Cyprus Is Not So Much An Anomaly as the Template For the Next Financial Crisis

This is not so much anything new, but a concrete reminder of the breadth of systemic banking risks inherent in the Anglo-American banking structure in which depositor money is intermingled with the Bank's speculative interests. 

The repeal of Glass-Steagall stripped the average person of important and time-tested safeguards against loss.   Things are different now.

Any deposits you have at a bank in excess of 'insurance guarantees' are at risk in case of another financial crisis.

This exposure may include wealth you think that you own, but do not know exactly where and how it is being held. This may include 401k's and IRA's, pension plans, health insurance deposits, life insurance and annuities, and so forth.

MF Global was very instructive on how even cash deposits and physical assets backed by a certificate of ownership may be fair game for the banking system in the event of a crisis.

Nothing is perfect and foolproof, but there are degrees of safety.

And you may wish to consider that the next time something like Occupy Wall Street starts up and demands reform, don't stand by on the sidelines and join in with the orchestrated jeering from the one percent's water bearers.

Simplify, streamline, organize.

Demand serious, meaningful, and genuine reform and transparency in the banking and political system.

"The goal is to produce resolution strategies that could be implemented for the failure of one or more of the largest financial institutions with extensive activities in our respective jurisdictions. These resolution strategies should maintain systemically important operations and contain threats to financial stability.

They should also assign losses to shareholders and unsecured creditors in the group, thereby avoiding the need for a bailout by taxpayers. These strategies should be sufficiently robust to manage the challenges of cross-border implementation and to the operational challenges of execution...

But insofar as a bail-in provides for continuity in operations and preserves value, losses to a deposit guarantee scheme in a bail-in should be much lower than in liquidation. Insured depositors themselves would remain unaffected.

Uninsured deposits would be treated in line with other similarly ranked liabilities in the resolution process, with the expectation that they might be written down."

Bank of England and Federal Reserve Joint Statement on Resolving Globally Active, Systemically Important, Financial Institutions.

Related:
A Message From the Banking and Brokerage System
Lawmakers Must Heed the Wisdom of the 1930's
Why Has the Financial System Failed and What Are We Going To Do About It?
A Brilliant Warning on Robert Rubin's Proposal to Deregulate the Banks in 1995

Gold Daily and Silver Weekly Charts.

I believe the general manipulation of markets we are seeing now will be traced back to Robert Rubin who formulated a principle of financial activism, or intervention before the fact, as being cheaper and more effective that repairing markets after they suffer a significant decline as Greenspan had done in 1987.

As you may recall the 1987 experience led Reagan to form the President's Working Group on Markets, which grew into the infamous 'Plunge Protection Team' of the 1990's which made generous use of the Exchange Stabilization Fund, an opaque kitty used for general market tinkering.

Treasury Secretary Rubin's favorite tool of choice in the markets was said to be the SP futures since they carry the best 'bang for the buck.'

Apparently LIBOR is quite good on the interest rate side of things as well.


The Federal Reserve is adding Daily Gold Prices to their FRED database.


Perhaps they think the price might become more interesting in the near future, or more deserving of their official concern.

Robert Rubin Runs Obama, SP 500 Futures, and Gold

The June Non-Farm Payrolls Report will be released on Friday, July 2. Tomorrow June 30 is the end of the quarter.

The 234th anniversary of the US Declaration of Independence is this weekend.

"I am well aware of the toil and blood and treasure it will cost us to maintain this declaration, and support and defend these states. Yet through all the gloom I see the rays of ravishing light and glory. I can see that the end is worth all the means. This is our day of deliverance." John Adams

The equity market feels somewhat artificial, if not contrived. Indeed, I think we are in a period of intensified disinformation running ahead of the fog of war, whether it is between countries, or classes, or both. It is customary to neutralize pre-emptively the moral standing of the friends and allies of something which you intend to attack and destroy.



Bear raids were coming hot and heavy as Gold attempted to break out through overhead resistance. HSBC was spreading talk of Central Bank selling of bullion that did not seem to be apparent in the physical market. As you know, HSBC is one of the banks most heavily short the paper metals markets.



