To the extent that strains in European sovereign debt and short-term money markets cause broader risk deleveraging, U.S. financials are not immune from falling asset prices. At the same time, while regulatory risk is (hopefully) reaching a peak, it does create the specter of an overhang for some time. In particular, our Washington analyst does not expect the Lincoln proposal to make it into the final bill, but should this occur, it would be very negative for investment banks and potentially exchanges, as volumes would suffer.

“Volumes would suffer” means nothing more or less than that derivatives speculation would become more expensive and thus less lucrative and thus less of a priority for investment banks — something that advocates of tighter regulation argue should be a feature, not a bug, of Sen. Chris Dodd (D-Conn.) and Rep. Barney Frank’s (D-Mass.) merged and final bill.

But, Brian Beutler reports at Talking Points Memo, Sen. Judd Gregg (R-N.H.), expected to be on the conference committee, says there is no way the Lincoln derivatives language is making it through.

“I mean there’s no partisan fight here, it’s just: let’s get the language right. And the language which is in the Senate bill is wrong. It’s just plain wrong. It’s going to cause significant contraction in the credit markets, and it’s going to make the derivative markets less stable less sound and push a lot of business and competition — business which we want in America — overseas.”

What does Goldman think the likely profits scenario for financial firms is? Not as good as the bubble years, but better than the average over the past 70 years — basically, rosy.

Our normalized EPS estimates adjusted for potential regulatory impact implies that large banks can still generate a return on tangible common equity of 21% which is equivalent to a ROE of 13%. This compares to an average ROE for the banking industry of 15% during the 15 years preceding the crisis (1992-2006) and 11% during the 70 years preceding the crisis (1937-2006). While our implied ROE is higher than the average of the past 70 years it is lower than the past 15 years which we think is attainable. We believe that the benefits of increased scale and efficiency stemming from industry consolidation will partly offset the costs of added regulation, implying that the industry can generate a return higher than the average of the past 70 years but not as high as the past 15 years.

The report also argues that fundamentals are improving: The real estate market has bottomed out, consumer delinquency has peaked and unemployment is starting to look better as well.

Sens. John McCain (R-Ariz), Richard Shelby (R-Ala.) and Judd Gregg’s (R-N.H.) amendment to end Fannie and Freddie’s governmental conservatorships within three years and to sell them off or wind them down — a proposal described as problematic by housing experts from both sides of the aisle — failed in a 43 to 56 vote.

But a proposal by Sen. Chris Dodd (D-Conn.), the architect of the financial regulatory reform bill, to ask the Treasury Department to study Fannie and Freddie and determine the best way to end the conservatorship will be added to the bill. It passed 63 to 36.

“This program needs to be fixed, no question about it,” Dodd said during floor debate before the votes. “You need an alternative housing finance system. But [the McCain] amendment doesn’t offer any. It just says get rid of the one you’ve got.”

“The election rules that were recently announced by this regime leave no opportunity for legitimate political dialogue because they prevent key stakeholders from participating, making the upcoming elections a charade,” Sen. Judd Gregg (R-N.H.), who sponsored the resolution, said in a statement Friday. “The U.S. expects the military regime to dramatically expand political participation and create an environment free from fear and intimidation before we will consider elections in Burma as anything but a farce.”

Trouble is, Burma’s leaders haven’t cared what the United States thinks of them for decades, and they have no reason to start now. Despite being cut off from most of the West, Than Shwe and his minions have done just fine for themselves by forging lucrative gem, oil and timber deals with China, Thailand and other Southeast Asian neighbors, who’ve shown zero inclination to jeopardize those trade relations over something as petty as human rights.

Meanwhile, Suu Kyi’s pro-democracy party announced this week that it has chosen to disband rather than participate in an election that would require the party to accept the nullification of the 1990 vote that should have swept it into power.

But their financial regulatory reform counterproposal offered little by way of a meaningful plan. The Republican proposal created an inspector general for the two enterprises, limited further taxpayer payments to them and then requested that the president submit to Congress a plan to figure out where to go from there.

Now, Sen. John McCain (R-Ariz.), Sen. Judd Gregg (R-N.H.), and Sen. Richard Shelby (R-Ala.) have created a more detailed proposal, Damian Paletta reports at The Wall Street Journal. He summarizes their idea for an amendment to the Dodd bill thus:

1. The conservatorships for both companies would end two years after the bill becomes law, though the government would be able to extend it for another six months if necessary.
2. Three years after the conservatorship ends, their government charter would expire. Then the companies would have 10 years to operate under a special holding company so that they can dissolve remaining mortgages or debt obligations they held as government-sponsored enterprises.
3. After the companies leave conservatorship, their mortgage assets would have to steadily decline, capital standards would have to go up, and the size of loans they would be able to purchase would shrink.
4. The companies would have to pay state and local taxes.
5. Fannie Mae and Freddie Mac would have to pay a fee “to recoup full value” of the government guarantee they enjoy.
6. It would reestablish the $200 billion funding limit the government set up for both companies in 2008. On Christmas Eve 2009, the Obama administration lifted that cap to an unspecified level.

