as a result of all this, the magnitude of that drop is meaningful to shareholders. But what about to bondholders? Not so much. We doubt that debt ratings would be reduced, nor would investor demand to approve and ultimately invest in such a bank. In fact, stronger and more liquid balance sheets and lower risk all sound like bondholder-friendly moves. Now, pressure on stocks rarely helps credit, and today was a good example, as large bank stocks fell 4-7%, and credit spreads widened 10-20 bp. But we believe once investors get their arms around these issues, and the tone coming out of Washington, any further widening would seem unwarranted.
And FBR Capital Markets’ Paul J Miller, Scott Valentin and Steve Stelmach:
On balance, we view the principles laid out in the Volcker Rule as a negative for larger financial institutions (JPM, BAC) as well as the two largest broker/dealers (MS and GS).
Based on discussions with our sources on the Hill, we believe that the proposed reform to eliminate prop desks and hedge funds from banks will gain strong traction in the Senate, and therefore has a higher probability of passage; however, the other elements of the package (Too Big to Fail [TBTF]/ reinstitute Glass-Steagall) are less certain and may be left to regulators rather than imposed by a Congressional mandate.
Today’s announcement is consistent with our thesis that political headline risk will continue to adversely affect the larger broker-dealers and money center banks (TBTF, TARP Tax, Bonus tax etc).
And from Wells Fargo’s Matthew Burnell:
Loosely scoping the problem for Goldman Sachs, the proposal could affect 10-15% of GS’ annual net revenue. In its Q4 conference call, GS CFO David Viniar estimated that ”pure” non-client related proprietary trading revenue approximates 10% of GS’s typical revenue. In addition, annual reported principal investment revenue has averaged 2% of reported net revenue from 2000-2009 (peak of 11% in 2005 and a low of -17% in 2008). Alternative Investments (as of Q4 2009) comprised 17% of GS Asset Management’s total AUM of $871B.
Defining what is strictly ”proprietary” for many investment banks could prove challenging. In GS’ call, Viniar emphasized the company ”does not even think about” exiting its status as a bank holding company, and we believe regulation is unlikely to allow regulated entities of any type to escape the proposed regulations. Still, it could be an easier move than for universal banks such as BAC and JPM. Viniar emphasized the highly integrated nature of GS’s businesses, focusing on the difficulty of defining proprietary risk in a client-related transaction, a comment we believe would be echoed by other investment banking management teams.
And from Wisco Research’s Sean J Ryan:
WHO IS IMPACTED AND HOW? The stress on separating government-insured (or otherwise supported) activities from proprietary risk-taking suggests that Goldman Sachs and Morgan Stanley may be unaffected, though that may hinge on whether they are required (or even permitted) to shed their BHC status. Instead the impact would largely fall on the large universal banks – JP Morgan Chase, Bank of America, and Citigroup. The key question then becomes whether the proprietary operations can be held together and spun out in some way that preserves value for shareholders, or the talent is simply lost to non-commercial bank competitors.
RUNNING THE NUMBERS. At JP Morgan and Bank of America, principal transaction and equity investment revenues equaled 20% and 19% of total 2009 net revenues, respectively. The potential bottom-line impact is difficult to quantify, however, since proprietary trading revenues contain a large (but unknown and non-uniform) proportion of trading related to customer orders (i.e. the bank putting its capital at risk to accommodate a customer’s trade).
ALL FIRMS OR JUST COMMERCIAL BANKS? Critical questions were left unanswered. Chief among them is whether the constraints will apply to firms beyond commercial banks (the wording seems to suggest not, but this, too, is vague), and if not, under what conditions firms such as Goldman Sachs would be permitted to shed their Bank Holding Company status. Moreover, while the wording of “proprietary trading operations unrelated to serving customers” suggests market-making activities could be exempted, that is far from clear.
