Through 2007, banks in the financial sector were annually posting returns that were much to the delight of the street. These companies created products that defied logic, but their profitability made them to spectacular to do away with.
These financial institutions included Bank of America (NYSE: BAC), JP Morgan (NYSE: JPM), Wells Fargo (NYSE: WFC) and Citigroup (NYSE: C). Back then, Lehman Bros. and Bear Stearns were also members of the pack.
They were all sailing along prior to 2008, profiting from the use of mortgage-backed securities. The housing market was on fire thanks to allowances that made it easier for homebuyers to secure subprime mortgages.
After billions of bailout dollars were funneled to the big banks like Bear Stearns and Lehman Bros to keep them from failing, lawmakers drafted the Dodd-Frank Wall Street Reform and Consumer Protection Act. The legislation was stocked with all kinds of rules and regulations that were meant to keep banks from working themselves to the danger point like they did through 2008. The Act became effective in 2010.
Now, a new “sheriff” is in town in the form of president-elect Donald Trump. Market players cheer his perceived anti-regulation stance. Look no further than the stock market rally and the participation in that rally by banks after Trump won the election last week. The thought that he may tinker with Dodd-Frank is striking hope and fear into the hearts of players in the financial industry.
On the chopping block
The Consumer Finance Protection Bureau will likely be first up to be either done away with or severely altered. The agency has taken what many deem a too heavy handed approach in dealing with issues it perceives harms consumers. In all its grandiose, complaints include its investigative conclusions negatively affecting small community banks, while helping big banks.
Those risky investments that led to the housing collapse may be back in play if Dodd-Frank is dismantled. One of the rules in the Act, the Volcker Rule, was meant to prevent banks from entering into risky, speculative investments.
But Dodd-Frank does some good
One of the pluses that came from Dodd-Frank are bank stress tests. Conducted annually, banks with more than $50 billion in assets must submit certain financial information to the Federal Reserve Board. In order to pay dividends or have share buyback programs, banks must show they are capitalized well enough to weather financial storms of the magnitude that caused Bear Stearns and Lehman to fail.
The Fed explains it this way:
“The changes we make in each year’s stress scenarios allow supervisors, investors, and the public to assess the resiliency of the banking firms in different adverse economic circumstances,” Fed Governor Daniel K. Tarullo said. “This feature is key to a sound stress testing regime, since the nature of possible future stress episodes is inherently uncertain.”
With the possibility of Dodd-Frank going away, investors may be eager to jump into financials. If you do, be like the Fed.
- Conduct your own stress tests; watching for signs that the bank’s capitalization is decreasing.
- Stay abreast of financial products that are being rolled out to understand their risks to the bank.
- Make a point to review quarterly earnings reports, and if you can get a copy of the transcripts from the quarterly conference call.
The possibility of Dodd-Frank going away may make financials attractive investments. However, if it does go away, the onus is on investors to be just as vigilant as the the law’s provisions to protect that investment.