In short: It dissolves Fannie and Freddie over a fifteen year time frame. (It is unclear whether or how the bill deals with other government-sponsored enterprises, like the Federal Home Loan Banks.) It limits taxpayer exposure to Fannie and Freddie’s losses in the near term. It would substantively change the way mortgage finance works in the United States — before the crisis, even, Fannie and Freddie backed 40 or 50 percent of mortgages, and this transfers that business to the private market. And it marks a sea change from three decades of Washington policy pushing and subsidizing homeownership.

I’ll have some responses to this proposal rounded up for tomorrow. But for now, I’ll note that regardless of how good the basic idea is, there is no way the amendment will make it into the Dodd bill — for reasons I have spelled out here. Moreover, putting aside the potential merits of the proposal, if it helps to define the conservative expectations for Fannie and Freddie reform and to jump-start the political and intellectual debate on the housing finance crisis in this country, I am all for it.

Ending “too big to fail” also requires building stronger shock absorbers throughout the system so it can better withstand the next financial storm. To do that, the Senate bill closes loopholes and opportunities for arbitrage, and it brings key markets, such as those for derivatives, out of the shadows. Transparency will lower costs for users of derivatives, such as industrial or agriculture companies, allowing them to more effectively manage their risk. It will enable regulators to more effectively monitor risks of all significant derivatives players and financial institutions, and prevent fraud, manipulation and abuse. And by bringing standardized derivatives into central clearing houses and trading facilities, the Senate bill would reduce the risk that the derivatives market will again threaten the entire financial system.

Sen. Judd Gregg (R-N.H.) had a detailed opinion piece in Bloomberg on the same topic:

Congress’s aim for OTC regulation is to reduce systemic risk to the financial system by, at the very least, providing an efficient regulatory structure that reduces the frequency and severity of market liquidity problems.

By and large, the swaps market is a wholesale, institutional market where most trades are large, block-sized transactions. Mandatory exchange trading would reduce market liquidity and increase execution costs for the ultimate end-user of these swaps. Advocates for mandated exchange trading want to decrease bid-ask spreads, which would theoretically lower the cost of these products, but they fail to understand the market sensitivities.

Mandating real-time dissemination of swap transaction price and quote data will require market participants to announce their trading interests to the entire market and allow others to step in front of their trades, moving the market against their hedges. In such an environment, market liquidity for swap transactions will decrease dramatically, if not disappear altogether.

To unpack: Geithner and Gregg sound like they might be at (incomprehensible) loggerheads, but they are not actually saying very different things. Geithner wants to exchange-trade derivatives, making pricing and volume information open to the market. Gregg argues that if pricing and volume information are public, the market will react to that information, making certain trades more expensive or even impossible. Both agree that exchange-trading derivatives will reduce fees for Wall Street banks and provide transparency into the true cost of swaps and other financial instruments.

There is a backdrop to the two wonky op-eds: Derivatives are the newest battleground between Democrats and Republicans, reformers and Wall Street. The Obama administration is currently pressuring the Senate Agricultural Committee (which is writing the derivatives part of the legislation) to ensure that the rules aren’t so loose as to exempt many financial firms and non-banks from using the exchanges.

Don’t hold your breath. Proving that their calls for bipartisanship are bunk, GOP leaders are already lashing out at the possibility that the commission would recommend that someone, somewhere pay higher taxes. “Americans know our problem is not that we tax too little, but that Washington spends too much,” Senate Minority Leader Mitch McConnell (R-Ky.) said yesterday in a statement. (That’s the same Mitch McConnell who once called a deficit commission “the best way to address the [budget] crisis,” then voted against the proposal anyway.)

That’s also the message coming from the headliners at CPAC this week. Florida GOP Senate candidate Marco Rubio yesterday told the conservative faithful assembled in Washington that his plan for balancing the budget features an across-the-board tax cut, including an abolition of taxes on capital gains, dividends and interest.

“While we’re at it, let’s eliminate the one on death, too,” he said.

The implication from McConnell, Rubio and a host of others is that they can slash federal revenues and balance the budget by simply taking a hatchet to government programs. They must have forgotten what happened when the White House recently proposed to cut some spending in GOP Sen. Richard Shelby’s Alabama. Or the Republican outcry that accompanied the Democrats’ proposal to cut some payments to the private insurance plans operating under Medicare. Or the inconvenient fact that conservative states have historically received a good deal more federal funding than their residents have paid in federal taxes.

