Too Big To Jail

Investing Daily Article of the Week

by Brian O’Connell

When Congress passed the Dodd-Frank Financial Reform Act in 2010 and President Obama signed it into law, consumer advocates had a field day crowing that the financial reform bill would finally rein in big banks.

Fat chance.

Apparently, the fix was in all along, and major US financial institutions are laughing all the way to the bank over legislation ostensibly designed to provide checks and balances to large financial services firms.

It turns out the only checks and balances involved are the large checks banks are cashing and the growing size of the account balances at mega-investment banking firms like Goldman Sachs (NYSE: GS), JPMorgan Chase (NYSE: JPM), and Bank of America (NYSE: BAC), among others.

In fact, buried deep inside the Dodd-Frank financial reform bill is a provision that every investor should know about, but few actually do.

It focuses on what the legislation calls “Systematically Important Financial Institutions,” which are financial services firms whose risk for failure has the potential to trigger damage across the rest of the US economy.

In a recent speech to the 49th Annual Conference on Bank Structure and Competition sponsored by the Federal Reserve Bank of Chicago, Federal Reserve Chairman Ben Bernanke said so-called “SIFIs” need special treatment, and implied special protection, by the US government so they don’t fail and potentially take the economy down with them.

Here’s a key passage from that speech:

“SIFIs are financial firms whose distress or failure has the potential to create broader financial instability sufficient to inflict meaningful damage on the real economy.

SIFIs tend to be large, but size is not the only factor used to determine whether a firm is systemically important; other factors include the firm’s interconnectedness with the rest of the financial system, the complexity and opacity of its operations, the nature and extent of its risk-taking, its use of leverage, its reliance on short-term wholesale funding, and the extent of its cross-border operations.

Under the Dodd-Frank Act, the largest bank holding companies are treated as SIFIs; in addition, as I mentioned, the act gives the FSOC [the Financial Stability Oversight Council] the power to designate individual nonbank financial companies as systemically important. This designation process is under way.”

In earlier testimony to Congress this year, Bernanke further described how Dodd-Frank was designed to better regulate big banks:

“Dodd-Frank has a strategy. It involves making big institutions internalize, and take account of, their systemic costs by tougher regulation, higher capital charges and so on, the orderly liquidation authority and strengthening the entire system. So there are steps that we are taking that are moving in that direction. I think the markets will come to see that these steps are effective.”

Now the Federal Reserve, at the urging of G-20 nations, are adapting new policies that virtually insure SIFI banks from failure, thus guaranteeing more bailouts if needed.

Wall Street watchers say this insurance policy comes straight out of taxpayers’ pockets, money that adds to the national debt and that could fuel a rise in inflation, both negative trends for the US economy.

This from David Leeper, reporting for the Western Free Press:

“There may never have been a more open invitation to abuse of governmental power and corruption of free-market capitalism than the SIFI concept. SIFIs can, and have, engaged in risky investments with depositor and client funds, knowing that SIFI protections will bail them out of failures with government funds. Dodd-Frank was supposed to protect taxpayers, but it is a gold-mine of opportunities for crony capitalist companies and their lobbyists to buy new carve-outs and exceptions. The complexity of Dodd-Frank is implicit protection for SIFIs since smaller competitors cannot afford the lawyers, lobbyists, and campaign contributions to buy themselves carve-outs and exceptions.”

The SIFI provision may indeed cost taxpayers plenty, but for smart investors, it’s an opportunity for some insurance protection of their own.

Since SIFIs are established to both regulate and protect mega-financial institutions, the savvy move is to add some protection in your portfolio that covers big banks.

I’m recommending the Market Vectors Bank and Brokerage ETF (NYSE: RKH), where three large US banks—Wells Fargo (NYSE: WFC), HSBC (NYSE: HSBC) and JPMorgan Chase—comprise 30 percent of the fund’s holdings.

In a research note, S&P Capital points out that the outlook for banks over the next year is an optimistic one, so an exchange-traded fund (ETF) play not only gives you the protection bestowed by US taxpayers via Dodd-Frank, it also gives you some room for growth in an industry that analysts see gaining steam in 2013 and 2014.

S&P Capital has issued a four-star rating on the major banks held in RKH, and calls another big bank fund holding, Wells Fargo, “undervalued.” RKH also holds Bank of America and Goldman Sachs in its “top 10” holdings, making it a strong, strategic play for investors looking for some portfolio insurance from big banks, via Dodd-Frank.

Market Vectors Bank and Brokerage is trading at about $52 right now, a price largely unmoved in the past 120 days, and has returned about 10 percent to investors so far in 2013.

Look for investors to flock to the ETF as more news seeps out about the Dodd-Frank SIFI provision, and as the Federal Reserve increasingly resolves not to let big banks fail — no matter what.