4.1.14: CCAR, the Big Banks and the Exchanges: The Exchanges control their own Destiny

CCAR is the Comprehensive Capital Analysis and Review (CCAR) instituted by the Fed and regulators after the Mortgage and Housing Crisis of 2008, that simply means that banks have to get “permission” from the Fed before paying dividends and repurchasing stock.

Much like a sad Oliver Twist replication, “may I have some more, please ?” the banks must now come hat in hand to the Fed, and ask for permission  to return capital to shareholders. In effect, Ive thought this made the banks public utilities, where the local utility must get “permission” for a rate increase, prior to implementing.

Because of this, while we’ve always been a big bank and financial investors, I also wonder if we will get to a day like Jeremy Grantham articulated or talked about post-2008, where he said that Bernanke, and Paulson should have required the banking system to raise capital in 2007, (naturally all suggested in perfect hindsight, after we had a near collapse of the banking system.)

The point is can the Fed now call a top for the credit cycle and require TBTF (Too Big to Fail) and other SIFI institutions to raise capital out of the blue ? What if the Fed forces too much capital to be raised and shareholders are thus diluted and crushed based on “Federal Reserve regulation”, and the credit cycle isn’t as bad as expected.

Big Brother is watching. And free-market capitalism has lost another leg to stand on (maybe).

The point being that although we own more banks for clients than the exchanges at present time, the exchanges in my opinion are better risk-management institutions, given their mark-to-market function. Craig Donohue, the CEO of the Chicago Mercantile said in the aftermath of 2008 – 2009 that exchanges would have been able to monitor the degradation of the swaps that were mostly over-the-counter (OTC) at that time, and forced the counterparties to put up collateral against the swaps. Because a lot of these counterparties were valuing or pricing their own swaps, (and hence maybe reluctant to write down a Lehman credit swap), the move by regulators today is to standardize these contracts and put a lot of these activities on the exchanges where they can be more “marked-to-market” and see some adult supervision.

Exchanges have taken a beating yesterday and today presumably in light of the “60 Minutes” high-frequency-trading (HFT) documentary run Sunday night. Using inflammatory and hyperbolic terms like “the market is rigged” Michael Lewis has pegged the HFT’s as electronic pirates. Ive heard both sides of the debate.

The reason the exchanges are taking a beating today is that if HFT is curtailed (and it very well could be) or even slowed down, it is highly likely volume on the exchanges will fall, since HFT was entirely based on speed to an exchange, and then millisecond trading of a  very high number of shares to execute the spread or the arbitrage at razor this margins. While that represents my inadequate knowledge of the subject matter it is clear that volume will likely slow or drop as HFT gets scrutinized by congress and various futures and financial regulators, the trading will get slower and the volume will drop.

Our largest holding is the Chicago Merc (CME), long held as a beneficiary of rising rates given the CME has 99% market share of the Treasury complex. ICE’s acquisition of the NYSE – Euronext was a shrewd move, but the old NYSE trading floor is going away. Since the CME went public in late 2002, early 2003, it has been clear the future of any kind of trading, (commodity or otherwise) trading is electronic and on screens, not open outcry.

ICE is getting very interesting here, with its Energy complex and now cash-equity clearing business, from the NYSE.

Our three exchanges that we follow fundamentally and track intrinsic value, are CME, ICE and CBOE.

We think CME’s intrinsic value is closer to $90 per share, while we have ICE’s intrinsic value near $295, while Morningstar has an intrinsic value on ICE near $200. The uptrend off the ’09 low for ICE on the weekly chart doesn’t show support until $150. I dontb think it will trade that low. At $193 ICE is hitting its 50-week moving average.

The CBOE is still overbought and the HFT scrutiny perhaps wont impact it to the degree it will the other exchanges.

We don’t follow the Nasdaq (NDAQ) but that exchange seems to be getting the brunt of the selling with HFT scrutiny.

We are going to develop this theme to a greater degree over the coming weeks and months. We may get a good shot at buying some exchanges at good valuations over the next 90 days. For now I’m staying with JPM, BAC, and WFC, but might start picking away at some ICE. The important theme to remember about the exchanges vis-à-vis the banks is that the exchanges control their own future. I think they are better positioned for the next 10 years, HFT notwithstanding.

(Comments and criticisms welcome please. If you are a floor trader or exchange member, please send me your comments.)

Finally join Bob Lang and I for an “SP 500 earnings” discussion at Explosive Options where Bob runs webinars on a variety of interesting topics. Thursday after the close we will talk about SP 500 earnings, what q1 ’14 will look like, and what it portends for the rest of 2014. This is the 2nd time Bob has been kind enough to invite me on the show, so we hope to make SP 500 earnings and where to invest for the rest of 2014 an interesting topic for listeners.

Thanks for reading today and giving us a minute of your time. A lot of blogs compete for your eyeballs, so “thank you” for reading ours.

Trinity Asset Management, Inc. by:

Brian Gilmartin, CFA

Portfolio manager




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