Into this picture, enter Alan Simpson, former GOP senator from Wyoming. Simpson — who, along with University of North Carolina President Erskine Bowles, will head Obama’s deficit commission — told PBS NewsHour’s Judy Woodruff yesterday that those who think deficits can be controlled solely with spending cuts are, well, dazed and confused. From the transcript:

Woodruff: Some people, mainly Republicans right now, are arguing, what’s really needed are tax cuts, that, even if it raises the deficit in the short term, that this would get government out of the way of business, business could grow, and the deficit will take care of itself.

Simpson:  Well, I’m not smoking that same pipe. …

Everything is on the table.  But, if we’re just going to use flash words like cutting children’s benefits or cutting veterans or raising taxes, it will be a tougher struggle.

Everything is out there.  We [know] how people use emotion, fear, guilt, and racism.  I have been through that old stuff with immigration. … I don’t use those.  I use facts.  And we’re going to do a lot of facts.

Whether facts mean anything in an election year is another question altogether.

No matter. Today, during a Senate Budget Committee hearing, Sen. Lamar Alexander (R-Tenn.) implied that the failure of the deficit task force bill was somehow Obama’s. Grilling Peter Orszag, the White House budget director, Alexander wondered what “problems” prevented the bill’s success the first time through.

You might want to consider a suggestion about bringing [the Conrad-Gregg proposal] up again, amending it, and finding out what the problems are. It had 16 Republican votes. If the president with 59 or 60 votes can’t pass something that’s important to him, it’s going to be a long four years.  So that’s a good start and maybe there are some adjustments that could be made in the statutory commission.

Or maybe there are some adjustments that could be made in the Republican strategy of blocking everything the White House supports, just for the opportunity to call the president ineffective.

That little inconvenience hasn’t dissuaded the Obama administration from proposing a $30 billion small-business loan program using repaid TARP cash. But it does set the White House up for a good deal of criticism from budget hawks. On cue, Sen. Judd Gregg (N.H.), senior Republican on the Budget Committee, issued a statement today reminding Democrats that “TARP is not a piggybank.”

Under the TARP law, repaid TARP funds must be used to reduce the debt — and given that we will have a $1.6 trillion deficit this year and the Senate just voted to increase the debt limit to more than $14 trillion, the requirements of the TARP law should not be changed…

TARP dollars should not be used as a slush fund for the President’s other priorities. The TARP program should end immediately, and, as the TARP law requires, all repaid funds should be used to reduce our staggering debt burden, not used in a way that will add to it.

Gregg would know. He authored the TARP provision requiring any returned funds to go toward debt reduction.

But that was before (1) the Democrats decided to actually consider the bill, and (2) President Obama endorsed it. After those things happened, McConnell voted against the “best way” to rein in federal spending. Here’s Hiatt’s analysis:

It’s impossible to avoid the conclusion that the only thing that changed since May is the political usefulness of the proposal to McConnell’s partisan goals. He was happy to claim fiscal responsibility while beating up Obama for fiscal recklessness. But when Obama endorsed the idea, as he did on the Saturday before the vote — and when the commission actually, against all odds, had the wisp of a chance of winning the needed 60 Senate votes — McConnell bailed.

Worth noting: The vote on the Conrad-Gregg bill was not subject to the usual pressures of Washington. That is, it wasn’t really being lobbied by any industry, and it wasn’t inspiring the voter reaction of, say, health care reform. So why would Republicans kill a bill they’d endorsed? McConnell’s office sent Hiatt an elusive statement implying that the senator fears that the deficit panel would suggest tax hikes as part of its balanced-budget solution — which has only been a central element of the Conrad-Gregg proposal since its inception years ago.

“Our problems are not a result of taxing too little, but of spending too much,” McConnell said.

McConnell and the Republicans have, for the last year, said that their opposition to the Democrats’ agenda is rooted in the simple notion that they think their legislative preferences to be superior. McConnell’s flip-flop on the Conrad-Gregg bill communicates another reality altogether. It says that GOP leaders would rather see the nation fail than the Democrats win.

A spokesman for Sen. Sam Brownback (R-Kan.), for example, told Politico that the senator withdrew his support “over concerns that the commission will be able to raise taxes.” The offices of Sens. Mike Crapo (R-Idaho), John McCain (R-Ariz.) and Kay Bailey Hutchison (R-Texas) said exactly the same thing.

What’s fascinating about that argument is this: Sens. Judd Gregg (R-N.H.) and Kent Conrad (RD-N.D), the heads of the Budget Committee, have been pushing their task force idea for years, and a central element of the proposal has always been that everything would be on the table — tax hikes, benefit cuts and everything in between. Here’s their statement from 2007, which indicates that the commission “will analyze all potential solutions.” And here’s a summary of their more recent bill, which clearly states that “all options will be considered by the Task Force.” It’s a concept that practically defines the bill.

So either (1) the six Republican flip-floppers are lying and voted against the commission solely under pressure from GOP leaders to deny the Obama White House a legislative victory, or (2) they threw their support behind a proposal they knew nothing about. Neither explanation says great things about their leadership skills — and both are indications of why Americans think Washington is broken.