Financial Services Reform Primer March 12, 2010

“Primum Non Nocere!” - Roman Senate Rules

Partners, We believe the discussions, proposals, counter-proposals, compromising, blame-gaming and erstwhile whining about potential financial reform are near the apex and worth discussing presently. And we see a very positive outcome for financial services stocks. The rules and procedures of the Roman Senate were the most complex of their time and while ancient (more than two millennia old now) they remain the basis upon which modern democracies are founded. Despite the inherent complexities of their republic, vast empire and sometimes even violent politics, the Roman Senate held one basic tenet when reforming law – “Primum Non Nocere!” or “First, Do No Harm!” Our own Constitutional framers often wrote of this “primus” as well.

"The only legitimate powers of government tend to such acts which are not injurious to others. It does me no injury (if) it neither picks my pocket nor breaks my leg." - Thomas Jefferson

Financial reform in the United States doesn’t garner the same level of attention as health care reform (HCR) despite the financial services industry being more than twice the size of the health care industry as a percentage of our gross domestic product or “GDP”. Both industries are enormous and touch all aspects of our lives and our commerce. Our House of Representatives already has passed a financial reform bill so convoluted a colossus (several thousand pages…some of which contradict themselves) that it has no chance of making its way through our Senate without substantial changes. The current debate within the Senate Banking Committee pits liberal Chairman Christopher Dodd (D-CT) against conservative Ranking Member Richard Shelby (R-AL) and the centrist negotiator Bob Corker (R-TN). Here’s where we believe reform is heading and why we believe it will be positive for financial stocks.

“Too Big To Fail” The ONLY major regulatory reform that we believe is necessary immediately is to formalize a resolution process for unwinding companies that pose systematic risk to the markets and the broader economy. We suspect that most would agree; our current laws are far too vague and antiquated. Our fractional-reserve banking system is the most complex and successful in world history. However, the two primary laws governing it are outdated and thus handicap the Federal Reserve, its protector. The Federal Reserve Act of 1913 or “FRA”, which established our uniquely independent central banking system, provides for “emergency lending powers” to the Fed under “unusual and exigent circumstances” or “FRA 13-3”. Most of us call this ‘power’ the “lender of last resort” and its operations the “Discount Window”. This is the foundation for the current resolution authority of the Federal Reserve. It needs to be updated with expansion and formalization to suit our complex financial environment which is now far more non traditional banking than when the law was first established and later amended.

Section 13. Powers of Federal Reserve Banks

3. Discounts for Individuals, Partnerships, and Corporations

In unusual and exigent circumstances, the Board of Governors of the Federal Reserve System, by the affirmative vote of not less than five members, may authorize any Federal reserve bank, during such periods as the said board may determine, at rates established in accordance with the provisions of section 14, subdivision (d), of this Act, to discount for any individual, partnership, or corporation, notes, drafts, and bills of exchange when such notes, drafts, and bills of exchange are indorsed or otherwise secured to the satisfaction of the Federal Reserve bank: Provided, That before discounting any such note, draft, or bill of exchange for an individual, partnership, or corporation the Federal reserve bank shall obtain evidence that such individual, partnership, or corporation is unable to secure adequate credit accommodations from other banking institutions. All such discounts for individuals, partnerships, or corporations shall be subject to such limitations, restrictions, and regulations as the Board of Governors of the Federal Reserve System may prescribe.

[12 USC 343. As added by act of July 21, 1932 (47 Stat. 715); and amended by acts of Aug. 23, 1935 (49 Stat. 714) and Dec. 19, 1991 (105 Stat. 2386.]

