Commentary: Financial industry rescue from the SEC and Treasury

Daily Record (Rochester, NY), Aug 6, 2008 by James Quackenbush

If you have been watching the U.S. stock markets or looking through quarterly statements from your local investment firm, you've probably observed that the markets are down significantly and your investment accounts have lost a noticeable amount of money.

As of Aug. 1, the S&P 500 Index is down 14.2 percent since the beginning of the year. Turmoil in the credit markets, a stagnant housing market, a weak dollar and record high commodity prices are the main contributors to the decline. Such circumstances make it extremely challenging for financial companies to operate and have led the U.S. Securities and Exchange Commission (SEC) and the Treasury Department to assist the financial industry.

The financial sector, which has contributed roughly 28 percent of the poor performance in the S&P 500 index, has been plagued by a slumping housing market, which created a credit crisis among all financial institutions. The crisis originally was created by lenders that offered sub-prime mortgages to high-risk individuals, who eventually defaulted on the loans. As the amount of defaults began to rise, mortgage-backed securities started to lose value at a very rapid pace, causing firms to write-down the values of mortgage- backed assets. The write-downs had a dramatic effect on corporate assets and earnings for almost all banks and lending agencies and sent their stock prices tumbling, generating poor performance in the financial sector. One company, Washington Mutual, which specializes in mortgages, has been crippled by write-downs causing its stock price to lose more than 90 percent of its value.

In the hope of containing and preventing further downsides on financial stock prices, the SEC has employed a temporary rule on short selling for 19 financial companies. (Short selling is the process of selling a stock that you don't own, betting it can be bought back at a lower price in the future, then profiting from the difference.) Because of the constant weakness on financial stocks, investors have been shorting them, in turn increasing pressure to sell financials and driving the price of such stocks lower.

The SEC's temporary rule requires short sellers to make specific arrangements with investment firms to physically borrow shares to sell short, making it more difficult to short them and alleviating a large amount of selling pressure. Since July 15, when the new rule was put in place, the S&P 500 Financial Index has gained 25 percent.

The U.S. Treasury Department also has taken action to aid the industry: Treasury Secretary Henry Paulson has been at the forefront of bringing the economic realities of the financial system to the attention of Congress and pushed for government intervention. Through Paulson's vigorous work, a new housing bill was passed July 30 that will offer relief to 400,000 struggling homeowners in the form of refinancing unaffordable mortgages. The bill offers a low- income housing tax credit to individuals and a tax credit of up to $7,500 for first-time homebuyers while also throwing a temporary financial lifeline to Fannie Mae and Freddie Mac. Once the plan is fully implemented, it should ignite the housing market by attracting buyers, decreasing the number of mortgage defaults and restoring confidence in the nation's two largest mortgage originators.

Paulson also initiated a plan to further ease the credit crisis and increase liquidity for banks by creating a covered bond market.

"The key to the U.S. economy making a major improvement will be turning the corner on housing finance and the housing market. We're not going to be able to do that unless we have availability of mortgage financing and this is an attractive new source," Paulson said.

Covered bonds, which are used predominately in Europe, are backed by mortgages or cash flows from other debt. They are similar to mortgage-backed securities, but considered far more secure because purchasers have a direct claim on the issuer's balance sheet.

To prevent similar problems with mortgage-backed securities, the Treasury Department developed strict guidelines for issuing banks that will create the new covered bond market. Four of the largest U.S. lenders -- Bank of America, Citigroup, J.P. Morgan Chase and Wells Fargo & Co. -- joined forces to lead the way in the market's development. If a covered bond market proves successful, it could help the housing market get back on its feet quickly and increase liquidity for banks offering mortgages.

It will be interesting to see how much of a positive impact the new short selling rule, the latest housing bill and the creation of a covered bond market will have on the financial sector and the stock market overall. Lately, there has been positive momentum. Hopefully the markets will continue to see additional gains in the coming months, as the recent Treasury Department and the SEC interventions work their way through the financial system and housing market.

James Quackenbush is an investment assistant for Karpus Investment Management, a local independent, registered investment advisor managing assets for individuals, corporations, non-profits and trustees. Offices are located at 183 Sully's Trail, Pittsford, N.Y. 14534; phone (585) 586-4680.