US Battles the Credit Crunch

Jul 28, 2008

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The dual track of limiting naked short selling and increased government powers to help Fannie and Freddie seems to have worked for at least the short term. Since that fateful Tuesday, both stocks have rebounded nicely.

And now the US wants to keep that momentum going. Today, movement was made in 3 key areas.

1) SEC Expanding Curbs on Shorts

In a Wall Street Journal article today, they indicated that curbs to shorts may in fact expand. Other industries such home builders, insurance, and other financials may now be included.

The temporary limits covering 19 financials was set to expire at 11:59pm est Tuesday July 29.

The SEC held calls with a major fund association over the weekend to discuss the issue. Of great concern to funds was the ability for computer traded programs to adjust their software for the new rules. That would seem like a technical problem for the industry rather than a major hang up for the SEC.


2) FOMC to Improve Inflation Transparency

As of today, Committee officials use core inflation to set a sustainable price target for the next 3 years.

In a speech in Washington today, outgoing Fed Governor Mishkin outlined how that might be improved. He suggested 3 key changes.
a) Set a mandate rate like that used in England and Europe
b) Switch to 5 year forecasts
c) Use headline inflation rather than core inflation.

This speech is notable as Governor Mishkin is sometimes thought of as an inflation dove. The wide divergence between headline and core inflation in recent months makes the third point unlikely for the near term. However, a mandate rate (which he has long supported) and 5 year outlooks are plausible.

I am not convinced mandate targets are really useful. The Bank of England, the Royal Bank of Australia, and the ECB seem to be cornered by their rates. In each case, the bank is willing to exceed their mandate in the short term while they wait for their respective economies to slow enough to justify further rate action.

Had the Fed been similarly handcuffed, it is unlikely they would have cut rates as substantially or as fast as they did in the last year. (Though watching Jim Cramer's head explode on national TV would have been great entertainment).



3) Paulson Pushes Covered Bonds

In what could be a major strike against the credit crunch, US Treasurer Hank Paulson announced best practices for covered bonds.

What are covered bonds and why would they help?

Glad you asked.

Like the mortgage backed securities that got the US into this mess, they are mortgage pools backed by cash flow.

I can hear the groans an snores already, but stay with me.

Unlike the CDOs of recent years - the originating institution MUST keep the security on their own balance sheet. That is, they can not sell them off to others. Perhaps the biggest problem with the recent run in mortgage securities is that they were sold off to other institutions. Forcing them to stay with origination should enforce higher lending standards.

More specifically, covered bonds would have the following limits:
- balance stays on asset sheet of lender
- covered bonds can not exceed 4% of lender liabilities
- loans must have documented income
- mortgages over 60 days delinquent must come out of the pool
- investors in the pool must be updated monthly

Today, Europe's mortgage market largely functions under this model to the tune of $3 trillion. In contrast, their are virtually no covered bonds in the US.
Credit Crunch, housing, Fed, SEC, USD