Chris Whalen of the highly respected Institutional Risk Analyst sees Robert Rubin as still pulling the strings in US financial policy and is virtually running the economic policy in the Obama Administration from behind the scenes, through surrogates.

"t comes as a surprise to many people that, despite the fiasco at Citigroup (C) and his role in causing the subprime mess (See "The Subprime Three: Rubin, Summers and Greenspan," The Institutional Risk Analyst, April 28, 2008), Rubin remains inside the circle at the White House. Nearly two decades after first migrating to Washington, he apparently is still calling the shots of U.S. financial and economic policy with the full support of President Barrack Obama. Working through his favorite marionettes, Treasury Secretary Tim Geithner and Economic Policy Czar Larry Summers, most recently Rubin managed the defense of Wall Street following the great crisis. No matter what Secretary Geithner says or when he says it in public, you can be sure that those utterances have the full knowledge and approval of his handler Larry Summers and their common political owner and sponsor, Robert Rubin.

A modern day colossus, Rubin effortlessly bestrides the worlds of political and finance, and mostly without leaving a trail of slime that often betrays the average political operator. Rubin stood at the right hand of Alan Greenspan on the famous February 1999 Time cover entitled: "The Committee to Save the World." Not an entrepreneur like Pierpont Morgan, Rubin is a mixture of banker, politician and global technocrat, a super fixer of sorts, but with a proper sense for public-private partnership. Case in point: The famous letter from Rubin to Goldman Sachs clients when he first went to the Clinton White House saying that just because he was in Washington didn't mean he wouldn't be looking after them...

The end result of financial reform is inconvenience for the financial services industry and more expense for the taxpayer and the consumer. But it should be noted that, once again, Wall Street has managed to blunt the worst effects of public anger at the industry's collective malfeasance. The banks can now start to focus their financial firepower on winning back hearts and minds on Capitol Hill. All it takes is money.

Notwithstanding anything said or done by the Congress this year, operating through trained surrogates such as Geithner, Summers and others, Robert Rubin is still pulling the economic and financial strings in Washington. The fact that there is a Democrat in the White House almost does not seem to matter. President Obama arguably has a subordinate position to Rubin because of considerations of money. If you differ, then ask yourself if Barack Obama could seek the presidency in 2012 without the support of Bob Rubin and the folks at Goldman Sachs. Case closed.

For America's creditors and allies, the key question is whether the Democrats around Rubin are willing to embrace fiscal discipline at a time when deflation in the US is accelerating. That roaring sound you hear is the approaching waterfall of the double dip. With the US at the moment eschewing anything remotely like fiscal restraint and the rest of the world going in the opposite direction, to us the next crisis probably involves U.S. interest rates and the dollar.

Judging by Rubin's performance in the past, when he talked first of a strong dollar, then a weak dollar policy, and fudged the issue regarding fiscal deficits, we could be in for quite a ride. But at some point the Obama Administration should acknowledge that this particular former CEO of Goldman Sachs is still driving the policy bus. If the Republicans are in control of the Congress come next January, maybe they should subpoena Rubin to appear periodically. At least then we all can hear directly to the person who is actually making national economic policy."

The World According to Robert Rubin, Chris Whalen, IRA

One has to wonder, of course, who is running economic policy for the Republicans? It seems to be more of a case of competing crime families, than a simple good vs. evil.

If Rubin does indeed run Obama, the question remains, who runs Rubin, and where do his loyalties lie? Whom does he serve?

A Brilliant Warning On Robert Rubin's Proposal to Deregulate Banks, circa 1995

There is little doubt in this mind that the GDP number will be revised lower, and the chain deflator lowball will prove to be transitory, and the recovery will be ephemeral, at least based on real numbers. The Clunkers programs pulled sales forward, which is a useful thing only if there is the follow up of systemic reform. The consumer is flat on their back, and median wages and employment are going nowhere. One can stoke monetary inflation with enough Fed expansion, but without the vitality that bestows permanence and self-sufficiency.

A reader sent in this prescient warning from 1995, when then Treasury Secretary Robert Rubin, late of Goldman Sachs, mentor to Larry and Timmy of the current US ship of state, wanted to unleash the power of the big money center banks to ensure their "efficiency and international competitiveness."

