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From the U.S. financial sector's point of view, the 2012 Presidential elections are of significant importance. Republican Presidential candidate Mitt Romney has, on several occasions, voiced his concerns against the Dodd-Frank Act, which many in the Banking Industry believe to be a hindrance in banks' most profitable business; proprietary trading. Many opponents believe that the presidential candidate will not be able to revoke the entire act; however, some sections may be repealed. In such a scenario, we believe that Goldman Sachs (NYSE:GS) and Morgan Stanley (NYSE:MS) will benefit the most. These banks have been facing considerable difficulty in terms of declines in their revenues due to the said rule. Both the banks have solid capital bases and present tremendous capital gains in a bullish scenario. Therefore, we recommend our investors to long these stocks if the Republicans take over Washington in the coming Presidential elections.

What is Dodd-Frank Act?

The act was enacted in July 2010 to enforce transparency and accountability within the U.S. financial sector. The act seeks to eliminate future bailouts of U.S. banks by the federal government in case of another recession. Under the Consumer Financial Protection Bureau (CFPB), banks are put under a closer watch. In order to protect consumers, the CFPB ensures that banks are not lending consumer money to risky ventures that will, ultimately, hurt the said consumers.

Section of Dodd-Frank Act Most Targeted

It is widely expected that if the Republicans come to power, Mitt Romney will not be able to repeal the entire act, however, sections of the act might be revoked, which is acceptable to Wall Street. The sections of the act that most of the banks believe go too far include the Volcker Rule. The proposed Volcker Rule limits banks' own trading activities. The final version of the act is expected to be released by the end of 2012. The rule prohibits banks from investing 3% or more of their net asset value in private equity and hedge funds.

The eight largest U.S. banks stand to lose pretax revenues from anywhere between $22 billion and $34 billion due to the new law. Much of this loss is associated with the Volcker Rule alone. The rule also has the ability to reduce liquidity in the bonds markets, which will result in an increase in costs of borrowing.

Banks to Benefit on a Republican Win

We believe that large-cap banks in the U.S., particularly Morgan Stanley and Goldman Sachs , will be the major beneficiaries if the Republicans make it to Washington and the proposed Volcker Rule is struck down. Both relied heavily on trading, which is why at one point in time, the future of these banks was in question. In order to continue to operate, it was considered that both these banks may have to shed their statuses as bank holding companies.

Morgan Stanley

Morgan Stanley was hit hard by the rule when it reported its second-quarter earnings. The bank relies heavily on revenue from trading, which is why a plunge in the revenue from trading led to a drop of 50% in the bottom line. The bank announced job cuts as revenue from trading declined by 48%. Morgan Stanley's plans to raise a global infrastructure fund were severely jeopardized by the proposed Volcker Rule. This highlights the problem that banks face when competing with other independent alternative asset management companies. At the end of the second quarter of the current year, approximately 37% of the bank's total revenue came from principal transactions. The previous year's share of trading activities in the bank's total revenue was 44%. Morgan Stanley is facing considerable headwinds because of the Volcker Rule. At least four of the key executives who oversaw the infrastructure fund have left the bank over the past one year.

Earlier in a report, we concluded that the bank was not favorably placed among the rest of the large-cap banks in the U.S. The bank's poor operating performance was visible when it reported results for the second quarter of the current year. It is notable to say that the bank was not able to maintain its market share in the bonds trading business, which was also blamed for the disappointing operating performance. The bank reported a decline in revenue, while the bottom line remained below expectations. The bank also witnessed favorable impact from debt value adjustment (DVA) worth $350 million.

The bank has a robust capital position, as reflected by its 2Q2012 Tier 1 capital ratio and total capital ratio of 17.2% and 18.4%, respectively. The Tier 1 capital ratio and total capital ratio for JPMorgan (NYSE:JPM) at the end of the second quarter of the current year were 11.3% and 14%, respectively.

Morgan Stanley trades at a discount of 47% to its book value. Consensus mean and bullish estimates for MS are $19.96 and $27, respectively. In a bullish scenario, this means an upside of 62%, as the stock is currently trading at $16.64 per share.

Goldman Sachs

Similarly, Goldman Sachs' second infrastructure fund remained unsuccessful. The fund's target had to be cut by almost half to $3.1 billion. At the end of the second quarter of the current year, approximately 34% of the bank's total revenue came from principal transactions. The bank, in order to comply with the new regulations, was forced to redeem $250 million worth of interests in hedge funds over the past quarter, and $500 million over the past two quarters. In 2011, the share of trading activities in the bank's total revenue was a significant 60%.

In an earlier report, we saw how the bank's second-quarter performance was above analyst estimates. Despite headwinds from the Volcker Rule and a deteriorating situation in the U.S. equity and bonds markets, the bank was able to post a turnover figure that was 5.5% above expectations. The bottom line remained a significant 51% above consensus mean expectations. Much of the unexpected improvement in performance was associated to higher debt underwriting revenue and lower operating expenses. Revenue from debt underwriting surged by 21% when compared with the same quarter of the previous year, while overall operating costs decreased by 8% when compared with the prior quarter. The bank has a solid cost-cutting program, through which it aims to save $1.9 billion by the end of the current year. This cost-cutting program, if implemented successfully, has the potential to positively impact the bank's bottom line in the coming quarters.

Goldman Sachs has a robust capital base when compared with its peer JPMorgan. This we say after looking at the Tier 1 capital ratio and the total capital ratio of 15% and 18.1%, respectively, for Goldman Sachs.

As part of the risk associated with the bank, we believe Goldman Sachs, which was considered to be the most preferred employer in the U.S. financial sector, has now lost its gold. The bank is shedding its workforce, slashing their salaries, and has been recently reported to have suspended its premier 2-year graduate program. These factors are making it difficult for the bank to attract and maintain a superior workforce.

Goldman Sachs trades at a discount of 20% to its book value. Consensus mean and bullish estimates for GS are $126.17 and $170, respectively. In a bullish scenario, this means an upside of 49%, as the stock is currently trading at $114.2 per share.

Since the banks under consideration still have a heavy reliance on principal trading activities, we believe that for both Goldman Sachs and Morgan Stanley, a bullish scenario would equal an improvement in the U.S. debt and equity markets, combined with the repeal of the Volcker Rule.

Source: 2 U.S. Banks To Buy On A Romney Win