June 28, 2010
United States: Financial Services
The debate is largely over, but many details still to come
Nearing the end of Congressional reform Next Steps: A speedy passage from here Passage of the financial service reform bill We expect final passage of the legislation should IMPLEMENTATION TIMELINES BY PROPOSAL represents an important milestone that will occur quickly. The House is expected to vote on Volcker Effective Enactment Study Rulemaking Compliance alleviate some of the uncertainty that has been the legislation this week, followed soon thereafter Date weighing on the sector. We expect investor focus by the Senate. While the legislation cannot be July, 2010 January, 2011 September, 2011 July, 2012 July, 2014 (potential for up 3 year extension) to migrate to operational trends as the debate amended, there is likely to be further activity in Derivatives 2012: Effective Date for 2012‐2014: Transition 2015: Optional around the impact of reform on normalized coming months to clarify congressional intent. Banks to set up separately period to move derivatives Transition Period earnings subsides. That said, while the big issues capitalized swap subsidiary to new subsidiary Capital Requirements (TruPS treatment) TruPS excluded from have been settled, some uncertainty remains as This is not necessarily the end of fin-reg Applies to banks with Phase out period begins Tier 1 capital assets > $15 bn 2013 many aspects of the proposed legislation require There is a long phase-in period in which the actual 2016 interpretation and specific rule making by rules will be crafted by regulators. While this may Regulatory Assessment September September September September $19 billion bill cost regulators. lead to further surprises down the line, we see this 2012 2013 2014 2015 as important as financial institutions have time to Annual Assessments paid annually
Final bill largely in-line with expectations adapt their business models. Other issues which Source: Goldman Sachs Research. Language around the swap push-out provision, are still on the table include a potential TARP tax, We would like to thank Alec Phillips for his contributions to debit interchange and the Collins amendment GSE reform as well as Basel 3. this report ended up being more manageable for the industry than many feared. The Volcker rule is more Stock implications: banks & exchanges mixed; language on prop trading is slightly more Banks are the most impacted, and unknowns have restrictive, while hedge fund/PE ownership is less been reduced, thus valuation may improve and restrictive. One surprise was a $19 bn “fee” that fundamentals should become more important; we will be borne by the industry for the cost of the like JPM, BAC and C. In addition, exchanges are bill, although it will be spread over a broad range positioned to benefit from new regulation. CME of financial institutions and not just banks. and NDAQ are our favorite stocks in exchanges.
Richard Ramsden The Goldman Sachs Group, Inc. does and seeks to do business with (212) 357-9981 [email protected] Goldman Sachs & Co. companies covered in its research reports. As a result, investors should Brian Foran be aware that the firm may have a conflict of interest that could affect (212) 855-9908 [email protected] Goldman Sachs & Co. the objectivity of this report. Investors should consider this report as Daniel Harris, CFA only a single factor in making their investment decision. For Reg AC (212) 357-7512 [email protected] Goldman Sachs & Co. certification, see the end of the text. Other important disclosures follow Jessica Binder Graham, CFA the Reg AC certification, or go to www.gs.com/research/hedge.html. (212) 902-7693 [email protected] Goldman Sachs & Co. Analysts employed by non-US affiliates are not registered/qualified as research analysts with FINRA in the U.S.
The Goldman Sachs Group, Inc. Global Investment Research June 28, 2010 United States: Financial Services
Table of Contents
Table of Contents 2 The debate is largely over, but many details still to come 3 Sector Impact 5 Volcker: Directionally similar – positive for alternatives and a hit to prop trading 9 Derivative legislation: swap push-out and clearing/trading clarity begins to emerge 10 Capital requirements: TruPS to be phased out from Tier 1, but more regulation to come 17 Resolution Authority: in-line with prior proposal, but still poses some risk to credit ratings 18 FDIC Assessment will be spread across a large number of financial firms and hedge funds 19 Debit Interchange – toward a “reasonable and proportional” world of debit 21 Merchant acquirers avoid the hot seat 24 Defining Qualified Residential Mortgages and the impact on Private Mortgage Insurers 25 Passing on the costs of regulatory burdens 27
GS Financials Equity Research Team Banks Insurance Asset Managers Market Structure & Real Estate/REITs Homebuilders Brokers Richard Ramsden Christopher M. Neczypor Marc Irizarry Dan Harris, CFA Jonathan Habermann Joshua Pollard Brian Foran Christopher Giovanni Alexander Blostein, CFA Jason Harbes, CFA Sloan Bohlen Anto Savarirajan Soumil Zaveri Eric Fraser Neha Killa Conor Fennerty Cooper McGuire Siddharth Raizada Vikas Jain
GS Financials Credit Research Team Technology: IT Services Financials Specialist Banks Insurance and Managed Care Julio C. Quinteros Jr. Financials Sector Specialist Louise Pitt Donna Halverstadt John T. Williams Jessica Binder Graham, CFA Ron Perrotta Amanda Lynam Vincent Lin Pradeep Verghese Snigdha Sharma
Goldman Sachs Global Investment Research 2 June 28, 2010 United States: Financial Services
The debate is largely over, but many details still to come
The debate around Financial Reform has provided clarity on well-discussed topics and reduced the ‘unknown’ impact of the process to a more manageable level, and provided guidance around the timeframe for implementation of the proposals.
Volcker Rule: The outcome was directionally as expected compared with the previous proposal, with somewhat less restriction on hedge/private equity fund sponsorship and investment, as it allows firm investment up to 3% of Tier 1 capital, and allows for organization/offering of funds in certain cases. However, it is somewhat more restrictive on proprietary trading than the previous text. An exemption is included from the prop trading ban for market making and hedging, however, there is a separate requirement that prohibits conflicts of interest with any client or counterparty, subject to regulatory interpretation. Firms will have at least four years to adjust to the prop prohibition, although additional capital charges could be applied to prop activities sooner.
Derivatives Legislation: This was the area of the greatest uncertainty heading into the last few days of negotiation. The final bill will allow banks to continue to serve as swap dealers for interest rate swaps, foreign exchange, cleared CDS on investment grade entities, and gold and silver-related swaps. Other swaps, including non-cleared CDS, commodities, and equity-related swaps, will be moved to a separate affiliate within the bank holding company structure. Our understanding is that banks will need to capitalize the subsidiary no sooner than two years, plus a period for transition. Importantly, the legislation exempts end users from clearing house requirements if the derivatives are being used to hedge or mitigate commercial risk (including balance sheet related risks) or are used to assist in selling the company’s products. Currently, we are unsure if existing contracts will be grandfathered.
Resolution Authority: Language around the Resolution Authority did not significantly change over the course of the conference. The Resolution Authority gives the FDIC power to unwind failing financial firms and explicitly bars the use of taxpayer funds to rescue them. As current credit ratings assume some level of government support, one of the concerns is that there are likely to be rating downgrades now that this support is not guaranteed. However, the rating agencies have said there will be some offset which will be determined by firm profitability and the macroeconomic backdrop.
Capital requirements: Language mandating the removal of TruPS from Tier 1 capital was softened somewhat over the course of the Conference as the grandfathering provisions for existing TruPS makes implementation more manageable. In addition, the final bill contained some broad language suggesting that large, complex banks will need to maintain a significant level of capital in the future.
Consumer Protection / Debit Interchange: The bill creates a Consumer Financial Protection Bureau to be created within the Federal Reserve. The director of the new agency will be a Presidential appointee subject to Senate approval. It will have rule-making and enforcement powers over banks and other financial companies. The Fed is permitted to limit the fees charged to merchants by banks and credit card companies each time a debit card is used.
Federal Insurance Office (“FIO”): While the full impact of systemic risk delegations is still unclear for insurance companies, the overall regulatory structure has not changed for the industry. Specifically, the newly formed Federal Insurance Office does not appear to have regulatory authority, thus allowing for state-based regulation to remain the de-facto regulator. The initial goal of the Federal Insurance Office appears to be “monitoring” the industry; however, the bill also requires a study
Goldman Sachs Global Investment Research 3 June 28, 2010 United States: Financial Services
to be done within the next 18 months on how to modernize and improve the system of insurance regulation in the United States.
FDIC Assessment: One of the surprises to the final bill was the addition of a $19 bn assessment through the FDIC on financial firms with assets over $50bn (including both Banks and Insurance Companies), and hedge funds over $10bn. This provision was added to offset the estimated cost of the bill, which was due in large part to the resolution authority and various administrative responsibilities created by the bill. There is some uncertainty on how this cost will be distributed across firms, and is expected to be scaled by riskiness.
Mortgage Risk Retention: As part of the Securities Reform Act, banks that are securitizing mortgages are required to retain some of the risk. The risk retention rules are intended to incent higher quality underwriting in the origination of residential mortgage loans sold into securitizations. Such an “incentive” is provided in the form of a requirement to hold “not less than 5% of the credit risk for any asset.” However, the bill allows for an exemption from such risk retention requirements if the underlying mortgage is a “qualified residential mortgage” (QRM). Thus, the definition of what exactly qualifies for a QRM could have a significant impact on future originations. The bill lists five ways a mortgage could qualify for QRM status, one of which is private mortgage insurance.
Exhibit 1: Implementation timelines by proposal
Volcker
Effective Enactment Study Rulemaking Compliance Date
July, 2010 January, 2011 September, 2011 July, 2012 July, 2014 (potential for up 3 year extension)
De r ivative s
2012: Effective Date for 2012‐2014: Transition 2015: Optional Banks to set up separately period to move derivatives Transition Period capitalized swap subsidiary to new subsidiary
Capital Requirements (TruPS treatment) TruPS excluded from Applies to banks with Phase out period begins Tier 1 capital assets > $15 bn 2013 2016
Regulatory Assessment
September September September September $19 billion bill cost 2012 2013 2014 2015
Source: Goldman Sachs Research
Goldman Sachs Global Investment Research 4 June 28, 2010 United States: Financial Services
Sector Impact
Banks: While there are still many aspects of the legislation that are uncertain as they require interpretation and implementation by regulators, and there is still the risk that there will be additional regulation in coming months and years (ie TARP tax, GSE reform, Basel III), we believe that passage of this bill represents an important milestone that will go some way to alleviating the uncertainty that has been weighting on the sector. Specifically, we believe that investors will be more inclined to focus on the rapid improvement in credit costs, the significant levels of capital generation (which should eventually be returned to shareholders) and the attractive valuations, particularly for the large cap names.
We have updated our estimates of the potential hit to normalized earnings framework to take into account the proposed legislation. The main changes include:
1. We assume 75% of the $19bn cost for introducing the bill will be passed onto the banks based on asset size.
2. Previously we estimated debit interchange fees would decline to 55 bps – we revise this to 80 bps considering that fraud and fraud prevention costs can be considered in setting the fee.
3. We re-assess the impact of the derivatives legislation given that the magnitude of the swaps spin out is smaller than initially thought.
4. Based on these changes, we now forecast that the large banks could see a 13% hit to normalized earnings while the regional banks could see a 5% reduction in normalized earnings.
Ultimately, we believe that some of the increased regulatory and legal burdens will be passed on to customers either in the form of annual fees or higher spreads on lending. As an example, conforming mortgage rates are currently 90bps above MBS yields vs. a historical average of 20bps. This implies that banks are not passing on the full benefit of low rates and the Fed MBS purchase program because on the other side they are concerned about losses such as GSE repurchase requests. Hence, we believe the impact that we have estimated on normalized earnings could prove to be too high over time.
This section was Banks Credit: We continue to believe that regulatory reform will be a positive for the sector in the long run and remain attractive on prepared by Louise Pitt US banks. While there are several open questions on implementation and just how profitable certain businesses may be going forward, we think banks with strong franchises and diversified earnings will outperform. Above all else, the end of the conference committee process provides some level of certainty. We think this is supportive for strong credits such as JPM, BAC and MS, whose spreads have seen increased volatility since the beginning of deliberations. We also remain constructive on the sub and Tier 1 asset classes relative to senior debt given the impact from the phase out of TruPS and expected improvement in quality of capital bases.