If only the US had rejected the Rubin - Greenspan doctrine then, and firmly said no to freewheeling finance, and not succumbed to the hundreds of millions of dollars in lobbying and donations spread about Washington in that 1990's campaign by Wall Street that culminated in Fed preemptive action, followed by a massive lobbying campaign led by Sandy Weill.

In December 1996, with the support of Chairman Alan Greenspan, the Federal Reserve Board issues a precedent-shattering decision permitting bank holding companies to own investment bank affiliates with up to 25 percent of their business in securities underwriting (up from 10 percent).

This expansion of the loophole created by the Fed's 1987 reinterpretation of Section 20 of Glass-Steagall effectively renders Glass-Steagall obsolete. Virtually any bank holding company wanting to engage in securities business would be able to stay under the 25 percent limit on revenue. However, the law remains on the books, and along with the Bank Holding Company Act, does impose other restrictions on banks, such as prohibiting them from owning insurance-underwriting companies.

In August 1997, the Fed eliminates many restrictions imposed on "Section 20 subsidiaries" by the 1987 and 1989 orders. The Board states that the risks of underwriting had proven to be "manageable," and says banks would have the right to acquire securities firms outright...

As the push for new legislation heats up, lobbyists quip that raising the issue of financial modernization really signals the start of a fresh round of political fund-raising. Indeed, in the 1997-98 election cycle, the finance, insurance, and real estate industries (known as the FIRE sector), spends more than $200 million on lobbying and makes more than $150 million in political donations. Campaign contributions are targeted to members of Congressional banking committees and other committees with direct jurisdiction over financial services legislation.

PBS Frontline: The Long Demise of Glass-Steagall

One might be tempted to conclude from this that they bought the attention of the Congress for their agenda then, and based on additional substantial contributions, have held it ever since.

As you may recall, it was in December, 1996 when Alan Greenspan made his famous 'irrational exuberance' speech. And then shortly thereafter laid the groundwork for the tech bubble of 1999, and the series of bubbles that are the basis of the American economy even today, and the long twilight of the US dollar.

Based on our read, the financial reform plans crafted by Tim Geithner, Larry Summers, and their friends on Wall Street is merely a continuation of the Rubinomics. Is there any wonder, as we have Rubinomics Recalculated by Obama.

Thanks to Mark for sharing this on a day in which I had not intended to post anything. There seem to be about 12,000 regular visitors to Le Cafe each day. Although this is not a lot by internet standards, I have to say that based on their valuable comments and exceptionally well-informed messages sent in by email, that when it comes to astute readers, we have an embarrassment of riches. And for this we give thanks and are grateful.

NY Times
End Bank Law and Robber Barons Ride Again
Published: Sunday, March 5, 1995

To the Editor:

Re "For Rogue Traders, Yet Another Victim" (Business Day, Feb. 28) and your same-day article on Treasury Secretary Robert E. Rubin's proposal to eliminate the legal barriers that have separated the nation's commercial banks, securities firms and insurance companies for decades: The American Bankers Association, Senator Alfonse M. D'Amato, Representative Jim Leach and Treasury Secretary Rubin are gravely misguided in their quest to repeal the Glass-Steagall Act.

Their contention that insurance companies, commercial banks and securities firms should be freed from legislative obstructions is predicated on fallacious, historically inaccurate statements. If the Baring Brothers failure does not give them pause, a history lesson is our only hope before the Administration and bank lobby iron out their differences and set the economy back 90 years.

The argument that American financial intermediaries will become "more efficient and more internationally competitive" is false. The American financial system is the most stable, most profitable and most dynamic in the world.

The notion that Glass-Steagall prevents American financial intermediaries from fulfilling their utmost potential in a global marketplace reflects inadequate understanding of the events that precipitated the act and the similarities between today's financial marketplace and the market nearly a century ago.

Although Glass-Steagall was enacted during the Great Depression, it was put in place because the Aldrich-Vreeland Act of 1908, the blue-sky laws following 1910 and the Federal Reserve System of 1913 failed to keep the concentration of financial power in check. The investment climate that ultimately led to Glass-Steagall was one filled with emerging markets, interlocking control of productive resources and widespread bank ownership of securities.

