Goldman Fears Lincoln’s Derivatives Language
Morning Money has posted a Goldman Sachs research report, and it seems the investment bank is spooked by just one thing in the financial regulatory reform bill: Sen. Blanche Lincoln’s (D-Ark.) derivatives spin-off language.
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.