The equity market, after opening last week on a stronger note and trading to its highest level in 16 months, staged a sharp 5 percent or so three-day sell-off at the end of the week. A significant portion of the selling in stocks was tied to Washington jitters associated with the latest assault on banks and Fed Chairman Bernanke. However, the actions in Washington include a solid dose of political grandstanding that suggest the bark may be worse than the bite.
Last Thursday, in his toughest response yet to the financial crisis, President Obama recommended that strict limits be imposed on the size, structure, and proprietary trading activities of our biggest banks. The proposal aims to reduce the risk-taking and deter banks from becoming so large that they place the broader economy at risk. The President’s press conference followed an announcement earlier in the week to impose a claw-back tax on the banks and could have had some political overtones given the election events in Massachusetts last Tuesday. These proposals are likely to be rolled into a bigger package of financial market reform that will, at a minimum, take months to address. Given the politics in Washington today, financial market reform could become a focal point issue for the elections this fall, which could further delay actual legislation.
As for the proposal itself, we find it interesting that it wasn’t the proprietary trading activities that got the banks in trouble --it was largely overly aggressive and risky lending practices. The biggest domestic financial blow-ups -- Bear Stearns, AIG, Lehman, Fannie Mae, and Freddie Mac -- weren’t banks and many of the biggest problems at banks were centered in their lending and derivatives activities. The financial market reform plans have yet to address derivatives, counterparty risk, and leverage, which were all at the heart of the financial crisis. Moreover, it might be difficult for the government to fully address the proprietary trading practices of the banks given that bank proprietary trading activities are often needed to underwrite the U.S. Treasury’s debt. Likewise, when Washington officials get down to actual legislation changes, they might decide not to dramatically reduce the playing field for U.S. financial institutions against their foreign rivals.
The downside move in equities last week was also tied to fears that the Senate would not approve the reappointment of Ben Bernanke to another four-year term as Chairman of the Federal Reserve Board. Although Bernanke’s position as a Fed Governor will last another 10 years, his term as chairman is set to expire on January 31, 2010. Last week several liberal Democratic Senators joined a block of conservative Republicans in announcing that they would not support Bernanke for another term as Fed chairman. This growing negative sentiment towards the Fed and Bernanke reflected the shaky political atmosphere in Washington and the widespread anger to get back at the Fed for how they handled the financial crisis. However, this weekend it looks like cooler heads might be starting to prevail in Washington as Senator Dodd and Senator Gregg issued a bi-partisan statement in support of Bernanke expressing their confidence that “Chairman Bernanke will win confirmation by the Senate for a second term.”
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