Goldman Sachs Global Investment Research 5 June 28, 2010 United States: Financial Services
Exhibit 2: Potential regulatory impact to normalized earnings
Large Banks Trust Banks Cards Regionals $bn BAC C JPM MS WFC PNC USB BK NTRS STT AXP COF DFS BBT CYN CMA FITB FHN FNFG HCBK HBAN KEY MI PBCT RF STI SNV WAL ZION Wtd Avg Regulatory Impact (pre-tax) 2009 Regulations OD / NSF Fees (1) 2.0 0.1 0.8 0.0 1.5 0.4 0.3 0.0 0.0 0.0 0.0 0.1 0.0 0.1 0.0 0.0 0.1 0.0 0.0 0.0 0.0 0.1 0.0 0.0 0.1 0.1 0.0 0.0 0.0 CARD Act (2) 1.40.50.9--0.40.10.1------0.60.70.3------Sub-Total: 2009 Regulations 3.4 0.6 1.7 0.0 1.9 0.4 0.4 0.0 0.0 0.0 0.6 0.7 0.3 0.1 0.0 0.0 0.1 0.0 0.0 0.0 0.0 0.1 0.0 0.0 0.1 0.1 0.0 0.0 0.0 2010 Restoring American Financial Stability Act Restrictions on "Prop" (3) 0.51.31.00.40.0------Derivatives Legislation (4) 0.7 1.0 0.7 0.4 ------CFPA / National Pre-emption (5) 1.8 1.2 2.0 0.0 1.7 0.3 0.4 0.0 0.0 0.0 0.3 0.2 0.1 0.2 0.0 0.0 0.1 0.0 0.0 0.1 0.0 0.0 0.0 0.0 0.0 0.1 0.0 0.0 0.0 Interchange Legislation (6) 0.5 0.0 0.3 0.0 0.4 0.1 0.1 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 FDIC Assessment (7) 1.0 1.4 1.1 0.6 -0.2 -0.1 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 -0.1 0.0 0.0 0.0 Financial Crisis Fund ($19 bn) (8) 0.7 0.6 0.6 0.2 0.4 0.1 0.1 0.1 0.0 0.0 0.0 0.1 0.0 0.0 -- 0.0 0.0 -- -- 0.0 0.0 0.0 0.0 -- 0.0 0.1 -- -- 0.0 Sub-Total: 2010 Regulations 5.2 5.6 5.8 1.6 2.3 0.3 0.6 0.1 0.0 0.0 0.4 0.2 0.1 0.2 0.0 0.0 0.2 0.0 0.0 0.1 0.0 0.1 0.0 0.0 0.1 0.1 0.0 0.0 0.0 Sub-Total: 2009, 2010 Regulations 8.6 6.2 7.5 1.6 4.2 0.7 0.9 0.1 0.0 0.0 1.0 0.9 0.3 0.3 0.0 0.1 0.2 0.0 0.0 0.1 0.1 0.1 0.1 0.0 0.2 0.3 0.0 0.0 0.1 Future Risks Financial Crisis Responsibility Fee (9) 0.7 0.6 0.6 0.2 0.3 0.1 0.1 0.1 0.0 0.0 0.0 0.1 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 Sub-Total: Future Risks 0.7 0.6 0.6 0.2 0.3 0.1 0.1 0.1 0.0 0.0 0.0 0.1 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 Total 9.3 6.8 8.0 1.8 4.5 0.8 1.0 0.2 0.0 0.1 1.1 1.0 0.4 0.3 0.0 0.1 0.3 0.1 0.0 0.1 0.1 0.1 0.1 0.0 0.2 0.3 0.0 0.0 0.1
Normalized EPS Current GS estimate $2.40 $0.55 $6.50 $3.90 $4.35 $6.80 $2.85 $3.13 $4.65 $4.50 $3.70 $5.00 $2.10 $3.35 $4.75 $4.45 $1.60 $1.30 $1.40 $1.30 $0.75 $1.00 $0.75 $1.00 $0.80 $3.50 $0.33 $0.70 $2.70 Adjusted for 2010 regulation $2.06 $0.43 $5.55 $3.16 $4.06 $6.39 $2.65 $3.09 $4.58 $4.44 $3.47 $4.69 $2.00 $3.16 $4.50 $4.31 $1.47 $1.23 $1.35 $1.20 $0.71 $0.95 $0.72 $0.99 $0.73 $3.32 $0.34 $0.70 $2.61 Adjusted for future risks $2.02 $0.42 $5.46 $3.05 $4.02 $6.30 $2.62 $3.06 $4.53 $4.39 $3.45 $4.61 $1.98 $3.12 $4.43 $4.25 $1.45 $1.22 $1.34 $1.18 $0.70 $0.93 $0.70 $0.98 $0.71 $3.26 $0.33 $0.69 $2.56
Impact by Regulatory Action 2009 Regulations OD / NSF Fees (1) 5% 0% 2% 0% 4% 6% 3% 0% 0% 0% 0% 2% 0% 2% 2% 3% 4% 5% 1% 0% 5% 4% 3% 0% 5% 5% 4% 1% 5% 3% CARD Act (2) 4% 2% 2% 0% 1% 1% 1% 0% 0% 0% 9% 19% 14% 0% 0% 0% 0% 0% 0% 0% 0% 0% 0% 0% 0% 0% 0% 0% 0% 2% Sub-Total: 2009 Regulations 9% 2% 4% 0% 5% 7% 4% 0% 0% 0% 9% 20% 14% 2% 2% 3% 4% 5% 1% 0% 5% 4% 3% 0% 5% 5% 4% 1% 5% 5% 2010 Restoring American Financial Stability Act Restrictions on "Prop" (3) 1% 5% 3% 5% 0% 0% 0% 0% 0% 0% 0% 0% 0% 0% 0% 0% 0% 0% 0% 0% 0% 0% 0% 0% 0% 0% 0% 0% 0% 2% Derivatives Legislation (4) 2% 4% 2% 5% 0% 0% 0% 0% 0% 0% 0% 0% 0% 0% 0% 0% 0% 0% 0% 0% 0% 0% 0% 0% 0% 0% 0% 0% 0% 1% CFPA / National Pre-emption (5) 5% 5% 5% 0% 5% 5% 5% 0% 0% 0% 5% 5% 5% 4% 3% 1% 4% 5% 3% 5% 5% 4% 3% 3% 3% 5% 2% 2% 2% 4% Interchange Legislation (6) 1% 0% 1% 0% 1% 1% 1% 0% 0% 0% 0% 1% 1% 1% 2% 1% 3% 1% 2% 2% 2% 1% 1% 1% 3% 2% 0% 2% 1% 1% FDIC Assessment (7) 3% 6% 3% 7% 0% -1% 0% 0% 0% 0% 1% -1% -2% -1% 0% 0% 0% -1% -2% -1% -3% -2% -2% -3% -1% -3% -5% -4% -2% 2% Financial Crisis Fund ($19 bn) (8) 2% 2% 2% 3% 1% 1% 1% 1% 1% 1% 1% 2% 1% 1% 0% 1% 2% 0% 0% 2% 2% 2% 3% 0% 3% 2% 0% 0% 2% 2% Sub-Total: 2010 Regulations 14% 22% 15% 19% 7% 6% 7% 1% 1% 1% 6% 6% 5% 6% 5% 3% 8% 5% 4% 8% 6% 5% 5% 1% 8% 5% -3% -1% 3% 12% Future Risks Financial Crisis Responsibility Fee (9) 2% 2% 1% 3% 1% 1% 1% 1% 1% 1% 1% 2% 1% 1% 1% 1% 2% 1% 1% 2% 2% 2% 2% 1% 3% 2% 2% 2% 2% 2% Sub-Total: Future Risks 2% 2% 1% 3% 1% 1% 1% 1% 1% 1% 1% 2% 1% 1% 1% 1% 2% 1% 1% 2% 2% 2% 2% 1% 3% 2% 2% 2% 2% 2% Total impact: 25% 27% 20% 22% 13% 15% 12% 3% 3% 2% 16% 28% 20% 9% 9% 7% 14% 12% 6% 10% 12% 10% 11% 2% 16% 12% 4% 3% 10% 18%
(1): estimated using 15% of annual deposit servicing charges (5% for trust banks), similar to banks that provide guidance. (2): estimated where not provided. (3): using disclosed % of revenue by bank where applicable, adjusted for comp expenses. (4): estimated as 10% discount to average quarterly FICC trading revenue, adjusted for comp expenses. (5): estimated using trust banks' recent legal charges over earnings over the last 5 years. (6): estimated based on debit market share. (7): assumes deposit insurance fund returns to 1.15% of insured deposits by 2017; weighted by assets less tangible equity. (8): assumes banks > $50 bn in assets pay 75% of total fee proportional to asset size. (9): assumes all banks pay $50 bn over 10 years; weighted by assets less tangible equity.
Source: Company data, Goldman Sachs Research.
Goldman Sachs Global Investment Research 6 June 28, 2010 United States: Financial Services
Insurance: As we understand the final language of the bill, it appears to contain both positives and negatives for the insurance industry. Broadly speaking, the implication that large insurance companies could likely now be considered systemically important (depending on the designation of the newly formed Financial Stability Oversight Council), which implies there is the potential for incremental regulatory and administrative burdens on the industry. With the possibility for such oversight comes a host of new questions. For example:
How will the Federal regulators view capital requirements for insurance specific risks?
How will guaranteed benefits on separate account assets be scored as risk-weighted assets?
What will be the incremental administrative costs of regulation?
Given the systemic risk language sets the prudential standards asset threshold at $50 billion, how will an insurer approaching such an asset level treat growth?
While there remain more questions than answers for the broader question of insurance regulation, we note there is a specific 18 month timeline for the FIO to report on how to modernize and improve the US system of insurance regulation.
Elsewhere within the bill, we would characterize the final language within the Volcker rule as being a net positive for the industry while the derivative language is a net negative. Specifically:
(1) The insurance company carve-out for proprietary account trading and the ability to invest up to 3% of capital hedge funds should allow insurers to be relatively unaffected from this particular amendment.
(2) However, the lack of an end-user exemption for the insurance industry within the derivatives portion of the bill is a negative development, with the consequences as yet unclear. The potential for increased costs – for example on large risk management trades that become clear to the market – as well as the potential incremental margin requirements (with questions around both quantity and types of collateral) could ultimately lower spread income and thus earnings.
As of Friday, the few companies that were willing to speak on the topic essentially said the true impact would not be understood for many months, but that the initial read on the bill was that the changes appeared to be manageable.
Exchanges and Market Structure: the reform is largely positive for the exchanges and for the inter-dealer brokers and electronic trading companies. The shift from non-cleared to cleared OTC products could increase global exchange revenues by up to $1.5 bn over time with full back-loading of swap positions into a clearing house. Further, any decline in swap based activity due to increased margin requirements (which we estimate could reach over $600 bn for interest rate and credit swaps) will likely shift to exchange based products. We see exchanges such as CME, NDAQ, and ICE as beneficiaries of the reform, and believe more activity will shift onto their platforms over time. For the inter-dealer brokers (GFIG and BGCP in our universe, but also including ICAP and Tullett), their investments in technology over the past few years to electronically trade various swap products will likely allow them to become Swap Execution Facilities (SEF’s) and leverage that investment to become potentially more instrumental in the trading of swaps over the next few years, potentially at a higher margin (as compensation pressures abate through technology).
Asset Managers: The $19 bn addition of the FDIC assessment is an incremental negative for a select group of asset managers with more than $10 bn in hedge fund AUM, but mostly manageable for the stand-alone publicly traded firms. While there are still many uncertainties with respect to the fee split between banks and hedge funds, risk metrics and timing, given the preliminary language of the bill, we believe Och-Ziff will be among the public managers most impacted by the regulation, followed by BlackRock to a smaller degree.
Goldman Sachs Global Investment Research 7 June 28, 2010 United States: Financial Services
Payment Processors: We believe that the financial impact of interchange legislation would be marginal for MA and V at 1%-2% of earnings. Even to get to these levels of earnings impact, one needs to make some assumptions about the potential impact of interchange legislation, including a 50% reduction in expected US debit growth. As things currently stand, we believe that MA and V remain on track on for average earnings growth of 22% in CY10 and 20% for CY11.
Rating Agencies: We view the prospective impact for the credit rating agencies from the financial reform bill to be relatively modest and therefore a positive for both MCO and MHP (both Neutral rated). Recall from our framework, that we see three separate facets of reform risk: (1) Compliance and oversight; (2) Legal liability standards; and (3) Business model risk (see our February 8 and May 27 reports). Here we summarize the likely final reform vs. discussed proposals:
Compliance and oversight – The biggest potential impact and possible overhang for the rating agencies will be a 2 year study to be performed by the SEC, with a focus on conflicts of interest in the “issuer-pay” business model. Outside of this study, new compliance and disclosure requirements have largely been implemented by the industry at a cost that we estimate will range between 100-300bp on operating margins. Also, a provision that would allow the SEC to remove NRSRO designation from any rating agency for poor ratings has been included in the bill. We view this as a modest risk but note that removal of the license would not preclude an agency from rating debt but would instead limit that debt from qualifying for capital requirements (bank or insurance companies).