Ever since railroad securities began driving secondary capital markets in the late 1860's, "emerging markets" have existed for investors looking for high-yield opportunities, and banks have been primary agents in industrial development. In the 19th century, emerging markets were scattered throughout the United States, and capital flowed into them from New York, Boston, Philadelphia and London. In the same way, capital flows from the United States, Japan and England to Latin America and the Pacific rim -- today we just have more terms to define the market mechanisms.

The economy and financial markets were even more interconnected in the 19th century than now. Commercial and investment banks could accept deposits, issue currency, underwrite securities and own industrial enterprises. With Glass-Steagall lifted, we will chart a course returning us to that environment.

J. P. Morgan and Andrew Mellon made their billions through inter locking directorates and outright ownership of hundreds of nationally prominent enterprises. Glass-Steagall is one crucial piece of a litany of legislation designed to place checks and balances on the concentration of financial resources. To repeal it would be tantamount to bringing back the days of the robber barons.

The unbridled activities of those gifted financiers crumbled under the dynamic forces of the capital marketplace. If you take away the checks, the market forces will eventually knock the system off balance.

MARK D. SAMBER
Stamford, Conn.
Feb. 28, 1995

The writer is a management consultant specializing in business history.

Robert Rubin's Role in the Bubble that Broke the World

Is it premature to speak of the failure of Citigroup?

No, the bank is finished. The only question is the nature of its post-death life as a zombie.

The Fed and FDIC may cut off a few of the more gangrenous pieces, stuff it full of paper, bolt on a prosthetic or two, perhaps apply enough cosmetics to give it some semblance of an afterlife, but the hard fact is the bank has collapsed, and would not open its doors again without extraordinary measures to maintain the appearance of existence.

How did this happen? Although this article does not mention the chief architect, Sanford Weil and another member of the supporting cast Larry Summers, it does pay tribute to Robert Rubin who, with Alan Greenspan, helped to create one of the greatest financial bubbles in history.

The New York Times
Citigroup Pays for a Rush to Risk
November 22, 2008

...The bank’s downfall was years in the making and involved many in its hierarchy, particularly Mr. Prince and Robert E. Rubin, an influential director and senior adviser.

Citigroup insiders and analysts say that Mr. Prince and Mr. Rubin played pivotal roles in the bank’s current woes, by drafting and blessing a strategy that involved taking greater trading risks to expand its business and reap higher profits. Mr. Prince and Mr. Rubin both declined to comment for this article.

When he was Treasury secretary during the Clinton administration, Mr. Rubin helped loosen Depression-era banking regulations that made the creation of Citigroup possible by allowing banks to expand far beyond their traditional role as lenders and permitting them to profit from a variety of financial activities. During the same period he helped beat back tighter oversight of exotic financial products, a development he had previously said he was helpless to prevent.

And since joining Citigroup in 1999 as a trusted adviser to the bank’s senior executives, Mr. Rubin, who is an economic adviser on the transition team of President-elect Barack Obama, has sat atop a bank that has been roiled by one financial miscue after another.

Citigroup was ensnared in murky financial dealings with the defunct energy company Enron, which drew the attention of federal investigators; it was criticized by law enforcement officials for the role one of its prominent research analysts played during the telecom bubble several years ago; and it found itself in the middle of regulatory violations in Britain and Japan....As it built up that business, it used accounting maneuvers to move billions of dollars of the troubled assets off its books, freeing capital so the bank could grow even larger....

Does a Weakness in Banking Regulations Result in Economic Imbalances and Asset Bubbles?

PBS Frontline: Mr. Weill Goes to Washington


Time Magazine February 15, 1999

A Nice Expose of the Shadow Banking System

Are we this dumb or are these guys that brazen?

The expose is in our parenthetical remarks. The rest of this is a thin coat of history and spin.

Its time to get medieval with Wall Street.

