Banks move to rescue debt market

To shield the US economy, they'll create a fund to shore up mortgage investments.

Some of the world's banks, under the watchful eye of the US Treasury, are starting one of the largest private financial rescue plans ever – throwing their reputations, credit ratings, and assets into an attempt to persuade investors it is safe to buy short-term debt used to fund mortgages.

The effort, announced Monday, is designed to shield the economy from a potential credit crunch, as hundreds of billions of dollars in short-term debt come due in the next 60 days. If credit tightens at a time when the economy is slowing, it could potentially push the US economy into a recession – despite the efforts of the Federal Reserve, which recently lowered short-term interest rates by half of a percentage point.

"A credit crunch is not apparent at this time, but it could happen," says Richard DeKaser, chief economist for National City Corp. in Cleveland.

Bank of America, Citigroup, and JPMorgan Chase said Monday they had reached an agreement in principle to create a new fund called the Master Liquidity Enhancement Conduit (M-LEC). The fund, which could be as much as $100 billion in size, will initially purchase what it terms high-quality assets that other investors have been reluctant to hold.

The new conduit is needed to absorb the billions of dollars in commercial paper – very short-term loans – sold to large institutional investors through a product called a structured investment vehicle. The SIVs have had difficulty finding buyers. Instead, they have been exercising their backup liquidity lines by borrowing directly from commercial banks. Those borrowings have shown up in Federal Reserve statistics that indicate bank loans are climbing.

The assets of the SIVs are not carried on the balance sheets of the banks. However, once the managers of the SIVs turn to the banks to provide backup liquidity, that changes, since it is now a loan made by the bank itself.

"Once it's on the balance sheets, the banks need to reserve against losses, and this potentially impairs their ability to lend out to everyone else," says Mark Zandi, chief economist for Moody's Economy.com.

For example, Citigroup announced Monday that its earnings had dropped 57 percent in the third quarter. As the bank has made loans, it has had to reserve against losses. Yesterday, the institution boosted loan-loss provisions by $2.24 billion.

"The danger here is that banks have to unload their loans at fire-sale prices," says Mr. Zandi.

A month ago, Treasury Secretary Henry Paulson indicated at a Monitor breakfast in Washington that he was concerned about the ability of the banking system to roll over the short-term debt that is used to fund mortgages. He said he was looking for a "vehicle" that would help provide liquidity. Since then, according to the banks, the Treasury Department has "facilitated" the discussions among a consortium of banks and investment managers.

The M-LEC plan is reminiscent of the government bailout of the savings-and-loan industry in the late 1980s. A government-backed fund, called the Resolution Trust Corp., acquired the assets of thrifts that had failed. At its peak, it had hundreds of billions of dollars in assets that no one wanted on their books.

"The M-LEC plan is an evolution of the Resolution Trust Corp.," says Zandi. "It's the same principle, trying to establish prices for assets."

Banks also teamed up after a hedge fund, Long Term Capital Management, failed. It had speculated in the Treasury market and taken large losses. By buying some of the assets of the company, the banks helped to maintain global confidence in the financial markets.

The problems for the SIVs began in early August, when losses in the subprime mortgage arena started to balloon. Subprime loans are those made to individuals with less-than-stellar credit ratings.

Since then, investors have been loath to continue to make loans to the SIVs even for loans that are performing. In the structure of the new M-LEC facility, the banks hope to assuage concerns by building in what they term "a cushion" of support through backup liquidity and layers of capital. It is expected the new fund will also carry the high credit rating of the banks.

Two of the three major banks involved, Bank of America and JPMorgan Chase, do not have SIVs. However, individuals involved in the market say they are involved with the rescue plan because there are potentially large fees that they could profit from.

Economist Bob Brusca of Fact and Opinion Economics in New York says M-LEC is a statement by the banks that they know the value of the assets in the SIVs better than the marketplace. "This is obviously a question of judgment: This entity thinks it knows credit better and can lend better."

If the banks are accurate in the assessment, they may be able to avoid writing down more assets, says Mr. DeKaser. "The premise here is that the depressed prices are aberrant," he says. "To keep the balance sheets looking clean, they can be sold to M-LEC, which can theoretically bring them back to a more respectable valuation," he says. "The risk is that prices are not aberrant, and you have just moved the problems from one place to another."