What Government Regulation Could Do to Your Portfolio

What Government Regulation Could Do to Your Portfolio

Did you see the rally in bank stocks earlier this week? Don’t be fooled. It won’t last long. I’ll only think differently if we get some great follow through – and I’m just not seeing it. Bank stocks have been falling for the last year. We’ve said it time and time again, stay away from the banking stocks. First it was sub-prime loans. Then it was the credit crisis. Then Bear Stearns collapsed. Rumors about Lehman are now followed by concerns over Fannie Mae and Freddie Mac.

Don’t touch these stocks. You’ll notice that I used a long term view. Just because the market has rallied over the last few days doesn’t mean we should jump right back into the quicksand. You’d think we’d be through the banking mess by now. But we’re not. I’ve got new concerns that many haven’t thought about. These new concerns are being caused by the Government in a lame attempt to help. It happens all the time. Markets always move to an extreme. Then when they blow up everyone looks to the government to save their hide. This time is no different. Unfortunately government assistance comes with strings attached. Just look at the SEC. They weren’t even a glimmer in anyone’s eye until after the stock market crash of 1929.

That opened the door for subsequent securities regulations and rules. Today is no different. Just last week Fed Chairman Ben Bernanke indicated that the emergency lending provision they put in place for Broker Dealers might be extended. They hope – and that’s all it is, hope. The hope is that the financial markets would view this as a supportive move. Unfortunately this is the first step towards permanent government involvement. All it’s going to do is add additional restrictions and regulations. So how might this impact the market? If broker dealers become more regulated by the government, the first thing to change will be capital ratios. Right now as the big broker dealers operate, their oversight is voluntary between the SEC and the company. It’s likely the first move government would make would be to increase minimum capital requirements. They dictate these ratios in the traditional banks, why not the broker dealers. By implementing mandatory liquidity levels all you’re going to see is their business model seriously challenged. What do I mean?

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Follow me here for a moment. A broker dealer has a certain amount of money – it’s their capital. This capital allows the company to place trades on behalf of their clients, make loans, provide margin, and basically run the business. It also allows them to enter into profitable financing transactions with their corporate clients. In reality their capital is rarely at risk (on certain transactions) but it serves as an important backstop. Capital requirements limit the amount of leverage broker dealers can use. I know it’s confusing. Here is what you need to know. If capital requirements are increased broker dealer profits will fall. If profits fall, company values fall. Why pay twice as much for half the earnings? And that means your stock will head lower. Realistically, if a broker dealer has their capital requirements increased they have only two options. First, they can raise more money. Not a good thought in today’s market environment. What investor wants to see a company they own dilute ownership?

The only other option is to reduce their leverage. If they reduce leverage they can’t process the very transactions they make money from. This means lower profits. What companies will be impacted most by this government oversight? The list is long, but here are the top names: Goldman Sachs (GS), Merrill Lynch (MER), Morgan Stanley (MS), and Lehman Brothers (LEH). Before taking a position in any of the financial stocks everyone needs to know this new challenge. Here’s the interesting government oversight is only starting to be discussed. Who knows what other restrictions the government will place on the broker dealers. I’d wait for these new developments to ripple through the industry before taking any position in these stocks.

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