Legal liability standards – As we highlighted post our dinner with MCO management, the lowering of pleading standards to negligence (instead of fraud-based) hurdle seemed likely. In the future, lawsuits may be successful if it can be proved that the agencies were “knowingly reckless” instead of acting with “malice or intent” to misrepresent information. As a result, both MCO and MHP will have increased liability, which may add both explicit and implicit costs to the ratings process (due diligence / head count or fewer ratings issued).
That said, we believe these risks are largely embedded in valuation and separately, that MCO and MHP may be able to pass along certain costs through higher fees. Additionally, we believe the rating agencies can add disclosure to insulate risk through a change in distribution (e.g. closed channel “email” vs. press release). As it pertains to legal risk, we believe the outstanding lawsuits still represent the key risk for MCO and MHP (Abu Dhabi, CalPERS, OH, CT). It is important to note that MCO believes the new legal standards may not be applied retroactively and would not be applicable in these cases.
Business model risk – For the time being, both the Franken and Lemieux-Cantwell amendments have been dropped from the final bill. We view this as a near-term positive and indicative of the challenge in implementing sweeping changes to the conventions for issuing debt. The window for business model change remains open given the two-year SEC study. In fact, at the end of the study, the rating agencies will be subject the Franken amendment, or government assignment for the initial rater for structured product issues if a better alternative cannot be developed. Recall, the Lemieux-Cantwell amendment proposed the elimination of references to credit ratings from statutory rules and regulations (such as FDIC and SEC). We view the SEC study as a modest overhang but would not view the Franken amendment a significant negative if eventually implemented.
Goldman Sachs Global Investment Research 8 June 28, 2010 United States: Financial Services
Volcker: Directionally similar – positive for alternatives and a hit to prop trading
Current legislation is directionally the same as previously proposed in regards to proprietary trading, hedge fund and private equity investments. On the margin the current legislation seems slightly better for banks’ that have investments in hedge funds and private equity, while being slightly less positive for proprietary trading.
Banks’ can organize fund investments and offer investors participation in hedge funds and private equity only if the entity:
• Offers trust, fiduciary or investment advisory services
• Does not have an ownership interest that exceeds 3% of the total fund, or an investment greater than 3% of Tier 1 capital.
• Does not guarantee or insure the obligations or performance of the hedge fund or private equity fund.
• Does not share the same name or variation of the same name
The proprietary trading proposal on the margin is more restrictive than the previously thought. A few examples pertain to the purchase and sale of municipal bonds and risk mitigating hedging activities.
While uncertainty still looms over what banks’ will be unable to do, a few broad points include:
• Transactions that include “a material conflict of interest” between the banking entity and its clients, customers or counterparties
• Transactions which would result directly or indirectly in “material exposure to high-risk assets or high-risk trading strategies”
• Transactions which pose a threat to the “safety and soundness” of the banking entity or the “financial stability of the United States”
The material conflict of interest clause leaves wide room for interpretation and hence the impact is uncertain. Furthermore, regulators can “adopt rules imposing additional capital requirements and quantitative limitations” where allowable trading activities can jeopardize the safety and soundness of the banking entity.
The Volcker proposal as currently outlined will become effective no later than two years from enactment with all trading and investing activities required to be in compliance no later than two years thereafter. The compliance period can be extended one year at a time for up to three years, ultimately giving firms approximately four years to adjust to the proposal and up to seven years in certain instances. In addition, this timeline may be even more extended.
Exhibit 3: Banks’ exposure to alternatives needs to shrink… but over the next ~ five years as disclosed in company filings
Source: Company filings, Goldman Sachs Research
Goldman Sachs Global Investment Research 9 June 28, 2010 United States: Financial Services
Derivative legislation: swap push-out and clearing/trading clarity begins to emerge
Key to the financial reform, in our view, are rules governing derivatives registration, trading, and clearing. These rules aim to improve transparency, risk management and distribution, and capital and margin requirements. In general, we view the proposed changes as positive for exchanges, inter-dealer brokers, and execution facility based firms, and neutral to incrementally negative for banks that make derivative markets.
Three main components of the Derivative legislation 1. Swap Push Out: certain swap businesses will likely be forced out of the bank and into a separately capitalized subsidiary;
2. Clearing: regulators will specify which OTC (over-the-counter) derivative instruments will require clearing; for OTC products not forced into a clearing house, the posting of initial margin will still be required;
3. Trading – transactions in OTC derivatives will be required, where possible, to occur on exchange or in an alternative execution facility (ASEF), and to post timely publication of trading information.
Setting the stage for the OTC swap market The push to improve transparency, trading, and risk management was driven by the growth in OTC markets. Since 1999, open interest (defined as gross notional value outstanding) within OTC swaps has grown at a 23% CAGR. As of December 2009, the gross value of open interest, as tracked by the Bank for International Settlements, was $615tn, compared with $88 tn at the end of 1999. Current composition is dominated by interest rates (73% of total) and F/X contracts (8% of total). Over the past five years, however, growth has been dominated by CDS contracts (at $33 tn, 39% 5-year CAGR) and Interest Rate Products (at $450 tn, and a 19% CAGR).
Exhibit 4: Open interest in OTC markets is $615 tn Exhibit 5: The OTC market is five times the size of the Listed markets $ in tn OTC vs exchange listed notional value/market capitalization ($mn) 700,000 614,674 OTC vs Listed Market Size ($ mn) 600,000 OTC open interest 500,000 is 5X Listed Markets 400,000
300,000
200,000 122,285 100,000
- OTC Exchange-traded
Source: BIS, Goldman Sachs Research. Source: BIS, World Federation of Exchanges, Goldman Sachs Research.
Goldman Sachs Global Investment Research 10 June 28, 2010 United States: Financial Services
Swap push out: Rates, F/X, investment grade CDS in; Energy, Ags, high yield CDS out The final version of the reform package modified the Lincoln amendment, essentially creating a set of OTC based products into two groups; those that can continue to trade within the bank holding company and those that must be separated. We believe those products that were viewed as core to a bank’s business were allowed to remain, while less core products may be required to move into a new affiliate with separate capitalization from the bank. Moreover, the products that were excluded are generally viewed as riskier, even if they are of a significantly smaller size than the IRS and F/X products. The vast majority of swaps will be able to stay; according to FDIC data, US commercial banks hold a total of $218 trillion in derivatives, of which $182 tn (90%) is interest rate derivatives, $19tn is FX derivatives, $14 tn is credit derivatives, $1.6 tn is equity, and $0.9 tn is other. As interest rate derivatives, FX derivatives and cleared CDS can stay within the bank, a very small percent of the total (around $15 tn at a maximum) will need to be “pushed out”.
Exhibit 6: Interest Rates and F/X headline the swaps kept in the bank, while Exhibit 7: The notional value outstanding of swaps kept in the bank is more commodities and equity swaps will likely move to a swap subsidiary than 30X the notional value excluded from the bank $ in tn $ in tn Seperation of OTC products $600 Notional Notional $514.5 Outstanding Outstanding $500 Kept 'in' the bank ($ tn) Swap Subsidiary ($ tn) $400 Interest Rates 449.8 Commodities (Energy, Ags) 2.4 Currency (F/X) 49.2 Equity 6.6 $300 Precious metals (Gold/Silver) 0.5 High Yield/ABS CDS 7.0 High Grade CDS (cleared) 14.9 $200 Total (in-bank) 514.4 Total (excluded to subsidiary) 16.0 $100 $16.0 $0 In-bank Subsidiary
Source: Bank for International Settlements, Goldman Sachs Research. Source: BIS, WFE, Goldman Sachs Research.
The subsidiary/affiliate that will be created will need to separate capitalization, though the level of that capitalization has not yet been determined and could change. The actual level of capitalization will likely be based on the risk of the products and perceived downside as well as the duration of the swaps included in the subsidiary. The push out will likely have a bigger impact on firms where derivative trading occurs within the bank (at most of the traditional commercial banks) versus a subsidiary (at most of the traditional broker dealers).
Capital is already held against many swaps books, generally, as is margin in some cases for riskier clients (smaller hedge funds) and riskier products (ABS, CDS). In general, margin is calculated utilizing both VaR calculations of potential loss as well as liquidity, product analysis, and other risk-based metrics. It is important to bear in mind that many dealer swaps books are largely hedged with long and short swap positions over a normal time period, though intraday and in short periods, long or short positions are hedged with exchange based futures and options.
Moving the equity, commodity, and high yield CDS swaps into a separate subsidiary was driven by the desire to ensure deposit taking institutions ring fence their swaps book from their bank so any loss issue in those swaps would not impact the deposits of its clients. Thus, we believe the capital requirements will exceed the well-capitalized threshold (Tier 1 risk-based capital of 6.0%), and could likely be based on a net asset position after offsetting long/short swap positions, though this will be decided by regulators.
Goldman Sachs Global Investment Research 11 June 28, 2010 United States: Financial Services
In the exhibit below we demonstrate where banks currently house their swaps business. Among covered companies, Morgan Stanley is the only bank with the majority of their swaps already housed in subsidiaries. We note that the below represents notional amounts of derivatives, which may not be representative of the allocation of risk and capital requirements.
Exhibit 8: Dealers reliance on subsidiaries for OTC market making Notional OTC derivates outstanding at 4Q 2009
80 Subsidiaries 70 Bank Holding co.
60
50
40
30 Notional Amount Amount ($Tn) Notional 20
10
- JPM BAC MS C
Source: Office of Comptroller of Currency
Capital requirements are uncertain for the new swap subsidiaries and future profitability is unclear, owing to questions regarding the correct amount of capital and ability to earn historical spreads. One concern surrounding the new structure is that some investors may be reluctant to trade with counter parties that do not have access to the Federal Reserves’ discount window or the FDIC. However, we believe this is a non-issue as it is already being done in practice as both Morgan Stanley and Bank of America already have a significant portion of their OTC swap business in subsidiaries. Moreover, swap entities will still have access to broad- based programs under the Fed’s Section 13-3 authority.
Goldman Sachs Global Investment Research 12 June 28, 2010 United States: Financial Services
Clearing: centralizing the risk should benefit exchanges with clearing capabilities Throughout the reform process, one initiative received broad support from both chambers of Congress: OTC contracts where possible should move into a cleared environment. The shift into clearing would centralize the risk into a few clearing houses, which would help regulators and market participants increase transparency in the market and collect initial and variation margin on the OTC derivatives not previously cleared. The concept of a clearing house is for a central party to be the counterparty to every trade, guaranteeing each side of a trade their position would be made whole even in the event of a default by one party. This is accomplished by collecting initial margin for each trade based on liquidity and risk, and then replenishing the margin required (which could change with changing macro and micro variables) with variation margin triggers.
Swaps dealers have been actively pursuing clearing for certain OTC products already, namely global CDS and dealer-to-dealer interest rate swaps. For CDS, the Intercontinental Exchange has become the dominant provider of clearing, while in IRS, LCH Clearnet’s SwapClear product is the clearing vehicle for dealer-to-dealer trades.
Over the past year and a half (since 1Q09), ICE Trust has cleared over 9.5 tn (USD) in notional CDS, in both Index and Single name CDS products, in US and in Europe. The rapid adoption of this clearing house as the standard within the industry – nearly 1/3rd of total CDS outstanding is cleared at ICE Trust in the U.S. and Europe – suggests that as other OTC products are moved into a clearing house, the adoption rate could be more rapid than initially assumed.
Exhibit 9: CDS clearing has grown to $9.5 tn from $0 in less than 1.5 years, and is almost 1/3rd through total CDS portfolio $ in mn
Open Interest ($ mn) Volume ($ mn) US Index US Single Name EU Index EU Single Name Total OI US Index US Single Name EU Index EU Single Name Total Volume 1Q09 6,041 6,041 44,906 44,906 2Q09 178,695 178,695 1,287,058 1,287,058 3Q09 186,999 59,966 246,965 910,639 656,354 1,566,992 4Q09 231,055 500 109,760 263 341,578 1,057,662 1,253 637,545 2,001 1,698,461 1Q10 262,880 49,337 124,564 159,200 595,981 1,254,189 93,682 922,262 219,028 2,489,161 2Q10TD 267,208 140,164 135,047 344,147 886,567 1,267,298 144,525 862,001 232,027 2,505,851 To Date 267,208 140,164 135,047 344,147 886,567 5,821,752 239,461 3,078,162 453,055 9,592,430 2Q10/1Q10 2% 184% 8% 116% 49% 1% 54% -7% 6% 1%
Source: Company data, Goldman Sachs Research.
