Wall Street Caught Between Barack and a Hard Place

November 8, 2012

Wall Street Journal

David Reilly

Bank stocks are taking an electoral pummeling.

President Barack Obama's re-election dashed investor hopes of an overhaul or repeal of the Dodd-Frank Act, or of a general loosening of bank regulation. Meanwhile, the election of Elizabeth Warren to the U.S. Senate has raised fears of renewed debate about breaking up big banks.

Ultimately, though, that is unlikely, and a continuation of the regulatory status quo may not be as bad as investors initially fear. After all, firms have been adapting for two years to the new landscape. In fact, tougher capital requirements make them more stable in the long run.

Elizabeth Warren celebrating her victory as the new senator from Massachusetts on election night. She has criticized big banks.

The more troubling short-term concern is what effect a battle over the "fiscal cliff" will have on trading flows, lending and overall economic activity. With markets selling off sharply Wednesday on the prospect of U.S. political turmoil—alongside continuing challenges in Europe and China—investors and companies may decide to sit on the sidelines until there is more clarity.

That kind of one-way movement is a roundhouse blow to the sales-and-trading operations of big banks. The third quarter of 2011, when the European crisis was reaching a crescendo, was an illustration of just how bad things can get as some banks saw trading revenue fall by 25% or more.

Any trading pullback in the remainder of this year's fourth quarter would come as revenue growth at Wall Street firms remains tepid at best. Another weight: The fourth quarter has already seen a loss of trading days and activity due to Hurricane Sandy.

The justifiable concern in the face of this is that already meager returns on equity, which have yet to surpass firms' cost of capital in some cases, will stay depressed.

More broadly, bank chiefs on third-quarter earnings calls talked about a slowing of lending activity as the election and fiscal cliff approached. If this crimps business lending, banks will see their main source of loan growth in recent quarters sputter.

One potential bright spot is mortgage activity. This has bolstered bank results for much of 2012, largely due to refinancing on the back of superlow interest rates. With the election past, the Obama administration could look to expand government programs aimed at making it easier for underwater borrowers to refinance.

That could be a further boon to the likes of Wells Fargo WFC +0.97% and regional banks. But it wouldn't be enough to counter a significant trading falloff at big banks like J.P. Morgan Chase JPM +2.01% . Nor would it offset a general economic slowing. "Banks at the end of the day are a reflection of the economy," noted Barclays BARC.LN +0.93% analyst Jason Goldberg.

Any beneficial effect of a continued mortgage-revenue boom may also be offset by renewed Federal Reserve action, should the worst fears over the fiscal cliff come to pass. Additional bond buying on the Fed's part could heighten the squeeze on banks' net interest margins. Market expectations for a first rate increase by the Fed, which had recently moved into 2014, were back out to early 2015 on Wednesday morning.

The biggest blow to bank stocks, though, may be a renewed sense that they are at the whim of events beyond their control.

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