The Troubled Asset Relief Program or “TARP” was designed to manage the problems inherent in Fair Value Accounting standards or “mark-to-market” accounting (“MTM”) as we have outlined repeatedly for several years now. The very need for TARP however, illustrates the void in FRA 13-3. In other words, the Fed didn’t have all the necessary tools available to deal with the MTM infused financial panic in 2008. For example, what if a company posed systematic risk; was under solvency assault by speculative ‘bear raiders’ using rare derivatives; yet, was not at risk from a cash flow standpoint or traditional insolvency crisis? For starters, the Fed had no authority to provide primary capital support to banks and other large financial institutions hit hard by the inaccuracies of MTM as described. Therefore, they had to collaborate with

Treasury and jointly approach the legislature with a “make-shift” law that few understood then and still fewer fully understand today known as ‘TARP”. The Bank Holding Company Act of 1956 or “BHC Act” established the Federal Reserve’s role in regulating our largest and most complex financial institutions. Needless to say, our financial system is intricate and constantly evolving. It certainly is not frozen in time circa 1956. Our global financial system has changed dramatically and become increasingly intertwined over the past fifty-four years. Clearly, the Fed was presented with a circuitous financial system crisis in 2008 without a modern apparatus to deal with it. Non-bank financials like Fannie Mae, Freddie Mac, AIG, Lehman Brothers, Bear Stearns, Merrill Lynch, Countrywide et al were not regulated by the Federal Reserve despite their systemic significance. The harried conversion of non-commercial banks like Goldman Sachs and Morgan Stanley into bank holding companies to allow them access to the Discount Window was a red herring for a conspicuously outdated regulatory framework. We like what we are hearing and seeing of late from our sources surrounding the Senate Banking Committee regarding the aforementioned regulatory framework reform compromises as they hold great promise in solving the needed updates to the two laws aforesaid. First, we believe an effort to update the BHC Act of 1956 is afoot and the Federal Reserve will emerge with an expanded role in large financial institution oversight. This expansion of oversight will not replace the BHC Act, but rather will be updated to address the needs of the modern era. The Fed likely will be able to identify and directly regulate any and all financial intermediaries that pose systematic risk with the temporary exemption of the Government Sponsored Enterprises or "GSE’s” Fannie Mae and Freddie Mac. We suspect that the Congress will tackle the GSE issue in 2011 in an effort to side-step this “hot button” until after the mid term elections as the GSE issue is the Congress’ fault. Ultimately, we believe that the GSE’s will be reorganized and will be subject to Fed oversight. Second, we believe the Federal Reserve will retain authority as the resolution arbiter by a de facto expansion and update to FRA 13-3. This would incorporate the successful aspects of TARP, including those features which banker’s dislike the most including the negative moral hazard influences of pay and operational restriction oversight. The incentives not to need rescue will be clear and the arbiter not politicized. The updates to FRA 13-3 and the BHC Act emanating from the current compromises being negotiated within the Senate Banking Committee will be subject to both disclosure and counsel. An advisory council consisting of existing financial regulators including the Federal Reserve; the Securities & Exchange Commission or “SEC”; the Office of the Comptroller of the Currency (the national bank examiners, who also will absorb the Office of Thrift Supervision); the Federal Deposit Insurance Corporation or “FDIC”; the Secretary of the Treasury; the Commodities Futures Trading Commission or “CFTC”;

and state insurance regulators et al will have some influence. However, despite this additional oversight and transparency, the Federal Reserve will retain its independent authority to act without hesitation and without politics to resolve the “too big to fail” issue. TARP did work in financial services after-all. The financial markets stabilized and everybody hated it – bankers, taxpayers, and politicians…the perfect resolution cocktail. The financial industry doesn’t always agree with or even care for the Federal Reserve’s regulatory staff; however they do respect the fact that the Fed does not use its authority for political purposes. Market participants will recognize this as good reform with the appropriate expansion of oversight to our only impartial regulator. Likewise, politicians don’t always appreciate the Fed’s independence, but they too respect the Federal Reserve’s lack of a political agenda and will also see this as viable bi-partisan reform. Special Purpose Banker Taxes We are quite confident that President Obama’s proposal to tax banks that have repaid TARP in an attempt to seize capital to “adjust” for the failings of non-banks which have not repaid TARP will die a swift death in the budget debate.