Similar to other OTC and derivative products, there is a robust dealer-to-dealer market for interest rate swaps and a similar business for dealer-to-client activity. For about a decade, dealer-to-dealer interest rate swap activity has been cleared by a facility of the London Clearing House (LCH), SwapClear. As of year-end 2009, SwapClear had $215 tn in notional interest rate swap derivatives in its clearing house, accounting for nearly half of the global IRS market and, likely all off clearable IRS products (excluding bespoke products, basis swaps, and other difficult to clear products). Growth has been substantial in both cleared open interest and trading (up 35% in 2009 over 2008), a trend we believe continues industry wide as client clearing becomes a focus over the next few years. SwapClear, along with CME and NDAQ, have announced plans to service the dealer-to-client markets with FCM (futures commission merchant) products, and we believe it is likely market share will distribute to all three exchanges and clearing houses.
Goldman Sachs Global Investment Research 13 June 28, 2010 United States: Financial Services
Exhibit 10: Notional open interest at SwapClear (dealer-to-dealer IRS) has Exhibit 11: Trading activity has increased each year since inception at reached $215 tn, or about 48% of global IRS positions SwapClear, even in 2009 after a robust and volatile 2008 $ in tn $ in mn
Transactions up 35% YoY $250 Open interest was $215 tn at $350,000 year-end 2009, about 48% of global IRS notional value 307,039 $300,000 $200
$250,000 228,139 $150 $200,000
$100 $150,000 140,886
$100,000 88,057 $50 70,732
$50,000 $0
$0 Jul-05 Jul-06 Jul-07 Jul-08 Jul-09 Apr-05 Oct-05 Apr-06 Oct-06 Apr-07 Oct-07 Apr-08 Oct-08 Apr-09 Oct-09
Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 2005 2006 2007 2008 2009E
Source: LCH, Goldman Sachs Research. Source: LCH, Goldman Sachs Research.
Global exchanges and clearing houses have either already started to pursue the remaining opportunities for clearing OTC or will begin to offer services to address this market. We estimate the potential revenue pool for global OTC clearing could approach $1.5 bn over time, once products have been loaded into exchanges and the initial processing period has passed. We looked at turnover in derivative products, potential revenue per transaction (used a $/mn notional estimate), and the size of the notional value outstanding to estimate the revenue opportunity.
Exhibit 12: We estimate the opportunity for exchanges to clear swaps could Exhibit 13: Many global exchanges/clearing houses are addressing the reach $1.5 bn clearing opportunity for swaps $ in mn Total revenue opportunity ($ mn) Exchange/Clearing House Initiatives Company Product Desciption CDS Clearing $200 - $300 ICE CDS ICE Trust US & EU are the dominant CDS clearing houses, now targeting dealer-to-client CME Interest Rate Swaps Has indicated its IRS platform will launch by 2H10 U.S. Client IRS $200 - $600 CDS Launched a CDS clearing house in 2009, now targeting dealer-to-client but limited success to date NDAQ Interest Rate Swaps IDCG is targetting the IRS opportunity and is shadow clearing over $3 tn in EU Client IRS $200 - $400 notional swaps LCH Clearnet Interest Rate Swaps The dominant dealer-to-dealer clearing house globally, now targeting dealer F/X Swaps $100 - $200 (SwapClear) client in EU and US NYSE Interest Rate Swaps The NYPC (NY Portfolio Clearing) initiative will target I/R futures, but could attempt to clear IRS if that initaitive is successful Total OTC Clearing Opportunity $700 - $1,500
Source: Goldman Sachs Research estimates. Source: Goldman Sachs Research.
Goldman Sachs Global Investment Research 14 June 28, 2010 United States: Financial Services
We estimate initial margin requirements will be fairly substantial, even after notional values are compressed to more manageable net exposures. Gross exposure of OTC derivatives can likely be compressed by up to 90%, as offsets, tear-ups, and offsetting trades minimize the actual outstanding level of risk. We estimate initial margin for CDS contracts will reach $75 bn, while U.S. clients could face up to $547 bn in margin requirements over time, reached assuming the level of IRS remains near current levels and initial margin requirements for IRS are 1-3% of net notional. However, it is important to bear in mind that the level of OTC notional value outstanding could trend lower over time should institutions transition some swap usage to exchange traded product, or the speculative trading in certain products decline amid Volcker Rule limitations or capital constraints.
Exhibit 14: Interest rate initial margin requirements could reach $547 bn over Exhibit 15: While CDS margin requirements could be $75 bn after whatever time when the full complement of IRS has been loaded into a clearing house product is possible is loaded into clearing houses, including ICE Trust Interest Rate Margin Estimates for U.S. Clients ($ bn) CDS Market Summary ($ in bn) Less than 1 Between 1-5 Duration Year Years Over 5 Years Total Dealer to Dealer Dealer to Client Client to Client Total Total Interest Rate OTC Global Market ($ bn) 179,994 134,282 135,517 449,793 Single Name 12,167 2,735 24 14,927 % of total 40% 30% 30% 100% Index 4,455 2,929 3 7,386 U.S. denominated swaps, % of total 34% Tranched 2,568 130 0 2,698 U.S. denominated swaps, in $ bn 61,369 45,784 46,205 153,358 Gross Exposure Outstanding 19,190 5,794 27 25,011 % of original interest rate swap notional value 34% 34% 34% 34% Estimated Compression 95% 75% 75% 90% Transaction Type Dealer-to-Dealer 60% Net Exposure Dealer-to-Client 25% Single Name 602 670 6 1,279 Non-Clearable (bespoke, option, basis) 15% Index 221 718 1 939 Dealer-to-Client summary of notional exposure ($ bn) 15,342 11,446 11,551 38,340 Tranched 127 32 0 159 % of original interest rate swap notional value 9% 9% 9% 9% Net Exposure Outstanding 950 1,420 7 2,377 Estimated Compression (netting, tear-ups) 25% U.S. estimated Exposure 40% 40% 40% 40% Net Exposure 11,507 8,584 8,663 28,755 Net U.S. exposure (estimate) 380 568 3 951 % of original interest rate swap notional value 6% 6% 6% 6% Initial Margin required for U.S. firms (% of net, est) 5% 10% 10% 8% Initial Margin required for U.S. denominated Swaps (est) 1.0% 2.0% 3.0% 1.9% Initial Margin required for U.S. firms ($ bn, est) $19 $56 $0 $75 Initial Margin required for U.S. firms ($ bn, est) $115 $172 $260 $547
Source: Goldman Sachs Research. Source: Goldman Sachs Research.
Trading: bringing transparency to markets through electronic trading and SEFs Complementing the clearing initiatives within the reform act, language is also present to drive increased levels of transparency in trading OTC derivatives. Specifically, the proposed bill defines a ‘swap execution facility’ (SEF) as a platform in which multiple participants have the ability to execute or trade swaps by accepting bids and offers made by other participants. An SEF can be a designated contract market (such as a futures exchange) or not (such as inter-dealer brokerage platforms), and there may be certain swaps that may not be required to trade through an SEF, based on liquidity and level of standardization.
The reform also highlights a swap execution facility will need to ‘make public timely information on price, trading volume, and other trading data’. Increasing the level of price and volume transparency may lead to tighter bid/ask spreads, improving performance for the purchaser, and reducing the profitability per trade for the swap dealer.
However, tighter spreads and increased transparency may improve market depth and experience for small-volume trades; however, larger block trades (common in OTC swap trading) could see a reduction in liquidity as dealers may be unwilling to commit to a trade given transparent bids/offers to all market participants. While we believe certain exceptions will be created to ensure both
Goldman Sachs Global Investment Research 15 June 28, 2010 United States: Financial Services
small and large orders have a higher likelihood of being completed, forcing near real time pricing on all swaps bids and offers could negatively impact volume, as well as profitability for dealers as they back away from some of these transactions.
In 2002, FINRA approved the TRACE (Trade Reporting and Compliance Engine) that facilitated the reporting of OTC secondary market transactions in certain fixed income securities, largely investment grade bonds, to improve transparency and help to improve the quality of executions. Bid-Ask spreads in corporate bonds fell post the implementation of TRACE, however, we note that volume in corporate bonds fell from 2003 to 2008, as increased levels of trading shifted to CDS, and the profitability of corporate bond trading declined. While TRACE is not a perfect corollary to the financial reform initiatives, it is possible volume in certain products could decline if profitability declines for dealers and traders, or certain volumes migrate to other similar products such as exchange traded derivatives, which are likely to have more liquidity for short term hedging and exposure.
Exhibit 16: TRACE reporting (implemented in 2002) was likely one contributor to lower corporate bond trading volumes, along with a migration to CDS from cash bonds, though that trend reversed in 2009 $ in mn, average daily trading volume of high-grade corporate bonds
14,000
12,151 12,000 11,504 Cash bond trading improved in 11,483 2009 as traders shifted away from derivatives back to cash products 10,000 9,349 9,218 8,908 8,218 8,000
6,000
4,000
2003 2004 2005 2006 2007 2008 2009
Source: TRACE, BondTicker, Goldman Sachs Research.
Goldman Sachs Global Investment Research 16 June 28, 2010 United States: Financial Services
Capital requirements: TruPS to be phased out from Tier 1, but more regulation to come
Most of the discussion around capital in the final bill was around the treatment of trust preferred securities (TruPS). The final language was slightly less restrictive than the original, as the phase-in period is longer and some banks are excluded from the new rules. The committee agreed that banks with less than $15 bn of assets can continue to include existing (but not any newly issued) TruPS in their Tier 1 capital base. However, for banks with more than $15 bn in total assets, there will be a phase out period of three years beginning in 2013. Looking at banks over $15 bn in assets, we estimate that roughly $100 billion in qualifying trust preferred securities would need to be refinanced over the phase out period in order to maintain current Tier 1 capital ratios. See Exhibit 17. In addition, the final bill contained some broad language suggesting that large, complex banks will need to maintain a significant level of capital in the future.
Exhibit 17: Current Qualifying TruPS for banks over $15 bn $100 billion re-financing risk
Qualifying Total Tier 1 TruPS as % Current Tier Pro Forma Ticker Total Assets Name TruPS Capital Tier 1 1 Ratio Tier 1 Ratio
Bank of America Corporation BAC 2,338,700 20,244 155,428 13% 10.2% 8.9% JPMorgan Chase & Co. JPM 2,135,796 19,288 131,350 15% 11.5% 9.8% Citigroup Inc. C 2,002,213 15,930 120,050 13% 11.3% 9.8% Wells Fargo & Company WFC 1,223,630 13,307 98,329 14% 9.9% 8.6% U.S. Bancorp USB 282,428 5,216 23,278 22% 9.9% 7.7% PNC Financial Services Group, Inc. PNC 265,396 4,209 22,905 18% 10.3% 8.4% Bank of New York Mellon Corporation BK 220,551 1,667 13,426 12% 13.3% 11.6% Capital One Financial Corporation COF 200,708 3,549 11,511 31% 9.6% 6.6% SunTrust Banks, Inc. STI 171,796 2,452 17,853 14% 13.1% 11.3% BB&T Corporation BBT 163,700 3,508 13,657 26% 11.6% 8.6% State Street Corporation STT 153,971 1,450 12,335 12% 18.0% 15.9% Regions Financial Corporation RF 137,230 846 11,701 7% 11.7% 10.8% Fifth Third Bancorp FITB 112,651 2,763 13,297 21% 13.4% 10.6% KeyCorp KEY 95,303 1,791 10,772 17% 12.9% 10.8% Northern Trust Corporation NTRS 76,319 268 6,631 4% 13.4% 12.8% M&T Bank Corporation MTB 68,439 1,147 5,614 20% 8.9% 7.1% Comerica Incorporated CMA 57,106 495 6,311 8% 10.4% 9.6% Marshall & Ilsley Corporation MI 56,569 101 5,173 2% 11.1% 10.9% Huntington Bancshares Incorporated HBAN 51,867 570 5,090 11% 12.0% 10.6% Zions Bancorporation ZION 51,713 447 5,467 8% 11.2% 10.3% New York Community Bancorp, Inc. NYB 42,431 412 3,424 12% 14.3% 12.5% Popular, Inc. BPOP 33,832 814 2,426 34% 9.5% 6.3% Synovus Financial Corp. SNV 32,439 10 2,495 0% 9.7% 9.6% First Horizon National Corporation FHN 25,924 300 3,485 9% 16.6% 15.1% BOK Financial Corporation BOKF 23,502 7 1,923 0% 11.5% 11.4% Associated Banc-Corp ASBC 23,108 205 2,366 9% 16.4% 15.0% First Citizens BancShares, Inc. FCNCA 21,216 265 1,854 14% 13.8% 11.8% East West Bancorp, Inc. EWBC 20,299 156 2,036 8% 18.9% 17.5% City National Corporation CYN 20,066 252 1,586 16% 11.4% 9.6% Astoria Financial Corporation AF 20,061 129 1,374 9% 11.8% 10.7% First BanCorp. FBP 18,851 225 1,605 14% 12.0% 10.3% TCF Financial Corporation TCB 18,187 127 1,369 9% 10.0% 9.1% Webster Financial Corporation WBS 18,025 232 1,506 15% 12.5% 10.6% Cullen/Frost Bankers, Inc. CFR 16,761 132 1,381 10% 12.7% 11.5% First National of Nebraska, Inc. FINN 16,551 150 1,226 12% 10.0% 8.8% Fulton Financial Corporation FULT 16,412 179 1,556 11% 12.2% 10.8% Total 102,841 721,791 14% 11.0% 9.4%
Source: SNL Financial, Goldman Sachs Research.