Brokers threatened by run on shadow bank system
Regulators eye $10 trillion market that boomed outside traditional banking
By Alistair Barr
Market Watch
6:29 p.m. EDT June 19, 2008

SAN FRANCISCO (MarketWatch) -- A network of lenders, brokers and opaque financing vehicles outside traditional banking that ballooned during the bull market now is under siege as regulators threaten a crackdown on the so-called shadow banking system. (Not 'under siege' but more like "imploding and crying for help after having bought off most of the establishment' - Jesse)

Big brokerage firms like Goldman Sachs, Lehman Brothers, and Merrill Lynch which some say are the biggest players in this non-bank financial network, may have the most to lose from stricter regulation. (Legal reform has a negative impact on criminal organizations - Insight! - Jesse)

The shadow banking system grew rapidly during the past decade, accumulating more than $10 trillion in assets by early 2007. That made it roughly the same size as the traditional banking system, according to the Federal Reserve. (And they didn't see it coming, uh huh - Jesse)

While this system became a huge and vital source of money to fuel the U.S. economy, the subprime mortgage crisis and ensuing credit crunch exposed a major flaw. Unlike regulated banks, which can borrow directly from the government and have federally insured customer deposits, the shadow system didn't have reliable access to short-term borrowing during times of stress. (Oh, they just needed a better and more reliable 'fence' to move their goods - Jesse)

Unless radical changes are made to bring this shadow network under an updated regulatory umbrella, the current crisis may be just a gust compared to the storm that would follow a collapse of the global financial system, experts warn. (Hey didn't we do just that with the Glass-Steagall law the last time they did this in the 1920's? - Jesse)

Such vulnerability helped transform what may have been an uncomfortable correction in credit markets into the worst global credit crunch in more than a decade as monetary policymakers and regulators struggled to contain the damage. (Sounds like a headline from the Wall Street Journal..... in 1931 - Jesse)

Unless radical changes are made to bring this shadow network under an updated regulatory umbrella, the current crisis may be just a gust compared to the storm that would follow a collapse of the global financial system, experts warn. (How come these guys always issue their weather reports while standing on the wreckage of a city that has already been devastated by a major hurricane, but the day before had been saying 'The beaches are open!' - Jesse)

"The shadow banking system model as practiced in recent years has been discredited," Ramin Toloui, executive vice president at bond investment giant Pimco, said. (As it had been just after the Crash of 1929 - Jesse)

Toloui expects greater regulation of big brokerage firms which may face stricter capital requirements and requirements to hold more liquid, or easily sellable, assets. (No sorry dear reader, 'greater regulation does not mean 'waterboarding.' - Jesse)

'Clarion call'

"The bright new financial system -- for all its talented participants, for all its rich rewards -- has failed the test of the market place," Paul Volcker, former chairman of the Federal Reserve, said during a speech in April. "It all adds up to a clarion call for an effective response."

Two months later, Timothy Geithner, president of the Federal Reserve Bank of New York, and others have begun to answer that call. (Timmy 'the Fixer' Geithner - Jesse)

"The structure of the financial system changed fundamentally during the boom, with dramatic growth in the share of assets outside the traditional banking system," he warned in a speech last week. That "made the crisis more difficult to manage."

On Thursday, Treasury Secretary and former Goldman Chief Executive Henry Paulson said the Fed should be given the authority to collect information from large complex financial institutions and intervene if necessary to stabilize future crises.

Regulators should also have a clear way of taking over and closing a failed brokerage firm, he added. (We do. Its run by the FDIC and its called 'orderly liquidation' and 'prosecution' - Jesse)
Banking bedrock

The bedrock of traditional banking is borrowing money over the short term from customers who deposit savings in accounts and then lending it back out as mortgages and other higher-yielding loans over longer periods.

The owners of banks are required by regulators to invest some of their own money and reinvest some of the profit to keep an extra level of money in reserve in case the business suffers losses on some of its loans. That ensures that there's still enough money to repay all depositors after such losses.

In recent decades, lots of new businesses and investment vehicles have evolved that do the same thing, but outside the purview of traditional banking regulation.

Instead of getting money from depositors, these financial intermediaries often borrow by selling commercial paper, which is a type of short-term loan that has to be re-financed over and over again. And rather than offering home loans, these entities buy mortgage-backed securities and other more complex securities.

