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More Than "The Cliff": 2013 Banking Outlook

Callum is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Bipartisanship (kinda)

It seems that the epic story is coming to an end. Speaker John Boehner said he was willing to accept tax increases on those who make over $1,000,000 a year, and President Obama said he would accept tax increases on those making over $400,000 a year. Now that both sides are willing to accept tax increases on the rich they just have to decide on what the threshold should be for the increases. My guess is that somewhere around $500,000 is where the final threshold ends up. On the other side of the equation, Republicans have been pushing hard for spending cuts and reforms in entitlement programs and it seems that the Democrats are finally willing to reform and cut entitlements as Obama says he is willing to talk about social security reform, as long as it comes with tax increases on the rich. It is nice to see some sort of bipartisanship (kinda) finally hit Washington for the first time in years. The fiscal cliff pushed the S&P 500 down to 1,353 on November 15. But now that a resolution is on the horizon it seems that we might finally be able to put this behind us and get back to our daily lives and get back to investing. While the stock market tanked Friday due to prolonged fiscal cliff talks, a resolution will still be passed soon.

Banks Rally, But Regulations Are On The Horizon

Goldman Sachs (NYSE: GS) is up 42%, JPMorgan (NYSE: JPM) is up 32.5%, and Morgan Stanley (NYSE: MS) is up 25% YTD. A deal that won't put the US economy in a recession will push all these stocks higher going into 2013, but I think some investors are focusing too much on the fiscal cliff and not looking ahead far enough. I'm talking about Dodd-Frank that is going into effect next year.

Dodd-Frank

One part of Dodd-Frank is mortgage qualification. Under the new mortgage qualification rules banks will have to establish lending standards that allow only those who are "qualified" to be able to take out loans. One problem with this is that those who default can claim that the bank they got the loan from gave them a loan that they shouldn't have gotten. This will discourage lending and will hurt the housing market, the banking sector, and the US economy as a whole as the housing market is supposed to help the US economy to keep growing in 2013 after the fiscal cliff deal. Another part of Dodd-Frank is the Volcker Rule. The Volcker Rule, named after Federal Reserve chief Paul Volcker, would make proprietary trading illegal. Proprietary trading is where banks trade with money they have on hand and supporters of this rule say that it will protect depositors by forcing banks to not make risky investments. Opponents of this rule say it will kill the financial industry and force bank fees to rise. One problem with implementing the Volcker Rule is that it still allows for hedging by banks. Now there is a very murky line between trading and hedging, which is why the rule was put off until July 2014, when banks have to fully comply with the rule. If the Volcker Rule gets implemented, bank profits will plummet and so will your investment. Be wary of Dodd-Frank when investing in the banking sector, because if it does get implemented then profits will fall and so will the banking sector.

Volcker Strangle

Goldman Sachs and Morgan Stanley will get hit the hardest by the Volcker Rule. Goldman Sachs makes 34% of its revenue from proprietary trading and in Goldman’s latest quarter they made $1.8 billion from proprietary trading. Morgan Stanley makes 44% of its revenue from proprietary trading. When the Volcker Rule goes into effect, revenue from fixed income investments could fall by 25%. Next year both Goldman and Morgan will get slammed by Dodd-Frank and the Volcker Rule. Their profits could fall by 10-20% at least, but some see that falling by even more (in the 30-50% area). JPMorgan gets less than 10% of its revenue from proprietary trading, but it does get 52.1% of its revenue from retail banking. With the new mortgage qualification rules JPMorgan's largest division will get hurt. While JPMorgan is the best bank to deal with Dodd-Frank due to low exposure to proprietary trading, every time JPM loans out a mortgage the liabilities are bigger than just a default.

Final Thoughts

It is nice to see a breath of fresh air in Washington. Now we might be able to finally put the fiscal cliff behind us, even though the debt ceiling is about to hit us (the debt ceiling is at $16.394 trillion, $60 billion away from us). A resolution on the fiscal cliff will push equities higher, but we need to start focusing more on 2013 and what lies ahead. Obamacare and Dodd-Frank begin to set in in 2013, but most investors and the general public seem to just care about the fiscal cliff. While banks have done well so far this year, I would be very cautious going into 2013 if you own bank stocks as the effects of Dodd-Frank remain to be seen. Goldman Sachs and Morgan Stanley will get hit the hardest by Dodd-Frank. JPMorgan seems well positioned to deal with some parts of Dodd-Frank, but the new mortgage regulations will force JPM to be more conservative with their lending practices. Plus the Volcker Rule will take out 5-7% of their revenue that comes from proprietary trading.  While we might get over one major political hurdle, many more lay ahead and investors should always keep an eye on everything going on, not just the popular topic at hand.


callumturcan has no positions in the stocks mentioned above. The Motley Fool owns shares of Bank of America, JPMorgan Chase & Co., and Wells Fargo & Company. Motley Fool newsletter services recommend Wells Fargo & Company. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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