Banks try to stave off debt shock

LONDON (CNNMoney.com) -- Wall Street banks made a big move Monday to shore up a key short-term financing market, but it remains to be seen whether the effort will calm investors and prevent the subprime contagion from spreading.

A group of banks led by Citigroup Inc. (Charts, Fortune 500), Bank of America Corp. (Charts, Fortune 500) and J.P. Morgan Chase & Co. (Charts, Fortune 500) said they have agreed to create a fund that will buy shaky mortgage-backed securities.

Citigroup, Bank of America and J.P. Morgan Chase are heading up the creation of a fund that will buy mortgage-backed securities.

The U.S. Treasury Department, which helped facilitate the move, applauded the effort. In a statement, the department said it was "pleased with the response by the private sector to enhance liquidity in the short term credit markets."

The fund will buy highly-rated assets from so-called structured investment vehicles, or SIVs. The size of the fund was not disclosed, although various estimates have pegged it at between $75 billion and $100 billion. The banks said the fund could be up and running within 90 days.

While the fund doesn't alter the fundamental problem facing the mortgage market - rising delinquencies on subprime mortgages - it could increase confidence in some better-quality mortgage-related debt.

"People should not get overexcited and think mortgage problems are solved, but this definitely helps in terms of raising sentiment," said Willem Sels, head of credit strategy at Dresdner Kleinwort in London.

The banks said the new fund, to be known as the master liquidity enhancement conduit, or M-LEC, is aimed at boosting the market for asset-backed commercial paper and medium-term notes issued by SIVs.

SIVs are investment vehicles that issue short-term debt to make investments in longer-term securities, including those backed by mortgages. Many of these investment vehicles have run into trouble recently because they have been unable to refinance their short-term debt in the commercial paper market.

This has raised fears that SIVs will have to sell off their assets, which could trigger another wave of shock that roils the credit markets.

As of August, SIVs had about $400 billion under management, according to Moody's Investors Service.

And as long as banks, which have agreed to backstop many of these investment vehicles, are tied up with SIVs, their ability to lend money is constrained.

Investors have shunned commercial paper, which is normally considered a safe investment, since the subprime meltdown raised worries about the quality of assets underlying certain paper.

Since the end of July, the amount of outstanding asset-backed paper - which accounts for about half of the total commercial paper market - has contracted about 23 percent to $899 billion, according to Federal Reserve data.

By creating a market for highly-rated assets, the fund could bolster demand for some of the paper that may have been unduly hit by the panic triggered by the subprime mess.

"The problem you get with a credit crunch is that investors don't discriminate very well. In order to stabilize lending, it's important that good-quality borrowers continue to get credit," Sels said.

Some have charged that the new fund amounts to a Treasury bailout of banks - a claim that one senior Bush administration official denied.

"Not a single penny of government funds is being used," the official said. "We are acting as a facilitator, helping to organize a group that can deal with this in an orderly fashion. The problem is that there was no mechanism in place to handle this situation."

The idea behind the fund is that access to liquidity should allow more issuers to meet pending redemptions and facilitate rollovers.

But since the fund will only buy "qualifying highly-rated assets," some observers are skeptical about how much of an impact it can have on the debt market.

"What really needs help is the paper and programs that have tainted securities, and this fund is not going to invest in that paper," said Michael Cheah, a portfolio manager at AIG SunAmerica Asset Management.

Furthermore, the value of many of these assets remains murky. Money market fund managers, who were big investors in commercial paper until the recent crisis, are still wary of wading back into the market, he said.

"The liquidity risk may be lessened, but the question is what's the reward for investors?" Cheah said.