Banks move to rescue debt market

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.

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