Goldman Sachs Global Investment Research 17 June 28, 2010 United States: Financial Services
This section was Credit View: The removal of TruPS from Tier 1 capital ultimately increases the quality of capital, which is a clear benefit to prepared by Louise Pitt bondholders, and recently added grandfathering provisions for existing TruPS makes implementation more manageable. The proposed phase-in is likely to result in liability management transactions as banks look to replace TruPS with other forms of capital such as common equity or preferreds.
The headlines of regulatory reform, even if not the implementation, are close to being behind us, however, Basel III discussions are just getting started. As noted on Discover’s 2Q earnings call, management is even more concerned about Basel III than the proposed reform bill. The intentions of higher quantity and quality of capital are again clear long term positives for bondholders. With that being said, deliberations on timeline and the potential cost of capital for certain businesses will create spread volatility. We have already seen changes with recent reports on the removal of the proposed net stable funding ratio and a reduction of the amount of liquid assets required to be held by banks. In our view, the US is further along in its reform of the banking sector than many European countries and is likely to keep global negotiations focused on these issues.
Resolution Authority: in-line with prior proposal, but still poses some risk to credit ratings
Language around the Resolution Authority did not change much from the original Senate Bill. The ratings methodology of S&P and Moody's includes uplift to ratings due to assumed support from governments in a stress scenario. Resolution Authority gives the FDIC power to unwind failing financial firms and explicitly bars the use of taxpayer funds to rescue them. Thus, the rating agencies have stated that lower ratings could result given increased risk of bondholder losses in a stress scenario.
This is one of the most significant issues for bondholders. Additional clarity on the overall bill means that investor attention may turn back to the potential actions taken by rating agencies. Resolution Authority is also a long term positive for creditors but should cause investors to differentiate between strong and weak credits. We think the likelihood of downgrades due to the removal of systemic support is well understood by the market, however, will likely be a source of volatility. Remarks by the rating agencies have stressed that individual firm profitability and the macroeconomic environment will be a driver in their analysis. Important items of note are that the passing of the bill will not likely have immediate ratings implications, not all support assumptions will be removed and the evaluation could continue throughout 2010 and potentially into 2011. We think BAC and C are the most likely to be impacted as their ratings currently benefit from the most notches of uplift among the money center banks.
While we recognize the risk of downgrades, there are some potential offsets that make the potential funding issues less concerning: (1) banks’ capital and liquidity have improved, (2) short-term funding is 17% of total funding and has shrank 37% since 3Q2007, and (3) cash on balance sheets is high.
Goldman Sachs Global Investment Research 18 June 28, 2010 United States: Financial Services
Exhibit 18: Current credit ratings
Moody's S&P Long Term Long Term Holdco Rating Bank Rating Short Term Rating Long Term Rating Short Term Rating Notches Notches Notches Senior of Uplift Senior of Uplift Holdco Bank Outlook Holdco Bank of Uplift Holdco Bank Outlook BAC A2 4 Aa3 5 P-1 P-1 Stable A A+ 3 A-1 A-1 Negative COF Baa1 0 A2 1 NA P-1 Negative C A3 3 A1 4 P-1 P-1 Stable A A+ 3 A-1 A-1 Negative JPM Aa3 1 Aa1 2 P-1 P-1 Negative A+ AA- 0 A-1 A-1+ Negative MS A2 2 A1 2 P-1 P-1 Negative A A+ 3 A-1 A-1 Negative PNC A3 0 A1 1 NA P-1 Stable WFC A1 3 Aa2 4 P-1 P-1 Stable AA- AA 0 A-1+ A-1+ Negative
Source: S&P, Moody’s.
FDIC Assessment will be spread across a large number of financial firms and hedge funds
One of the biggest surprises to the final bill was the last-minute addition of a $19 bn assessment (expected to be collected annually between 2012 and 2015) through the FDIC on financial firms with assets over $50 bn (including both Banks and Insurance Companies), and hedge funds over $10bn, which will be deposited with Treasury. This provision was added to offset the estimated cost of the bill, which was due in large part to the resolution authority and various administrative responsibilities created by the bill. There are still many uncertainties on how this cost will be distributed across the firms, and is expected to be scaled by riskiness. The bill leaves many unanswered questions as it currently lacks clarity on the split between banks and hedge fund managers, measures used to assess risk, and a more precise definition of hedge funds to be included. In particular, it is unclear if the assessment will extend to fund-of-funds, “hybrid” hedge funds or other alternative investment vehicles. We assume that the fee will be assessed with a 75/25 split between banks and other financial service firms including hedge funds, paid over the period of four years starting in 2012. For the banks we estimate an average reduction in normalized earnings of 2%, taking the conservative stance that banks over $50bn in assets ultimately foot 75% of the $19 billion bill owing to their relative importance as a source of credit for households and businesses.
Goldman Sachs Global Investment Research 19 June 28, 2010 United States: Financial Services
Exhibit 19: Impact to normalized earnings by bank assuming banks pay 75% of the $19 bn regulatory bill
GS-covered Banks with Assets > $50 bn Annual Total Assets Total Asset Implied Per Share Normalized % of Name Ticker (bn) Weight * Charge (mn) Impact EPS Normalized
Bank of America Corporation BAC 2,339 20% 704 0.05 2.40 2% JPMorgan Chase & Co. JPM 2,136 18% 643 0.10 6.50 2% Citigroup Inc. C 2,002 17% 603 0.01 0.55 2% Wells Fargo & Company WFC 1,224 10% 368 0.05 4.35 1% Morgan Stanley MS 820 7% 247 0.10 3.90 3% U.S. Bancorp USB 282 2% 85 0.03 2.85 1% PNC Financial Services Group, Inc. PNC 265 2% 80 0.10 6.80 2% Bank of New York Mellon Corporation BK 221 2% 66 0.04 3.13 1% Capital One Financial Corporation COF 201 2% 60 0.09 5.00 2% SunTrust Banks, Inc. STI 172 1% 52 0.07 3.50 2% BB&T Corporation BBT 164 1% 49 0.05 3.35 1% State Street Corporation STT 154 1% 46 0.06 4.50 1% American Express Company AXP 143 1% 43 0.02 3.70 1% Regions Financial Corporation RF 137 1% 41 0.02 0.80 3% Fifth Third Bancorp FITB 113 1% 34 0.03 1.60 2% KeyCorp KEY 95 1% 29 0.02 1.00 2% Northern Trust Corporation NTRS 76 1% 23 0.06 4.65 1% Discover Financial Services DFS 62 1% 19 0.02 2.10 1% Hudson City Bancorp, Inc. HCBK 61 1% 18 0.02 1.30 2% Comerica Incorporated CMA 57 0% 17 0.07 4.45 2% Marshall & Ilsley Corporation MI 57 0% 17 0.02 0.75 3% Huntington Bancshares Incorporated HBAN 52 0% 16 0.01 0.75 2% Zions Bancorporation ZION 52 0% 16 0.07 2.70 2%
Banks 11,833 100% 3,563 2% Other Financial Companies 1,188
Total Annual Cost 4,750 x 4 years = $19 billion
* Weight relative to banks over $50 bn in assets
Source: Goldman Sachs Research estimates
We expect hedge funds and other financial firms, including insurance, to pay the remaining 25% of the total. Given the number of companies this fee will be spread across, we expect the impact on earnings to be manageable. As of the end of 2009, there were about 43 firms with $10 billion or more in hedge fund AUM, accounting for $717 billion in assets. This includes banks such as JP Morgan ($45 bn in total hedge fund AuM), traditional managers such as BlackRock ($17 bn) and Wellington ($12 bn), and public alternative firms such as Och-Ziff. Within our asset management coverage, we believe Och-Ziff will be among the public managers most impacted by the regulation, followed by BlackRock to a smaller degree. For the Insurance industry, the size of the fee will be likely be determined by a risk metric in addition to size. Below we show the largest insurance companies ranked by assets.
Goldman Sachs Global Investment Research 20 June 28, 2010 United States: Financial Services
Exhibit 20: Insurance companies with greater than $50bn in assets account for over 30 companies with $5.6 trillion in assets Data in $ millions
Rank Company Name $mn Rank Company Name $mn Rank Company Name $mn 1 American International Group, Inc. 863,697 12 Northwestern Mutl Life Ins Co. 168,165 23 Aflac Incorporated 85,178 2 MetLife, Inc. 565,566 13 AXA 143,840 24 Jackson National Life Group 81,726 3 Prudential Financial, Inc. 491,861 14 Principal Financial Group, Inc. 140,837 25 ACE Limited 79,329 4 Hartford Financial Services Group, Inc. 317,282 15 Massachusetts Mutual Life Ins 134,533 26 Allianz SE 76,905 5 Berkshire Hathaway Inc. 356,320 16 Allstate Corporation 132,386 27 Liberty Mutual Holding Co. 66,319 6 TIAA Board of Overseers 219,383 17 State Farm Mutual 124,547 28 Sun Life Financial Inc. 62,186 7 Manulife Financial Corp. 218,379 18 Ameriprise Financial, Inc. 122,377 29 Zurich Financial Services Ltd 62,105 8 New York Life Insurance Group 203,820 19 Travelers Companies, Inc. 108,696 30 CNA Financial Corporation 55,679 9 AEGON NV 181,317 20 Genworth Financial, Inc. 109,093 31 Unum Group 54,997 10 ING Groep N.V. 179,945 21 Pacific MHC 98,518 32 Chubb Corporation 50,870 11 Lincoln National Corporation 181,621 22 Nationwide Financial Services 94,600 Total 5,650,455
Note: Assets are 1Q 2010 where available, otherwise 2009 Includes US insurance company assets of foreign companies
Source: SNL, Goldman Sachs Research.
Debit Interchange – toward a “reasonable and proportional” world of debit
Final language around the Durbin Amendment, which aims to cap debit interchange fees, ended up slightly less restrictive than the original bill. The key changes were
Definition of “interchange transaction fee” has been toned down to refer to the just the interchange that is received by the card issuer and would not refer to the network fees charged by the networks (MasterCard and Visa).
Interchange fees would be regulated after factoring costs under a broader definition – Regulators would still have the power to regulate interchange fees, but card issuers would be able to charge fees related to the management and prevention of fraud, reducing the possibility of drastic interchange reductions that many were anticipating.
Longer-term, the risk is to volumes and not the economic model. If interchange reductions reduce the profitability of card issuers, they will likely have to reevaluate their business models to offset this reduction through the restructuring of their reward programs and fee structures. This could result in lower end-usage by the consumer and could ultimately result in a reduction in credit/debit card volumes. Next steps...
The Federal Reserve Board will be mandated to issue rules not later than nine months after the date of enactment of the Consumer Financial Protection Act of 2010 to establish standards for assessing whether the amount of any interchange transaction whether the amount of any interchange transaction fee is reasonable and proportional to the actual cost incurred by the issuer or payment card network with respect to the transaction.
