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In lieu of the recent predictions that I made for future investment banking regulation, there are new developments that warrant commentary. First, by and large, my predictions ended up being part of Paulson’s plan for more regulation of the financial services industry.

I would most like to focus on the idea that regulators, which could be the Fed in the future, are going to demand more capital and lower leverage on investment bank’s balance sheets. The regulators are going to make these demands in light of the bailout of Bear Stearns (NYSE:BSC) and the perception that leverage combined with non liquid assets on an investment bank’s balance sheet could lead to another investment bank getting killed in the future, which would force the Fed to step in again.

Basically, the Fed and regulators in general are going to demand less risk taking on Wall Street if they are going to assume the role of lender of last resort for the industry.

Now these demands, which are directed at investment banks for less leverage and more liquidity (more capital cushion), are very similar to the demands that regulators made on commercial banks following the stock market crash/great depression. However, very little attention has been focused on how this is going to affect the organization of the investment banking industry or how it will affect profitability in the industry. Bill Gross, famed bond investor and CIO of PIMCO, wrote on his company’s website in his April investment outlook that regulators will force investment banks to set aside more capital, "resulting in reduced profitability."

A report by analysts at Morgan Stanley (NYSE:MS) and consulting firm Oliver Wyman predicts "longer term ROEs to fall as banks seek to de-lever and regulators ask banks to hold more cushion.” Others have privately speculated that profitability will go down as measured by ROE but how this change in profitability induced by further regulation will effect the competitive positions of the various firms has not been directly addressed.

In this article from Bloomberg David Viniar, Goldman Sachs’ (NYSE:GS) chief financial officer, was asked if he thought the crisis would have “permanent implications” for Wall Street’s appetite for leverage. His answer: “No, I don’t.” He made this statement less than 48 hours after a government-backed deal rescued Bear Stearns. I disagree, and in fact, the regulation that will come about to limit leverage and the liquidity of assets will impact Goldman more than its peers. Despite Mssr. Viniar’s strong comments I believe that privately Goldman management is seriously worried about how their firms comparative advantage in proprietary trading may be taken away by regulators wanted to reign in risk at investment banks.

Like I wrote earlier, if Goldman’s edge over JP Morgan (NYSE:JPM) is removed by more regulation, then the JP Morgan business model will reign supreme on Wall Street and firms that used to have big trading books like GS will be permanently handicapped.

Lloyd Blankfein, CEO Goldman Sachs Group: Smug Contrarian or Arrogant Fool?

I'd like to make clear how liquidity and leverage are inextricably linked when an investment bank tries to finance its balance sheet. Keep in mind that most firms, except Goldman Sachs which increased its leverage, are reducing historically high leverage levels right now because of market volatility and uncertainty.

I think Goldman Sachs increasing its leverage reeks of arrogance and will probably end poorly for them given the lack of confidence and volatility in the market place. They do have more freedom to increase their leverage compared to their competitors, since Goldman can still borrow at a 10 year duration at 2.41% over 10 year treasuries versus 3.02% over treasuries for Lehman (LEH). Yet, just because they have the freedom to do it does not mean it is a good choice. In fact I think they will regret it but I have to grant that recently their contrarian stances have paid off. On this move, however, their luck may run out.

Yet, back to the strong link between liquidity and leverage when financing an investment bank’s balance sheet. Clearly regulators and to some extent ratings agencies will put pressure on banks to lower their leverage. There are multiple ways for an investment bank to finance and most use a combination of long-term debt, short-term commercial paper, and repurchase agreements to finance their liabilities and lever up on the equity they have. The better the bank is as a credit risk the more opportunity they will have to get longer term capital by issuing long-term bonds (like 10 years) or issuing short-term commercial paper. The third kind of financing, repurchase agreements or repos (also remember the opposite reverse repos), is where Bear Stearns got crushed.

In the case where no one will buy new issuance of commercial paper or more new issuance of long-term debt or the yield demanded just makes such paper too expensive for a bank to make the interest payments a bank must rely more and more on repos to finance their liabilities and leverage. Goldman tends to borrow more short-term CP and long-term debt and not rely as heavily on overnight or short-term repos. "Goldman is still AA rated and has a good image in the marketplace as shrewd risk takers, so the spreads they’re paying for 10-year money are a lot less than everybody else’s,” said CreditSights’ Hendler. Goldman only finances 14.8% of its balance sheet with repos while Lehman finances about 27.2% of its balance sheet with repos.

For comparison, Bear Stearns used repos for 26.2% of its borrowing at the end of 2007. The problem with the repo market is that you must rely on other broker dealers or other counterparties to trade with you. When Bear could not tap the commercial paper or long-term debt markets, could not get an equity infusion, and its counterparties stopped doing repos with them they were inches from becoming insolvent. Combine that with all the prime brokers saying at once that they would not disintermediate trades done with Bear Stearns for derivative contracts like CDS.

Now how much money you can borrow against your cash bond collateral in the repo market is directly proportional to the quality of the bond collateral you hold. So in Bear Stearns' case the CDO and MBS collateral they were trying to borrow against would not fetch as much money on loan as if they held government treasuries. So banks that have AAA rated non-mortgage debt of long and short term maturities can actually get more leverage cheaper in the repo market using such debt as collateral in the repurchase agreement. So in this case the better your assets they more you can lever up and the more liquid your collateral/financing.

Now in Bear Stearns' case they were holding illiquid mortgage securities that were falling in value or had no bid in the marketplace. They were trying to borrow against this collateral but some banks would not take that mortgage debt as collateral to lend money in the repo market. When no one would do repo with Bear with any kind of collateral the game was really up. So in this case the banks that are left standing now will have as much liquidity and freedom of action to lever their balance sheets as the strength of the bonds they hold can provide serving as collateral in the repo market for cash on loan. Yet, like the Prince said before, freedom of action with respect to leverage is not a reason in and of itself to actually put on more leverage given market conditions.

To summarize my predications. ROE will fall across Wall Street as regulators force banks to deliver. Goldman Sachs will suffer more losses than peers in this volatile environment because of their contrarian move to increase leverage. In the long term Goldman Sachs will be stripped of its proprietary trading advantage which is the central component of its business model by regulators wanting to lower risk in the investment banking world.

JP Morgan and other big balance sheet banks with small trading books will replace Goldman Sachs as the top investment banks. Disagree with the Prince's analysis or predications? He grants an audience to any subjects that wish to question his commentary. Want him to tone down the negative comments on Goldman Sachs? Tough.

Disclosure: The Prince currently owns SKF but has no other positions in broker dealers or other positions linked to broker dealers.

Source: Paulson's Plan: Can Wall Street's Appetite For Leverage Stomach Regulation?