Why The Reform Bill Boosted Financial ETFs

by on May 24, 2010 | Updated May 25, 2010 | ETFs Mentioned:

After the passage of a controversial health care bill earlier this year, many analysts wondered if the Obama administration lacked the political capital to push through comprehensive financial reform as the next big domestic issue. After various packages met stiff resistance on several occasions, Senators passed the financial regulation overhaul bill on Thursday in a 59-39 vote. The bill, which comes months after a similar measure was passed by the House, looks to make sweeping changing to the nation’s financial industry. Among the most extensive changes in the legislation is a council of systemic risk regulators that would set capital stands for big banks and monitor systemic risk. Additionally, many derivatives transactions made by big banks, hedge funds and other groups would be required to go through clearinghouses and put their contracts through exchanges or swap-execution facilities.

These changes are expected to have far-reaching effects on the industry with some analysts estimating it could cut profits of major financial institutions by roughly 20%. This is largely due to the changes that will impact derivatives trading, which by some estimates accounts for up to half of trading desk revenue at large financial firms. Despite the vast changes and the possible negative implications, many financial ETFs saw their shares surge higher as news of the bill was announced. Among the top gainers were iShares Dow Jones U.S. Financial Services Index Fund (IYG), HOLDRS Merrill Lynch Regional Bank (RKH), and iShares S&P Global Financial Index Fund (KBE) were all up more than 2% on Friday (also see ETFs With Significant Goldman Sachs Exposure).

Why The Surge?

Some say that the risk of the bill has already been priced into the stocks. Others believe that banks are just glad to finally know what they will up against and how extensive the reforms will be. Financial executives can now better plan their operations without having to worry about  further extensive reforms; the political risk associated with financial shares has been sharply cut and most firms are probably rising on this news. Furthermore, many banks must be encouraged regarding some of the aspects of the bill that have been left out of the Senate version. Most notably, the House bill calls for a $150 billion fund to be paid for by the largest financial companies in order to liquidate failing companies at no cost to taxpayers. The Senate version, however, calls for the costs of a bailout to be paid for by the large banks after the failure has taken place. The Senate approach greatly reduces the fees imposed on the largest banks and this section of the bank bill may be one of the main catalysts for today’s rally in big name financials (also see Three Sector ETFs With Sky-High Betas).

Wall Street breathed a collective sign of relief as the bill took shape, not because banks had dodged the bullet completely but because the latest iteration lacks components many had feared would be included. “Despite the outcry from lobbyists and warnings from conservative Republicans that the legislation will choke economic growth, bankers and many analysts think that the bill approved by the Senate last week will reduce Wall Street’s profits but leave its size and power largely intact,” writes Eric Dash. There is little doubt that the bill will cut into Wall Street profits in coming years. But concerns over slimming profit margins have been overshadowed by ecstasy over provisions that were left out. “Caps on how much banks can charge credit card holders to borrow also fell by the wayside,” writes Dash. “And the long-established wall between trading and commercial banking, which was torn down in 1999, will not be going back up.”

What’s Next?

Lawmakers must now reconcile the differences between the House and Senate versions of the Bill before it can be given to Obama for his signature. While some Congressmen are hoping to have this process done by the 4th of July, major hurdles remain between matching the bills and the hammering out the many differences. Some of the key differences include what to do with ‘too big to fail’ corporations as well as where to house a new consumer protection agency. A full list of the main differences can be found in a recent New York Times feature on the subject (also see Financial ETFs: Seven Ways To Play).

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Disclosure: No positions at time of writing.