Goldman Sachs Global Investment Research 21 June 28, 2010 United States: Financial Services
The Federal Reserve Board is mandated to consult with a number of government agencies including the Comptroller of the Currency, the Board of Directors of the Federal Deposit Insurance Corporation, the Director of the Office of Thrift Supervision, the National Credit Union Administration Board, the Administrator of the Small Business Administration, and the Director of the Bureau of Consumer Financial Protection (expected to be created with the passing of the financial reform bill), in issuing rules and standards for the setting of interchange.
Exhibit 21: Key provisions of the final interchange amendment
Key provisions of interchange amendment Explanation
"Interchange fee" refers to part of merchant discount rate received by issuer. Network fees do not 1. Definition of interchange fee clarified form part of this definition.
Government administered cards and Does not come as a suprise as most government entities receive the lowest interchange. Exemption of 2. prepaid cards are exempt prepaid incentivizes growth in the prepaid product.
Interchange will be regulated after Card issuers would be include fees related to the management and prevention of fraud within 3. factoring costs "interchange fee".
Discounting between card networks has 4. Beneficial to networks as merchants would not be able to promote one card over another. been eliminated
Elimination of exclusivity agreements 5. Merchants will be able to choose between atleast two networks through which to route a transaction. between issuers and network providers.
Discounting / minimums for payment are Merchants can provide a minimum amount required for a transaction, but it can not exceed $10 6. allowed initially. Discounting is also permitted for use of alternative payment types.
No discrimination between cards issued by Eliminates some concern for banks with assets less than $10 bn who would have been placed at a 7. different banks disadvantage against larger issuers with lower interchange levels.
Authority for regulation rests with the Positive for issuers and networks, as the Fed is seen as the most rational body to have oversight of this 8. Federal Reserve Bank regulation.
Source: Senate, House of Representatives
Interchange levels are rates set by networks (MA and V) for the use of a payment system by consumers and merchants; they are a revenue stream for issuers of credit cards. Interchange is a component of the overall Merchant Discount Rate (MDR), which is charged to the merchant for the acceptance of payment cards. The MDR is split into three different portions: (1) interchange, which is received by the issuer of the card; (2) network fee received by the payment network; (3) acquiring fee received by the merchant acquirer/processor. Interchange legislation aims to address the fees received by issuers for the provision of payment cards. Although this forms a component of the revenue stream for an issuer, it is not a part of the revenue stream for the merchant
Goldman Sachs Global Investment Research 22 June 28, 2010 United States: Financial Services
acquirer or network. Therefore, we do not see any near term-impact to the networks (MA and V) or the merchant acquirers (Global Payments and Heartland Payment Systems) in our coverage from the introduction of interchange legislation. The biggest impact will be on banks, which we estimate at 1.3% of normalized earnings on average.
Exhibit 22: Debit interchange legislation represents 1 percent risk to industry normalized earnings
Estimated Using Weighted Average Debit Volume Market Share Fees at Risk Fees at Risk Earnings at Impact per % of $bn ($bn, pre-tax) after Offsets Risk * share Normalized RF 0.2 0.0 0.0 $0.03 3% FITB 0.2 0.0 0.0 $0.04 3% HBAN 0.1 0.0 0.0 $0.02 2% STI 0.2 0.0 0.0 $0.06 2% ZION 0.0 0.0 0.0 $0.04 2% FHN 0.0 0.0 0.0 $0.02 1% KEY 0.1 0.0 0.0 $0.01 1% BAC 2.286 0.5 0.3 $0.03 1% PNC 0.3 0.1 0.0 $0.09 1% CMA 0.1 0.0 0.0 $0.05 1% WFC 1.7 0.4 0.2 $0.05 1% MI 0.0 0.0 0.0 $0.01 1% USB 0.4 0.1 0.1 $0.03 1% BBT 0.2 0.0 0.0 $0.03 1% PBCT 0.0 0.0 0.0 $0.01 1% JPM 1.395 0.3 0.2 $0.05 1% COF 0.1 0.0 0.0 $0.04 1% DFS 0.1 0.0 0.0 $0.01 1% C 0.207 0.0 0.0 $0.00 0% Average 1.3% Wtd Avg 1.0% *: 35% tax rate. Note: assuming new interchange rate at 60bps for both signature and PIN debit.
Source: Nilson reports, Goldman Sachs Research estimates.
We believe that the financial impact of interchange legislation would be marginal for MA and V at 1%-2% of earnings Interchange legislation does not directly affect MA and V’s fundamentals as they do not derive revenues from interchange directly. The impact to the MA and V models is of a derivative nature, with reduced interchange possibly resulting in lower card issuance and eventually lower payment volume growth. For perspective, commentary compiled by our Goldman Sachs Bank equity research team suggests that banks are not initially inclined to drastically change their willingness to offer debit cards as this product is now a core part of the customer relationship. That being said, the banks could re-think how they charge for the product including annual fees (vs. free currently), rewards, etc. For perspective, we have focused on the EPS impact to CY2011, and assumed that US debit volume is reduced by 50% due to interchange legislation. In our view, the impact is marginal to both MA and V at 1%-2% of earnings. Even to get to these levels of earnings impact, one needs to make some assumptions about the potential impact of interchange
Goldman Sachs Global Investment Research 23 June 28, 2010 United States: Financial Services
legislation, including a 50% reduction in expected US debit growth. As things currently stand, we believe that MA and V remain on track for average earnings growth of 22% in CY10 and 20% for CY11. There are no changes to our estimates or price targets.
Exhibit 23: Pricing on transactions We detail below the normal split on a credit, cross border, signature debit and PIN debit transaction.
Credit card transaction Cross‐border credit card transaction Average size $80.00 Average size $80.00 Avg MDR $1.94 2.42% Avg MDR $3.14 3.92%
Interchange $1.42 1.78% V CPS/Rewards 1: 1.65% + $0.10 Interchange $1.42 1.78% V CPS/Rewards 1: 1.65% + $0.10 Merchant acquirer $0.32 0.40% assume: 40 bp of each trans Merchant acquirer $0.32 0.40% assume: 40 bp of each trans Card network $0.20 0.25% gross assessments: 11 bp of $ amt (merchant and issuer) Card network $1.40 1.75% gross assessments: 5.5 bp of $ amt on each side (merchant and issuer) acq proc fee (APF/NABU): 0.0195 per trans acq proc fee (APF/NABU): 0.0195 per trans switch fee: $0.025 on each side (merchant and issuer) switch fee: $0.025 on each side (merchant and issuer) authorization, settlement, other: $0.035 on each side (merchant and issuer) authorization, settlement, other: $0.035 on each side (merchant and issuer) 1% intl service assessment (ISA) fee: 100 bp FX spread revenue 50 bp
Signature debit card transaction PIN debit card transaction Average size $50.00 Average size $50.00 Avg MDR $0.81 1.62% Avg MDR $0.57 1.15%
Interchange $0.54 1.07% V CPS/retail debit—Perf Thr II: 0.81% + $0.13 Interchange $0.43 0.86% Visa retail merch threshold II 0.60% + $0.13 Merchant acquirer $0.15 0.30% assume: 30 bp of each trans Merchant acquirer $0.10 0.20% assume: $0.10 per trans (fixed per GPN) Card network $0.12 0.25% gross assessments: 5.5 bp of $ amt on each side (merchant and issuer) Card network $0.04 0.09% switch fee (debit netwk access): $0.035 on merchant side acq proce fe (APF/NABU): 0.0195 per trans $0.035 on issuer side switch fee: $0.025 on each side (merchant and issuer) acquirer proc fees (APF/NABU): 0.0195 per trans authorization, settlement, other: $0.035 on each side (merchant and issuer)
Source: Company data, Goldman Sachs Research estimates.
Merchant acquirers avoid the hot seat Merchant acquirers, including GPN (Neutral), HPY (Neutral), and TSS (Sell), interface directly with merchants and are responsible for collecting and paying out the various fees to parties along the payment chain—including the final settlement with the merchant. Although the merchant acquirer is really the party that ultimately determines what level of pricing each merchant actually pays, the role of the acquirer in the four-party payment system has been largely overlooked in the bill. This has created an opportunity for acquirers to pass through fairly substantial de facto pricing increases for many small and medium-sized merchants (though not for larger merchants with more volume and, therefore, more pricing leverage).
To illustrate, if debit interchange decreased by a hypothetical 25 bp, an acquirer could elect to pass through just 20 bp of that decrease to the merchant, pocketing the other 5 bp as a pricing increase which, in many cases, would not actually be seen by the merchant given the relative opacity of bundled monthly pricing (in other words, the only way to see the savings for many merchants would be if the acquirer chose to list it out separately on a monthly statement—which we believe is unlikely). We also think the debit network processing routing changes permitted by the financial reform bill could create an additional, though considerably smaller, opportunity for acquirers to retain additional pricing benefits when merchants choose to route their debit transactions over
Goldman Sachs Global Investment Research 24 June 28, 2010 United States: Financial Services
preferred (likely lower cost) debit networks. That said, the Fed has not yet evaluated and set a new debit interchange pricing structure, making it difficult to determine what the ultimate impact will be for merchant acquirers. While the scenario we outlined above is hypothetical, it illustrates the potential positive impact for acquirers. Among our covered companies, we think the largest potential positive impact will be on GPN, followed by a more moderate impact on TSS, and a minimal near-term impact on HPY, though our estimates and price targets are unchanged. GPN has historically passed through regular pricing increases when network and other fees have been adjusted upward—though this time, the process will work in reverse as GPN will keep part of the downward fee adjustment. We also note that when we recently met with GPN, CEO Paul Garcia made it clear that while the company is not in favor of the bill, it is very clearly positioned to benefit from the changes. TSS’ majority ownership of the First National Merchant Services joint venture (with First National Bank of Omaha) should allow it to share in any pricing increases, though the impact will be more limited given that TSS does not own the entire business. Finally, HPY will likely benefit least in the near-term, as the company does not mark up (or in this case, retain) pricing changes as a matter of policy. We recently discussed this with management, which indicated that while there are likely no near-term pricing benefits associated with the new rules, the company’s “fair dealing” pricing model actually keeps merchants happier and contributes to deeper relationships over the long-term—an assertion that makes sense given the company’s ability to keep its merchant attrition rates (though not its volumes) relatively stable in the wake of its 2009 systems breach. For our closed-loop acquirer/processor coverage, which includes WXS (Buy) and ADS (Neutral), the impact of the debit-related provisions of the financial reform bill is zero given their lack of exposure to debit. Recall that WXS exclusively issues commercial charge cards (the best type of card lending, in our view, given no consumer and no revolving credit exposure), while ADS issues only private label (and some co-branded) retail cards.
Defining Qualified Residential Mortgages and the impact on Private Mortgage Insurers
It appears that the impact on the near-term demand for private mortgage insurance has not been significantly impacted in either a positive or negative direction. As part of the Securities Reform Act, banks that are securitizing mortgages are required to retain some of the risk. The risk retention rules are intended to incent higher quality underwriting in the origination of residential mortgage loans sold into securitizations. Such an “incentive” is provided in the form of a requirement to hold “not less than 5% of the credit risk for any asset.” However, the bill allows for an exemption from such risk retention requirements if the underlying mortgage is a “qualified residential mortgage” (QRM). Thus, the definition of what exactly qualifies for a QRM could have a significant impact on future originations. The bill lists five ways a mortgage could qualify for QRM status, one of which is private mortgage insurance.
Specific considerations:
The bill allows for a group of agencies (including the Federal banking agencies, the Secretary of HUD, and the Director of the FHFA) to define the term qualified residential mortgage by taking into consideration underwriting and product features such as:
1. Documentation and verification of the financial resources relied upon to qualify the mortgagor
2. Standards with respect to
a. The residual income of the mortgagor after all monthly obligations
Goldman Sachs Global Investment Research 25 June 28, 2010 United States: Financial Services
b. The ratio of housing payments of the mortgagor to the monthly income of the mortgagor
c. The ratio of total monthly installment payments of the mortgagor to the income of the mortgagor
3. Mitigating the potential for payment shock on adjustable rate mortgages through product features and underwriting standards
4. Mortgage guarantee insurance or other types of insurance or credit enhancement obtained at the time of origination, to the extent such insurance or credit enhancement reduces the risk of default.
