The Forecast for Financials

Despite concerns about regulation, the long-term outlook is positive, a fund manager says.

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In Wednesday's State of the Union address, President Obama reiterated his plans to propose a tax on some of the country's largest banks and legislation that could limit their size and restrict certain types of trading. A wave of populism has swept through the country, and big banks seem to be bearing the brunt of citizens' frustration. Questions about what the final proposals will seek to accomplish has rattled the stock market. What does this antibanker sentiment in Washington mean for investors? Jeff Arricale, manager of the T. Rowe Price Financial Services Fund (symbol PRISX), says that uncertainty about potential regulation hasn't stopped him from investing in some of the biggest names in the banking industry. He runs a sector fund, meaning it primarily focuses on one slice of the market. The fund returned 28 percent in 2009 and an annualized 5 percent over the past decade. U.S. News spoke with Arricale to get a better understanding of the situation and who's most likely to be affected by further regulation of Wall Street. Excerpts:

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Since the darkest days of the recession, how much improvement have you seen in the financial sector?

As we shifted into the end of 2008 and spring of 2009, fundamental analysis on banks, credit, and the overall environment suggested credit issues would begin to abate and it was appropriate to start increasing investments in the big money-center banks like Bank of America and JPMorgan and the regional banks like Fifth Third, First Horizons and Key Bank. …We believed credit loses will peak in 2010. We still hold that view, and when we look at fourth quarter earnings, that seems to be what is happening. Basically, losses are moderating, and reserve building, which means setting aside earnings to cover future losses or the rate at which companies are increasing their reserves, is declining. Importantly, the net interest margins—basically, the difference between what they pay on deposits and what they make on loans—is expanding. So the fundamentals overall are incrementally getting better. They're not good yet, but they're getting better, and they're likely to continue to get better through 2010. We think the banks will be back to normal earnings and return to profitability in 2012, so our investment thesis is longer-term in nature.

How have you positioned your fund?

We've shifted from a defensive posture in 2008, where we had lots of property casualty insurance and about 10 percent cash, to one where our largest exposure is banks and regional banks. We have less cash, and we're really more aggressively positioned. What would derail our thesis is if unemployment really spikes higher. That will cause more people to default on credit cards and mortgages and lending will continue to be restricted, and I don't think our fund will do very well in that environment.

What exactly is Obama proposing?

They're proposing a tax based on basically the size of the bank's balance sheet, and it could impact earnings anywhere from very modest levels to somewhere between 5 and 10 percent. It's unclear. So there's that proposed bank tax that would disproportionately punish the large banks, and there's the Volcker plan, which among other things would encourage or force some of the large banks to cease activities in private equity and hedge funds and what they call proprietary trading. … That goes on all the time, and that's how the banks make their money. It's the service they provide. They're a source of liquidity for buyers and sellers. … It's in many ways hard to disaggregate what's client-driven activity and what is trading for the investment bank's own account. Sometimes it's very clear and sometimes it's very opaque. … It becomes very difficult to define what is proprietary trading and what is just risk management. It's a very difficult task that the regulators and politicians have taken on.

What companies will be most affected by this potential legislation?

You can paint scenarios where companies like Goldman Sachs could have 10 percent of their earnings that could potentially have to be divested to zero, and again, we don't know. Bank of America does the same thing as Goldman Sachs, but Bank of America is also a gigantic, plain vanilla deposit-taking, commercial loan-making, mortgage loan-making institution. Goldman Sachs doesn't do that, but both banks happen to have very large investment banks that do these kinds of things. So JPMorgan, Citigroup, Bank of America, and to a lesser extent Wells Fargo have the kind of operations that we're talking about. However, they're a much smaller part of the overall organization than they are for Goldman Sachs and Morgan Stanley because Goldman Sachs and Morgan Stanley typically aren't big deposit-gathering institutions, and Morgan Stanley happens to have a big retail brokerage. They've just made less money in proprietary trading and trading overall than Goldman Sachs, so when you look at who has the most to potentially lose, Goldman stands out. … Then, of course, there's some probability that this is all populist, midterm election year posturing and it does not address any of the systemic considerations and problems that actually need to be addressed and it's all going to go away or be largely diluted. So you have a continuum of outcomes to where a company like Goldman Sachs has to stop some activities and you could see their earnings be impacted by maybe 10 percent.

Does the threat of this regulation affect your investment strategy?

For Goldman Sachs and Morgan Stanley, I think the shares adequately reflect the risk we're talking about. The companies have very strong business sheets. In fact, they're now excessively capitalized. They've picked up a lot of market share in their businesses as wounded competitors have pulled back and companies like Bear Sterns and Lehman Brothers no longer exist. They're good investments for long-term shareholders because these companies are generally well managed and do provide a very important role as a greasing mechanism for the wheels of capitalism and commerce. They're an intermediary. … We think it makes sense to invest for our shareholders in light of the uncertainty, and that's what we're doing. We're cognizant of the risk but think that there's a wide continuum of outcomes from very favorable to modestly negative, and if it's the modestly negative outcome, then we think the price adequately reflects that. … In the very near term, there's a lot of uncertainty. Longer term, these banks have plenty of capital. The U.S. economy is going to recover. Banks tend to be a microcosm of the economies in which they operate. We think the U.S. economy will be sluggish but with a positive bias to growth over the next couple of years and that these banks will have strong earnings.