New Financial Regulations

After months of intense debate and extensive media coverage, Capitol Hill and the White House have finally agreed upon a plan to overhaul financial regulations in the US. The bill still must pass through both chambers of Congress before it becomes law, but this is all but assured as President Obama and Democrats from the House and Senate are on board. Major last-minute concessions, such as allowing banks to trade swaps and derivatives to hedge against their own risk, had to be made to gain support of the bill from moderate and conservative Democrats so that the proposed bill could be finalized in time for Obama to present it to the G-20 meeting in Toronto. The provisions of the 2,000-page bill can be broken down into four categories: expanding the power of the government, tightening regulations for financial companies, protecting consumers from institutional banks and protecting investors from bad deals.

Regulations on financial companies are greatly increased in the financial reform bill. The provision that will likely have the most significant impact on how banks do business is the Volcker Rule, which prevents financial institutions from making risky trades with their own funds. This rule, similar to the Glass–Steagall Act of 1932, protects taxpayers from having to bail out institutions that risk (and lose) funds that are protected by the FDIC. It should be noted, however, that the ban on proprietary trading is not total: banks can still invest up to 3% of their funds in hedge funds and similar vehicles. Swaps will now have to be done through affiliates of banks, with the exception of trades that are tied into the banks’ business and necessary for hedging risk (interest-rate swaps, foreign-exchange swaps, gold and silver). Swaps relating to agriculture, uncleared commodities, most metals and energy will have to be traded by affiliates, since these trades do not directly pertain to banks’ business. Banks will also be required to meet more stringent capital standards, and will no longer be allowed to include trust-preferred securities in their calculations of capital. Also, financial institutions and hedge funds with more than $50 billion and $10 billion in assets, respectively, will be assessed fees over the next five years that will total $19 billion (to offset the cost of the bill). These fees will be collected by the FDIC, with any leftover funds going towards paying down the national debt.

The other goal of the bill is to protect investors and consumers from being taken advantage of by financial institutions and related businesses. Under the Federal Reserve, the new Consumer Financial Protection Bureau will oversee banks and other non-bank financial firms (including mortgage-related businesses and credit unions) and enforce regulations as needed. Mortgage lenders will now have to verify a borrower’s income, credit history and job status before giving them a loan. Banks will have to keep 5% of the credit risk from packaged loans on their own balance sheets, which should incentivize them to issue loans only to worthy borrowers. Also, the bill established a Financial Stability Council, which will monitor large financial firms and advise the Fed of any potential threats to these companies and their business. If necessary, the council, along with the FDIC, would have the authority to wind down failing firms, and the bill addresses this liquidation procedure. The bill also gives states the power to impose additional consumer protection laws against banks if they feel it necessary. For investors, the bill gives the SEC the authority to hold broker-dealers to a fiduciary standard similar to the one that investment advisers, including KCS, are currently held to. Hedge funds and private-equity firms will now have to register with the SEC as investment advisers and provide more information on their trades than currently required.

If signed into law, the financial reform bill would be the most dramatic financial regulatory overhaul in the US since the 1930s. But at this point, given that it is still just a bill and there are a number of details to be dealt with yet, it is hard to say at this point how it would affect our financial system and the way we do business in the long term. And while it seems like a lock that the bill (now being referred to as Dodd-Frank) will pass through the House and Senate, even after the death of Senator Robert Byrd (D-WV) over the weekend, we know how quickly things can change.

Today’s Market Reflects Tomorrow’s News

So far in June, the stock market has continued to be volatile, but has gone nowhere since the end of May. Usually a stagnant period in the middle of a recovery would be disappointing, but in this case is more of a relief after a crummy May that saw a –8.3% drop in the S&P 500. In any case, mediocre market performance over the last month should not come as a surprise, given the amount of apparently bad news we have been receiving over the last few months about the progress of the recovery.

Investors often make the mistake of attributing current market performance to recent news. In reality, the stock market acts as a leading indicator for the economy. (For an explanation of economic indicators, see my last entry about the Volatility Index). News we hear on any given day is nearly always already reflected in current stock prices. (This concept is often called the “efficient market hypothesis.”) Exceptions include unforeseeable occurrences, such as the BP oil rig explosion, and events about which advance information is privy to only a select few individuals, such as the announcement of civil charges against Goldman Sachs. In nearly all other cases, so-called “current” information has already been considered by millions of investors, particularly professionals with huge amounts of capital, whose decisions move stock prices. On average, the stock market reflects information about five months in advance, so that today’s news is already 5 months old as far as the stock market is concerned.

Investment banks pay huge salaries and bonuses to analysts because they depend on them for recommendations that they use when making enormous bets on the market. Analysts are human like the rest of us, which means they can make mistakes and lack clairvoyance. But the combination of intelligence, experience, training and the resources at their disposal allows them, as a whole, to develop hypotheses about the future with a significant collectivedegree of success. This success comes from the sum of the incredible amount of manpower and money that professional investment firms devote to research.

Analysts are usually assigned to a specific sector or industry; some operate in the even narrower scope of analyzing a single security, or a select few. Many firms have multiple analysts working in each sector, which illustrates the amazing amount of resources dedicated to analyzing each area of the market (especially when you consider the inhuman hours that many analysts work). So it should come as no surprise that the European debt situation was being considered and accounted for months ago by large institutions—weeks or months before it was mentioned by the media. The same goes for financial reform, the anticipated slowdown in corporate earnings growth, and other economic issues that have recently induced fear (and selling) by day traders and non-professional investors.

Given their level of compensation and resources at their disposal, you can understand why analysts and their firms are expected to remain ahead of the curve and be right more often than not. However, this informational “edge” is not, by itself, enough to ensure outsized success for Wall Street, and it also does not mean that non-institutional investors can’t compete. Rather, it tends to create a marketplace that rewards contrarian investors who don’t blindly follow the crowd. The best investors do not act on information as it becomes public, because they know this information is already priced into the market. They take the information a step further and figure out what sort of opportunities it might create in the future.