A $10 trillion shadow

By early 2007, conduits, structured investment vehicles and similar entities that borrowed in the commercial paper market and bought longer-term asset-backed securities, held roughly $2.2 trillion in assets, according to the Fed's Geithner.

Another $2.5 trillion in assets were financed overnight in the so-called repo market, Geithner said.

Geithner also highlighted big brokerage firms, saying that their combined balance sheets held $4 trillion in assets in early 2007. (With the active help and collusion of Robert Rubin, Alan Greenspan, Ben Bernanke, Henry Paulson... - Jesse)

Hedge funds held another $1.8 trillion, bringing the total value of asset in the "non-bank" financial system to $10.5 trillion, he added.

That dwarfed the total assets of the five largest banks in the U.S., which held just over $6 trillion at the time, Geithner noted. The traditional banking system as a whole held about $10 trillion, he said.

While acting like banks, these shadow banking entities weren't subject to the same supervision, so they didn't hold as much capital to cushion against potential losses. When subprime mortgage losses started last year, their sources of short-term financing dried up.

"These things act like banks, but they're not," James Hamilton, professor of economics at the University of California, San Diego, said. "The fundamental inadequacy of their own capital caused these problems."

Big brokers targeted

Geithner said the most fundamental reform that's needed is to regulate big brokerage firms and global banks under a unified system with stronger supervision and "appropriate" requirements for capital and liquidity. (Didn't the Fed 'repeal' that system in the 1990's? Oh yeah. Oops. Their bad. - Jesse)

Financial institutions should be persuaded to keep strong capital cushions and more liquid assets during periods of calm in the market, he explained, noting that's the best way to limit the damage during a crisis.

At a minimum, major investment banks and brokerage firms should adhere to similar rules on capital, liquidity and risk management as commercial banks, Sheila Bair, chairman of the Federal Deposit Insurance Corp., said on Wednesday.

"It makes sense to extend some form of greater prudential regulation to investment banks," she said.

Separation dwindled

After the stock market crash of 1929, the U.S. Congress passed laws that separated commercial banks from investment banks.

The Fed, the Office of the Comptroller of the Currency and state regulators oversaw commercial banks, which took in customer deposits and lent that money out. The Securities and Exchange Commission regulated brokerage firms, which underwrote offerings of stocks and corporate bonds.

This separation dwindled during the 1980s and 1990s as commercial banks tried to push into investment banking -- following their large corporate clients which were selling more bonds, rather than borrowing directly from banks.

By 1999, the Gramm-Leach-Bliley Act rolled back Depression-era restrictions, allowing banks, brokerage firms and insurers to merge into financial holding companies that would be regulated by the Fed. (That's Gramm as in Phil Gramm chief economic adviser to current presidential candidate John McCain - Jesse)

Commercial banks like Citigroup Inc. and J.P. Morgan Chase signed up and developed large investment banking businesses. (Under Sandy Weill of Citigroup enough lobbyists were paid to overturn these regulation to fund several institutions of major learning for their kids and strip clubs for dad and mega-manions for mom - Jesse)

However, big brokerage firms like Goldman, Morgan Stanley and Lehman didn't become financial holding companies and stayed out of commercial banking partly to avoid increased regulation by the Fed.

Run on a shadow bank

The Fed's bailout of Bear Stearns in March will probably change all that, experts said this week.

Bear, a leading underwriter of mortgage securities, almost collapsed after customers and counterparties deserted the firm.

It was like a run on a bank. But Bear wasn't a bank. It financed a lot of its activity by borrowing short term in repo and commercial paper markets and couldn't borrow from the Fed if things got really bad.

Bear's low capital levels left it with highly leveraged exposures to risky mortgage-related securities, which triggered initial doubts among customers and trading partners.

The Fed quickly helped J.P. Morgan Chase, one of the largest commercial banks, acquire Bear. To prevent further damage to the financial system, the Fed also started lending directly to brokerage firms for the first time since the Depression.