From The Buckingham Research Group:
First, we would note that proprietary trading is a very small contributor to overall trading revenues for most firms. For instance, MS only has two small statistical arbitrage prop desks that contribute very little to overall revenue. The one outlier is GS, where management has estimated it generates an average of 10% of revenues normally. But outside of GS, we see a relatively small impact (a few percentage points) on revenues if adopted. For example, assuming 10% of JPM’s trading revenue were proprietary related (likely high), that would imply that roughly just 2% of total revenue is proprietary trading related. We see similar percentage exposure at the likes of BAC (less than 2%) and C (3%) using the same assumptions.
Private equity is a more broad based issue, but still small. Private equity has been a more broadly used asset class for the larger banks/brokers in past up cycles, with again GS being the largest player. But keep in mind, most investors (and analysts) do not forecast large revenues in private equity given the unpredictable nature of this revenue stream, so private equity revenues are not a material part of our estimates for “normalized” earnings power. We would note that private equity contributed less than 3% of revenues at GS in 2009, and they are one of the larger players. We would peg private equity revenues at 1%-2% of total revenue at most of the large banks.
Asset management revenues could also be impacted. Large asset managers among the top 5 banks (namely GS and JPM) do have sizable alternative investment platforms (17% of AUM at GS and 7% of AUM at JPM). Although it is not clear whether asset management arms would be included in the proposed “Volcker Plan”, it presents some modest risk to revenues, particularly at GS. But again, the revenues are small, with an estimated 2% of total revenue at GS from alternative asset management and well below 1% at JPM. Otherwise it seems relatively immaterial for others. (While MS also has some alternative AUM, MS is losing money in asset management, so not a real impact). ≠
Any proposal still needs to make it through Congress. While democrats seem keen to “win” on something and are pushing hard for regulatory reform, there is likely to be strong efforts to water down anything too harsh. But it is an effort that needs to be closely watched.
And to end things, CLSA’s Mike Mayo:
This proposal is an overhang for large wholesale-funded US banks (especially Citigroup, JP Morgan, Bank of America, Goldman Sachs, and Morgan Stanley) given greater uncertainty about business models and the scope of any new rules. As a reminder, Paul Volcker will speak at our conference in San Francisco on March 1-3, where we will also have about a dozen US financial-firm CEOs as well as speakers from companies in other industries and countries (sign up soon to get 1-on-1s).
Goldman Sachs as a guide
On today’s earnings conference call, Goldman indicated that about 10% of its revenues relate to pure walled-off proprietary trading (including private equity), implying that 10% of revenues at Goldman may need to get reconfigured under this strict interpretation of “The Volcker Rule”. A more general issue is the impact that this proposal would have on any market-making business inside a bank because this activity typically involves taking positions as principal. Thus, there are going to be dramatic definitional issues around “proprietary” and potential unintended consequences. There will need to be an evaluation of the impact this may have on trading costs (higher?), liquidity (less?), risk management (tougher?), and other areas. Goldman indicated on the call that removing its bank holding company status is not an option, and is almost certainly not an option for others.
Issues and uncertainty
One issue is the potential role of foreign banks that may or may not still be allowed to participate in some of these activities, and whether some of these businesses will simply be pushed out to Europe and Asia. Another issue is the definition of what is considered proprietary (very difficult). Also, balance sheet risk management may either be harder or need additional requirements to document the use of specific actions to show that they are customer-related. Moreover, the President indicated that financial services consolidation has gone far enough, leaving uncertainty about growth in investment banking at large banks (financial services has been a big driver) and whether large universal banks may or may not need to get downsized (could be a mitigating factor since this could lead to business).
Net-net: the regulatory wild-card consideration remains a major negative consideration for this sector. The main mitigating factor is that the broad scope of the initiative and its complexity could make substantial change difficult, in which case the words for change would be much tougher than the implementation. If so, banks may end up taking proactive measures on their own that would be less harsh than implied by the initial headlines, but we’ll have to monitor closely.
Next up — some comment from the European-focused analysts.
Related links:
Can Goldman really dodge the Volcker rule? – FT Alphaville
Whither Goldman’s prop desk – FT Alphaville
‘Volcker rule’ takes bankers by surprise – FT
Obama and US banks – Lex