5. Prohibiting or restricting the use of balloon payments, negative amortization, prepayment penalties, interest-only payments, and other features that have been demonstrated to exhibit a higher risk of borrower default. Our initial take on the implications for private mortgage insurance
If QRM ends up being defined in a way that results in an increase in the placement of private MI on loans being sold into non-GSE securitizations, this would be positive for the industry. However, given that the bulk of residential mortgage securitizations continue to be in the GSE market, any such positive impact may only materialize over some longer period of time. And, once again, as we move into “longer periods of time,” it is important to be mindful about any changes to the residential mortgage securitization markets brought to bear through the process of GSE resolution.
Goldman Sachs Global Investment Research 26 June 28, 2010 United States: Financial Services
Passing on the costs of regulatory burdens
Ultimately, we believe increased regulatory and legal burdens will result in higher lending rates to the consumer. As an example, conforming mortgage rates are currently 90bps above MBS yields vs. a historical average of 20bps. This implies that banks are not passing on the full benefit of low rates and Fed MBS purchase program because on the other side they are concerned about losses from GSE repurchase requests, etc.
Exhibit 24: Spread on confirming mortgage rates to MBS currently at an all-time high
8.0%
7.0%
6.0%
5.0%
4.0%
3.0% MBS Conforming Mortgage Rate 2.0% 03/01 03/02 03/03 03/04 03/05 03/06 03/07 03/08 03/09 03/10
Source: Bloomberg, Goldman Sachs Research.
Goldman Sachs Global Investment Research 27 June 28, 2010 United States: Financial Services
Exhibit 25: Banks valuation as of June 25, 2010
Price Price Normalized P / Normalized Tier 1 Market GS EPS TBVPS P / TBVPS BVPS TCE/TA Ticker 06/25/10 target EPS EPS Common Cap 2Q10 E 2010 E 2011 E
Large-Cap Banks Bank of America Corporation BAC $15.42 $20.0 $11.7 1.3x $21.1 $2.40 6.4x 7.6% 5.2% 154.7 0.23 1.05 2.20 Citigroup Inc. C $3.94 $4.5 $4.1 1.0x $5.3 $0.55 7.2x 9.1% 6.5% 114.2 0.05 0.30 0.45 J.P. Morgan Chase & Co. JPM $39.44 $54.0 $26.4 1.5x $39.4 $6.50 6.1x 9.1% 5.0% 156.9 0.74 3.40 5.25 Morgan Stanley MS $25.01 $36.0 $18.3 1.4x $27.7 $3.90 6.4x 8.2% 3.3% 35.0 0.54 3.00 3.55 PNC Financial Services PNC $61.03 $67.0 $25.7 2.4x $49.8 $6.80 9.0x 7.6% 5.4% 32.1 1.12 4.25 5.75 U.S. Bancorp USB $23.36 $28.0 $7.6 3.1x $13.2 $2.85 8.2x 7.1% 5.4% 44.8 0.37 1.60 2.20 Wells Fargo & Company WFC $27.05 $40.0 $13.4 2.0x $20.8 $4.35 6.2x 7.1% 6.1% 140.9 0.52 2.20 2.95
Regional Banks BB&T Corp. BBT $28.76 $33.0 $14.7 2.0x $23.8 $3.35 8.6x 8.7% 6.4% 19.9 0.28 1.15 2.40 City National Corp. CYN $55.53 $47.0 $25.4 2.2x $35.4 $4.75 11.7x 9.4% 6.7% 2.9 0.30 1.35 3.15 Comerica, Inc. CMA $38.43 $44.0 $31.3 1.2x $32.2 $4.45 8.6x 9.6% 9.7% 6.8 0.21 0.40 2.45 Fifth Third Bancorp FITB $13.37 $16.0 $9.2 1.5x $12.3 $1.60 8.4x 7.0% 6.4% 10.6 0.02 0.25 1.00 First Horizon National Corp. FHN $12.47 $12.8 $8.8 1.4x $9.6 $1.30 9.6x 9.9% 7.7% 2.9 -0.03 0.00 0.69 First Niagra Financial Group Inc. FNFG $13.08 $15.0 $8.0 1.6x $13.0 $1.40 9.3x 12.4% 10.5% 2.7 0.19 0.90 1.25 Hudson City Bancorp Inc. HCBK $12.70 $13.0 $10.6 1.2x $11.0 $1.30 9.8x 7.6% 8.6% 6.7 0.28 1.20 1.25 Huntington Bancshares Inc. HBAN $6.00 $7.0 $4.3 1.4x $5.1 $0.75 8.0x 6.5% 5.8% 4.3 -0.02 -0.05 0.35 KeyCorp KEY $8.27 $10.0 $7.9 1.0x $9.0 $1.00 8.3x 7.5% 7.4% 7.3 -0.10 -0.30 0.60 Marshall & Ilsley Corp. MI $7.92 $7.5 $8.5 0.9x $10.0 $0.75 10.5x 8.1% 8.1% 4.2 -0.22 -0.85 -0.05 People's United Financial Inc. PBCT $14.01 $16.0 $10.3 1.4x $15.1 $1.00 14.0x nr 18.6% 5.3 0.12 0.40 0.55 Regions Financial Corp. RF $6.99 $8.0 $6.7 1.0x $11.8 $0.80 8.7x 7.1% 6.1% 8.3 -0.14 -0.35 0.40 SunTrust Banks, Inc. STI $25.51 $35.0 $22.2 1.1x $35.2 $3.50 7.3x 7.7% 6.9% 12.8 -0.40 -1.05 1.45 Synovus Financial Corp. SNV $2.80 $3.0 $3.4 0.8x $3.5 $0.33 8.5x 10.1% 8.0% 2.4 -0.30 -1.00 -0.08 Western Alliance Bancorp. WAL $8.18 $8.0 $5.6 1.5x $6.1 $0.70 11.7x 8.3% 6.7% 0.6 -0.04 -0.05 0.15 Zions Bancorporation ZION $23.82 $27.0 $19.9 1.2x $26.9 $2.70 8.8x 7.0% 6.3% 3.8 -0.55 -1.75 1.00
Processing & Trust Banks Bank of New York Mellon Corp. BK $25.88 $29.0 $8.7 3.0x $24.5 $3.13 8.3x 11.6% 6.1% 31.4 0.51 2.20 2.65 Northern Trust Corp. NTRS $48.44 $59.0 $24.8 2.0x $26.7 $4.65 10.4x 12.8% 7.9% 11.7 0.80 3.30 3.95 State Street Corp. STT $35.83 $50.0 $18.2 2.0x $30.7 $4.50 8.0x 15.9% 7.5% 18.0 0.70 3.00 3.55
Consumer Finance American Express Co. AXP $42.67 $50.0 $8.5 5.0x $11.2 $3.70 11.5x 9.8% 9.5% 51.3 0.73 3.00 3.45 Capital One Financial Corp. COF $43.44 $45.0 $22.9 1.9x $53.4 $5.00 8.7x 7.0% 5.5% 19.8 0.80 3.65 4.35 Discover Financial Services DFS $14.52 $19.0 $9.9 1.5x $10.8 $2.10 6.9x nr 10.1% 7.9 0.13 0.50 1.50
Risks: Worse than expected credit deterioration
Source: Source: FactSet, SNL, Goldman Sachs Research estimates.
Goldman Sachs Global Investment Research 28 June 28, 2010 United States: Financial Services
Exhibit 26: Valuation, methodology and risks
Ticker Rating Valuation Methodology Risks CME CL‐Buy 21X P/E on 2011 estimates Adverse regulatory changes, increased competition, declining open interest NDAQ CL‐Buy 11X P/E on 2011 estimates Lower volumes, market share erosion, declining fee capture rates ICE Neutral 20X P/E on 2011 estimates Upside: energy volume growth, clearing revenues; downside: margin erosion, adverse regulatory changes BGCP Neutral Blended: P/E on 2011 and M&A premium Upside: better OTC activity, improved earnings visibility, ELX; downside: adverse regulatory changes GFIG Neutral Blended: P/E on 2011 and M&A premium Upside: higher client activity and shift to electronic trading; downside: lower margins and lower client activity OZM Neutral 12 month P/E based Upside Risks: better asset flows; downside: performance declines and unfavorable tax changes BLK CL‐Buy 12 month P/E based Risks: BGI integration, fee rate compression We apply a 20% discount to long‐term average PE and MCO Neutral then apply an additional 25% discount for outstanding Upside / downside risks for our respective price targets are primarily tied to outcomes in current lawsuits. legal liability. $26 target with a 12‐month horizon. We apply discounted EV / EBITDA multiples in our SOTP analysis and similarly apply an additional 25% MHP Neutral Upside / downside risks for our respective price targets are primarily tied to outcomes in current lawsuits. discount for outstanding lawsuits. $33 target with a 12‐ month horizon. Our 12‐month price target of $93 is derived using a weighted average model incorporating our sector‐ Risks: Downside: (1) Lower credit and debit volumes. (2) higher costs and limited margin expansion. (3) VBuy relative Investment Framework, FTM P/E, and FTM competitive account losses. EV/EBITDA, and implies 22.3X our FTM EPS of $4.17 Our 12‐month price target of $250 is derived using a weighted average model incorporating our sector‐ Risks: Downside: (1) Lower credit and debit volumes. (2) higher costs and limited margin expansion. (3) MA Buy relative Investment Framework, FTM P/E, and FTM competitive account losses. EV/EBITDA, and implies 18.5X our FTM EPS of $13.48 Our 12‐month price target of $46 is derived using a weighted average model incorporating our sector‐ Risks: Upside: (1) Higher volumes. (2) Lower pricing pressure. (3) Contract wins. Downside: (1) Dilutive GPN Neutral relative Investment Framework, FTM P/E, and FTM acquisitions. (2) Lower volumes. (3) Pricing pressure. (4) Margin compression. EV/EBITDA, and implies 18.1X our FTM EPS of $2.53 Our 12‐month price target of $15 is derived using a weighted average model incorporating our sector‐ Risks: Upside: (1) Higher transaction value. (2) Lower legal liability. Downside: (1) Operating/Gross margin HPY Neutral relative Investment Framework, FTM P/E, and FTM underperformance due to technology costs. (2) Legal liability. EV/EBITDA,d an implies 15.9X our FTM EPS of $0.94 Our 12‐month price target of $13 is derived using a weighted average model incorporating our sector‐ TSS Sell Risks: Upside: (1) Faster than anticipated domestic and international account‐on‐file growth. relative Investment Framework, FTM P/E, and FTM EV/EBITDA, and implies 13.7X our FTM EPS of $0.95 Our 12‐month price target of $39 is derived using a weighted average model incorporating our sector‐ WXS Buy Risks: Downside: (1) Slower than expected economic recovery. (2) Gas prices. relative Investment Framework, FTM P/E, and FTM EV/EBITDA, and implies 16.4X our FTM EPS of $2.38 Our 12‐month price target of $70 is derived using a Risks: Downside: (1) Slower than expected economic and advertising market recovery. (2) High client weighted average model incorporating our sector‐ ADS Neutral concentration. (3) Deteriorating credit issuance trends. Upside: (1) Faster than aniticipated revenue growth and relative Investment Framework, FTM P/E, and FTM margin expansion. EV/EBITDA, and implies 14.5X our FTM EPS of $4.83
Source: Goldman Sachs Research estimates.
Goldman Sachs Global Investment Research 29 June 28, 2010 United States: Financial Services
Rating and pricing information
Alliance Data Systems Corp. (N/N, $63.90), BGC Partners, Inc. (N/N, $5.35), BlackRock, Inc. (B/N, $152.34), CME Group Inc. (B/N, $297.28), GFI Group Inc. (N/N, $6.05), Global Payments Inc. (N/N, $38.65), Heartland Payment Systems, Inc. (N/N, $15.95), IntercontinentalExchange, Inc. (N/N, $118.36), Mastercard Inc. (B/N, $218.39), Moody's Corporation (N/C, $22.01), NASDAQ OMX Group Inc. (B/N, $18.89), Och-Ziff Capital Management Group LLC (N/N, $13.89), The McGraw-Hill Companies, Inc. (N/C, $29.74), Total System Services, Inc. (S/N, $14.13), Visa Inc. (B/N, $76.66) and Wright Express Corp. (B/N, $31.30).