We also suspect Senator Boxer’s retroactive bank executive bonus tax proposal will meet with the same fate. While not a part of a proposed financial reform bill per se, they are part of the overall financial reform “push” which the administration has attempted to

“stuff’ in the federal budget. We previously addressed this issue*. So, we will let the Congressional Budget Office or “CBO” address this as succinctly described by the Heritage Foundation in the chart above… *Western Reserve previously addressed this in another communiqué – See: Specious Bank Proposals from the White House, January, 22 2010). So President Obama wants to slap a tax on banks, but should you really care? Absolutely! Those taxes are going to wind up costing YOU money, whether you’re a customer, a bank employee or an investor, according to the non-partisan Congressional Budget Office (CBO).

President Obama announced his bank tax during his State of the Union Address in January and claimed it would be a way to “recoup” money dished out to banks as part of the Troubled Asset Relief Program bailout. The truth, though, is that those banks already paid-back TARP with interest! The real deadbeat offenders are Freddie Mac, Fannie Mae, Chrysler and General Motors, who have yet to repay their debt. (Take a look at the above chart to see who has repaid – and who hasn’t.)

The President’s proposal was a not-so-thinly-veiled populist proposal, intended to play to an America disgruntled with government bailouts and those institutions that appear to be given preferential treatment via government handouts. The President should brace himself for an America that finds itself even more disgruntled when they realize they’re being directly penalized with the very tax that was meant to appease them.

The ‘Volcker Rule’ We also addressed the non sequitur that was the so-called ‘Volcker Rule’ proposal in the research that we published on January 22nd. We think some version of this will exit the Senate in a form that is very amenable to the industry. We suspect that the Senate Banking Committee debate will result in no hard and fast “rule” at all. We expect to see some language emerge which will place the primary regulator of a financial institution with the onus and ability to apply restrictions on certain trading and investment activities. This would be applied on an ad hoc basis where said regulator sees clear and present risk to the institution and the system. Naturally, the primary regulator in most cases will be the Federal Reserve due to its existing (and what is likely to be its expanded) role in regulating the most complex institutions. Consumer Financial Protection Agency The proposal of a Consumer Financial Protection Agency via the House version of financial reform is highly controversial on a number of levels. There is significant debate surrounding this idea and the White House appears to be dogged in its agenda. This is likely to result in a dramatically compromised Senate bill on this agenda item, which we believe will allow it to get beyond the Senate Banking Committee.

Many leading democrats are pressing for an entirely new bureaucracy devoted to setting prices for consumer credit; establishing new laws; de facto allocating capital; assessing fees (taxes) on financial institutions and regulating, prosecuting and judging (penalties/fines) for all of the above. Depending on where such an agency would be “housed” would determine its constitutionality in part and in whole. This is the genesis of the controversy both across and within party ranks; and the reason why it will have “no teeth” if this agency emerges at all. Senator Dodd’s compromise was to initially propose housing such an agency under the Treasury Department and this proposal was immediately dismissed. Why? Treasury reports to the Executive branch. Under our Constitution, the President cannot make law, set prices, or assess taxes…just for starters. So, for Mr. Dodd’s compromise to “work”, the mandate of the agency itself would have to be watered-down to eliminate all of the aforementioned unconstitutional powers. Senator Shelby has championed housing this agency with the FDIC. This is because Shelby is no friend of the Federal Reserve per se. This domicile approach is more effective as the FDIC reports to the Congress. As a result, some of the desired lawmaking and tax assessing authority could conceivably pass muster but it could not be direct. The Congress certainly can “direct” this agency but first only by enacting new law through the normal course of the legislative process akin to how it “directs” the GSE’s presently. This is where most will step-off this proposal. The liberals will view this as too much “red tape.” And the GSE debacle has tainted the Congress as a financial ‘regulator of choice’, consequently turning-off conservatives as well as most voters. This is aside from the fact that the FDIC is not staffed or equipped for enforcement related regulatory efforts. The FDIC is a “clean-up” shop. Senator Corker has adroitly promoted the Federal Reserve to take-on this role. Now, this proposal “works”. For starters, the Federal Reserve already handles the “teeth” in the closest thing we have related to the CFPA or the Community Reinvestment Act or “CRA”. CRA’s only legal retort is to allow regulators to block mergers, acquisitions and de novo branch expansions by financial institutions. Since the Fed already regulates bank holding companies and likely will see that role expanded as describe earlier, Corker puts forth a most vibrant compromise in our view. Almost all CRA protests now go through the Federal Reserve’s applications department due to their bank holding company oversight. In addition, the Federal Reserve arguably needs to be very close to any consumer finance reforms and regulation due to consumer credit playing such a significant role in our financial system and the economy at large. Consumer finance is BOTH a regulatory oversight and systematic risk management issue as well as a macro monetary policy issue. Two areas that the Federal Reserve System is charged with under current law.