"They stepped in because Bear was facing a traditional bank run -- customers were pulling short-term assets and the firm couldn't sell its long-term assets quickly enough," Hamilton said. "Rules should apply here: You should have enough of your own capital available to pay back customers to avoid a run like that." (Nice precedent - more public money for JPM - Jesse)

Bear necessity

A more worrying question from the Bear Stearns debacle is why customers and investors were willing to lend money to the firm in the absence of an adequate capital cushion, Hamilton said.

"The creditors thought that Bear was too big to fail and that the government would step in to prevent creditors losing their money," he explained. "They were right because that's exactly what happened."

"This is a system in which institutions like Bear Stearns are taking far too much risk and a lot of that risk is being borne by the government, not these firms or the market," he added.

The Fed has lent between $8 billion and more than $30 billion each week directly to brokerage firms since it set up its new program in March. Most experts say this source of emergency funding is unlikely to disappear, even though it's scheduled to end in September.

"It's almost impossible to go back," FDIC's Bair said on Wednesday. (We have a few ideas - let's get medieval on their asses - Jesse)

With taxpayer money permanently on the line to save big brokers, these firms should now be more strictly regulated to keep future bailouts to a minimum, Bair and others said.

"By definition, if they're going to give the investment banks access to the window, I for one do believe they have the right for oversight," Richard Fuld, chief executive of Lehman, told analysts during a conference call this week. "What that means, though, particularly as far as capital levels or asset requirements, it's way too early to tell."

Super Fed

Next year, Congress likely will pass legislation forcing big brokerage firms to be regulated fully by the Fed as financial holding companies, Brad Hintz, a securities analyst at Bernstein Research and former chief financial officer of Lehman, said.

Legislators will probably also call for tighter limits on the leverage and trading risk taken on by large brokers, while demanding more conservative funding and liquidity policies, he added.

Restrictions on these firms' forays into venture capital, private equity, real estate, commodities and potentially hedge funds may also follow too, Hintz warned.
This may undermine the source of much of the surging profit generated by big brokerage firms in recent years.

A newly empowered "super Fed" will likely encourage these firms to arrange longer-term, more secure sources of borrowing and even promote the development of deposit bases, just like commercial and retail banks, the analyst explained.

This will make borrowing more expensive for brokerage firms, undermining the profitability of businesses that require a lot of capital, such as fixed income, institutional equities, commodities and prime brokerage, Hintz said.

Such regulatory changes will cut big brokers' return on equity -- a closely watched measure of profitability -- to roughly 15.5% from 19%, Hintz estimated in a note to investors this week.

Lehman and Goldman will be most affected by this -- seeing return on equity drop by about four percentage points over the business cycle -- because they have larger trading books and greater exposure to revenue from sales and trading. Goldman also has a major merchant banking business that may also be constrained, Hintz added.

Morgan Stanley and Merrill Lynch will see declines of 3.2 percentage points and 2.2 percentage points in their return on equity, the analyst forecast. (move that decimal point several places to the right - Jesse)

If you can't beat them...

Facing lower returns and more stringent bank-like regulation, some big brokerage firms may decide they're better off as part of a large commercial bank, some experts said.

"If you're being regulated like a bank and your leverage ratio looks something like a bank's, can you really earn the returns you were making as a broker dealer? Probably not," Margaret Cannella, global head of credit research at J.P. Morgan, said.

Regulatory changes will be unpopular with some brokerage CEOs and could result in a shakeup of the industry and more consolidation, she added.

Hintz said the business models of some brokerage firms may evolve into something similar to Bankers Trust and the old J.P. Morgan. (as they say in Halo - new zombies - Jesse)

In the mid 1990s, Bankers Trust and J.P. Morgan relied more on deposits and less on the repo market to finance their assets. They also operated with leverage ratios of roughly 20 times capital. That's lower than today's brokerage firms, which were levered roughly 30 times during the peak of the credit bubble last year, according to Hintz.

However, both firms soon ended up in the arms of more regulated commercial banks. Bankers Trust was acquired by Deutsche Bank in 1998. Chase Manhattan Bank bought J.P. Morgan in 2000.

Alistair Barr is a reporter for MarketWatch in San Francisco.