Goldman Sachs Global Investment Research 30 June 28, 2010 United States: Financial Services
Reg AC
We, Richard Ramsden, Brian Foran, Daniel Harris, CFA, Jessica Binder Graham, CFA, Marc Irizarry, Christopher M. Neczypor, Julio C. Quinteros Jr., Sloan Bohlen and John T. Williams, hereby certify that all of the views expressed in this report accurately reflect our personal views about the subject company or companies and its or their securities. We also certify that no part of our compensation was, is or will be, directly or indirectly, related to the specific recommendations or views expressed in this report.
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Disclosures
Coverage group(s) of stocks by primary analyst(s)
Richard Ramsden: America-Large Banks. Brian Foran: America-Credit Cards, America-Regional Banks, America-Trust Banks. Daniel Harris, CFA: America-Brokers, America-Discount Brokers, America- Market Structure. Marc Irizarry: America - Asset Managers. Christopher M. Neczypor: America-Insurance Brokers, America-LifeInsure, America-Mortgage Insurance, America-NonLifeInsurance. Julio C. Quinteros Jr.: America-IT Consulting and Outsourcing, America-Transaction Processors. Sloan Bohlen: America-REITS, America-Specialty Finance. John T. Williams: America-Transaction Processors. Alexander Blostein, CFA: America - Asset Managers. Christopher Giovanni: America-LifeInsure. America - Asset Managers: Affiliated Managers Group, Inc., AllianceBernstein Holding L.P., Ameriprise Financial, Inc., Artio Global Investors Inc., BlackRock, Inc., Calamos Asset Management, Inc., Cohen & Steers, Inc., Eaton Vance Corp., Federated Investors, Inc., Fortress Investment Group LLC, Franklin Resources, Inc., Gamco Investors Inc., INVESCO Ltd., Janus Capital Group Inc., KKR & Co. (Guernsey) L.P., Legg Mason, Inc., Och-Ziff Capital Management Group LLC, T. Rowe Price Group, Inc., Pzena Investment Management, Inc., The Blackstone Group L.P., Waddell & Reed Financial, Inc.. America-Brokers: Duff & Phelps Corporation, Evercore Partners Inc., Greenhill & Co., Inc., Jefferies Group Inc., Lazard Ltd., Piper Jaffray Companies Inc., Raymond James Financial, Inc., Stifel Financial Corp.. America-Credit Cards: American Express Co., Capital One Financial Corp., Discover Financial Services. America-Discount Brokers: E*TRADE Financial Corp., optionsXpress Holdings, Inc., The Charles Schwab Corp., TD Ameritrade Holding Corp., TradeStation Group, Inc.. America-IT Consulting and Outsourcing: Accenture Plc, Amdocs Limited, Cognizant Technology Solutions, Computer Sciences Corp., ExlService Holdings, Inc., Fidelity National Information Svcs., Fiserv, Inc., Genpact Ltd., Hewitt Associates, Inc., Lender Processing Services, Inc., Pitney Bowes Inc., Sapient, WNS (Holdings) Ltd.. America-Insurance Brokers: Aon Corp., Marsh & McLennan Companies. America-Large Banks: Bank of America Corporation, Citigroup Inc., J.P. Morgan Chase & Co., Morgan Stanley & Co., PNC Financial Services, U.S. Bancorp, Wells Fargo & Company. America-LifeInsure: Lincoln National Corp., MetLife Inc., Principal Financial Group, Inc., Protective Life Corp., Prudential Financial, Inc., StanCorp Financial Group, Inc., Symetra Financial Corporation, Torchmark Corp., Unum Group.
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America-Market Structure: BGC Partners, Inc., CME Group Inc., GFI Group Inc., IntercontinentalExchange, Inc., Investment Technology Group, Inc., Knight Capital Group, Inc., MarketAxess Holdings Inc., NASDAQ OMX Group Inc., NYSE Euronext, Inc., TMX Group, Inc.. America-Mortgage Insurance: Genworth MI Canada Inc., MGIC Investment Corp., The PMI Group, Inc., Radian Group Inc.. America-NonLifeInsurance: ACE Limited, Allied World Assurance Co. Hldgs. Ltd., The Allstate Corp., Arch Capital Group Ltd., Chubb Corp., Everest Re Group Limited, The Hartford Financial Services, PartnerRe Ltd., Platinum Underwriters Holdings, The Progressive Corporation, RenaissanceRe Holdings Ltd., The Travelers Companies, Inc., Transatlantic Holdings, Inc., Validus Holdings, Ltd., XL Capital Ltd.. America-REITS: Alexander & Baldwin, Inc., AMB Property Corp., Apartment Investment & Management, AvalonBay Communities Inc., Boston Properties, Inc., BRE Properties, Inc., Brookdale Senior Living Inc., Brookfield Properties Corp., Camden Property Trust, CB Richard Ellis Group Inc., CBL & Associates Properties, Cousins Properties Incorporated, Developers Diversified Realty, Duke Realty Corp., Equity Residential, Essex Property Trust, Inc., Federal Realty Invmt Trust, Forest City Enterprises, General Growth Properties, HCP, Inc., Health Care REIT, Inc., Jones Lang LaSalle Inc., Kimco Realty Corp., Liberty Property Trust, Mack Cali Realty Corporation, Post Properties Inc., ProLogis, Public Storage, Inc., Regency Centers Corporation, Simon Property Group, SL Green Realty Corp, Tanger Factory Outlet Centers, Inc., Taubman Centers, Inc., The Macerich Co., UDR, Inc., Vornado Realty Trust, Weingarten Realty Investors. America-Regional Banks: BB&T Corp., City National Corp., Comerica, Inc., Fifth Third Bancorp, First Horizon National Corp., First Niagara Financial Group, Inc., Hudson City Bancorp, Inc., Huntington Bancshares Inc., KeyCorp, Marshall & Ilsley Corp., People's United Financial, Inc., Regions Financial Corp., SunTrust Banks, Inc., Synovus Financial Corp., Western Alliance Bancorp., Zions Bancorporation. America-Specialty Finance: H&R Block, Inc., Jackson Hewitt Tax Service Inc., Moody's Corporation, The McGraw-Hill Companies, Inc.. America-Transaction Processors: Alliance Data Systems Corp., Automatic Data Processing Inc., Cybersource Corp., Global Payments Inc., Heartland Payment Systems, Inc., IHS Inc., Mastercard Inc., Paychex, Inc., Solera Holdings, Inc., Total System Services, Inc., Visa Inc., Western Union Co., Wright Express Corp.. America-Trust Banks: Bank of New York Mellon Corp., Northern Trust Corp., State Street Corp..
Company-specific regulatory disclosures
The following disclosures relate to relationships between The Goldman Sachs Group, Inc. (with its affiliates, "Goldman Sachs") and companies covered by the Global Investment Research Division of Goldman Sachs and referred to in this research. There are no company-specific disclosures.
Distribution of ratings/investment banking relationships
Goldman Sachs Investment Research global coverage universe
Rating Distribution Investment Banking Relationships Buy Hold Sell Buy Hold Sell Global 30% 54% 16% 48% 46% 38% As of April 1, 2010, Goldman Sachs Global Investment Research had investment ratings on 2,821 equity securities. Goldman Sachs assigns stocks as Buys and Sells on various regional Investment Lists; stocks not so assigned are deemed Neutral. Such assignments equate to Buy, Hold and Sell for the purposes of the above disclosure required by NASD/NYSE rules. See 'Ratings, Coverage groups and views and related definitions' below.
Regulatory disclosures
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See company-specific regulatory disclosures above for any of the following disclosures required as to companies referred to in this report: manager or co-manager in a pending transaction; 1% or other ownership; compensation for certain services; types of client relationships; managed/co-managed public offerings in prior periods; directorships; for equity securities, market making and/or specialist role. Goldman Sachs usually makes a market in fixed income securities of issuers discussed in this report and usually deals as a principal in these securities. The following are additional required disclosures: Ownership and material conflicts of interest: Goldman Sachs policy prohibits its analysts, professionals reporting to analysts and members of their households from owning securities of any company in the analyst's area of coverage. Analyst compensation: Analysts are paid in part based on the profitability of Goldman Sachs, which includes investment banking revenues. Analyst as officer or director: Goldman Sachs policy prohibits its analysts, persons reporting to analysts or members of their households from serving as an officer, director, advisory board member or employee of any company in the analyst's area of coverage. Non-U.S. Analysts: Non-U.S. analysts may not be associated persons of Goldman Sachs & Co. and therefore may not be subject to NASD Rule 2711/NYSE Rules 472 restrictions on communications with subject company, public appearances and trading securities held by the analysts. Distribution of ratings: See the distribution of ratings disclosure above. Price chart: See the price chart, with changes of ratings and price targets in prior periods, above, or, if electronic format or if with respect to multiple companies which are the subject of this report, on the Goldman Sachs website at http://www.gs.com/research/hedge.html.
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Ratings, coverage groups and views and related definitions
Buy (B), Neutral (N), Sell (S) -Analysts recommend stocks as Buys or Sells for inclusion on various regional Investment Lists. Being assigned a Buy or Sell on an Investment List is determined by a stock's return potential relative to its coverage group as described below. Any stock not assigned as a Buy or a Sell on an Investment List is deemed Neutral. Each regional Investment Review Committee manages various regional Investment Lists to a global guideline of 25%-35% of stocks as Buy and 10%-15% of stocks as Sell; however, the distribution of Buys and Sells in any particular coverage group may vary as determined by the regional Investment Review Committee. Regional Conviction Buy and Sell lists represent investment recommendations focused on either the size of the potential return or the likelihood of the realization of the return. Return potential represents the price differential between the current share price and the price target expected during the time horizon associated with the price target. Price targets are required for all covered stocks. The return potential, price target and associated time horizon are stated in each report adding or reiterating an Investment List membership. Coverage groups and views: A list of all stocks in each coverage group is available by primary analyst, stock and coverage group at http://www.gs.com/research/hedge.html. The analyst assigns one of the following coverage views which represents the analyst's investment outlook on the coverage group relative to the group's historical fundamentals and/or valuation. Attractive (A). The investment outlook over the following 12 months is favorable relative to the coverage group's historical fundamentals and/or valuation. Neutral (N). The investment outlook over the following 12 months is neutral relative to the coverage group's historical fundamentals and/or valuation. Cautious (C). The investment outlook over the following 12 months is unfavorable relative to the coverage group's historical fundamentals and/or valuation. Not Rated (NR). The investment rating and target price have been removed pursuant to Goldman Sachs policy when Goldman Sachs is acting in an advisory capacity in a merger or strategic transaction involving this company and in certain other circumstances. Rating Suspended (RS). Goldman Sachs Research has suspended the investment rating and price target for this stock, because there is not a sufficient fundamental basis for determining an investment rating or target. The previous investment rating and price target, if any, are no longer in effect for this stock and should not be relied upon. Coverage Suspended (CS). Goldman Sachs has suspended coverage of this company. Not Covered (NC). Goldman Sachs does not cover this company. Not Available or Not Applicable (NA). The information is not available for display or is not applicable. Not Meaningful (NM). The information is not meaningful and is therefore excluded.
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The Global Investment Research Division of Goldman Sachs produces and distributes research products for clients of Goldman Sachs, and pursuant to certain contractual arrangements, on a global basis. Analysts based in Goldman Sachs offices around the world produce equity research on industries and companies, and research on macroeconomics, currencies, commodities and portfolio strategy. This research is disseminated in Australia by Goldman Sachs JBWere Pty Ltd (ABN 21 006 797 897) on behalf of Goldman Sachs; in Canada by Goldman Sachs & Co. regarding Canadian equities and by Goldman Sachs & Co. (all other research); in Hong Kong by Goldman Sachs (Asia) L.L.C.; in India by Goldman Sachs (India) Securities Private Ltd.; in Japan by Goldman Sachs Japan Co., Ltd.; in the Republic of Korea by Goldman Sachs (Asia) L.L.C., Seoul Branch; in New Zealand by Goldman Sachs JBWere (NZ) Limited on behalf of Goldman Sachs; in Russia by OOO Goldman Sachs; in Singapore by Goldman Sachs (Singapore) Pte. (Company Number: 198602165W); and in the United States of America by Goldman Sachs & Co. Goldman Sachs International has approved this research in connection with its distribution in the United Kingdom and European Union. European Union: Goldman Sachs International, authorized and regulated by the Financial Services Authority, has approved this research in connection with its distribution in the European Union and United Kingdom; Goldman Sachs & Co. oHG, regulated by the Bundesanstalt für Finanzdienstleistungsaufsicht, may also distribute research in Germany.
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