Thus, it is Mr. Corker’s proposal that is most likely to succeed. Mr. Corker’s compromise simply makes the most sense by a country mile. We believe it emerges. And anything that ends up with the Federal Reserve should please both Wall Street and Main Street. Possible Road Block We admit. CFPA is the one issue that can destroy compromise in financial reform negotiations now on the “five yard line” and derail badly needed regulatory updates specifically dealing with “too big to fail.” The White House has been adamant about their desire to see a strong new agency that can set laws; assess taxes and become an independent overseer of consumer credit. Mr. Obama will have to “pivot” on this and therefore set the tone for the House to accept the Senate bill we see advancing. A stand alone CFPA in health care reform parlance is the “public option”…a government take-over of a large swath of the US economy, in this case, consumer credit. It’s so “toxic” that a stubborn left could short circuit financial reform over an agency that we do not need and reforms which are not regulatory in nature, but rather economic restructuring in nature. For our purposes, (stocks), the CFPA poses no risk despite the constant fear. It either gets watered-down to a simple agency that provides some regulatory clarity for consumers (e.g. where to file a complaint); gets written out of financial reform altogether; or gets housed at the Federal Reserve where appropriate checks and balances between lawmaking; fee assessments; regulating and resolution is possible. We think the Senate will opt for the latter and the President and House will pivot towards this as they are desperate for a victory. Derivatives We know the least about derivatives in the Senate compromises as the negotiations have been halted in favor of parliamentary procedure wrangling over health care reform. We suspect that the House version of this, which forces parity between rules for cash markets like stocks and bonds regulated by the SEC and derivatives (futures, swaps etc.) which are regulated by the CFTC, will win out. MTM was a serious contributor to the financial crisis as we often cited in previous discussions. The inherent leverage in credit default swaps as well as their overall lack of formalization and regulation is what caused otherwise well intended new accounting pronouncements to work against a free market. They put the “pro” in pro-cyclical accounting so to speak. Margin requirement for cash markets like debt and equity are 50%, while derivatives often are as low as 5%. This is how oil e.g. reached $150 a barrel. We called the phenomena the “sub prime oil mortgage” conundrum.

The Senate Agriculture Committee oversees the CFTC, so there will be some push-back on regulating derivatives more strictly and in our view prudently at the Senate debate level. We believe that the few Senators that feel a need to protect the natural resources and agricultural commodity lobby will have a tough time defending their position that derivatives should be allowed to be levered 20 to 1. The House version calling for parity likely wins this area. This could have a material impact on commodity markets, so just be aware.

We are nearing the end of this reform threat overload against the financial sector; we see very positive compromise leaking out of the Senate; and we believe risks of serious punitive outcome to financial firm profits declining rapidly. We end our financial Regulatory Reform Primer with the above chart courtesy of our friends at Hedgeye. The chart well…it speaks for itself. We have been here before. Regards,

Michael P. Durante Managing Partner