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Fed loans not easing credit crunch

Banks are still afraid to lend money even with cash infusions from Federal Reserve.

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By Tami Luhby, CNNMoney.com senior writer

NEW YORK (CNNMoney.com) -- Banks could very well trip over themselves Monday as they bid on $50 billion in loans in the latest Federal Reserve auction.

But despite this eagerness to accept the government's "liquidity" injections, banks aren't significantly increasing their lending, experts said. In fact, some banks seem to be pulling back even further - for example, Citigroup Inc.'s (C, Fortune 500) last week said that it will scale back its mortgage business.

"It's still not enough to get the banks to loosen their lending terms," said Walker Todd, a research fellow at the American Institute for Economic Research and former attorney and economist at the New York Fed.

Banks have already borrowed a total of $160 billion since the Fed started holding these auctions in December as a way to ease the credit crunch, which began last year when mortgage defaults and foreclosures began to skyrocket. Since then, the crisis has extended far beyond the residential home loans, roiling the markets for everything from municipal bonds to student loans to auto financing.

After a particularly tough week in the credit markets, when even the value of formerly golden securities backed by Fannie Mae and Freddie Mac were called into question, the Fed announced Friday that it was upping the amount that would be available at the next two auctions to $50 billion, from $30 billion, and would continue to hold more rounds for at least six months.

In addition, the Fed said starting Monday it would hold a series of 28-day term repurchase transactions totaling $100 billion. Much as they have for the auctions, banks jumped on the opportunity, seeking $52.2 billion though only $15 billion is being made available in the first round.

These moves "indicate a deepening sense of anxiety on the part of the Fed," said Tom Schlesinger, executive director of the Financial Markets Center, which studies the central bank.

To be sure, the auctions are easing the credit crunch to some degree. Some financial institutions may use the Fed funds to replace money they could have raised by packaging bundles of mortgages and selling them as securities or by borrowing from other banks, said David Wyss, chief economist at Standard & Poor's.

Also, the Fed is allowing banks to use as collateral mortgage-backed securities from Fannie Mae and Freddie Mac, allowing them to trade securities of faltering value for cash.

But that doesn't mean the banks are, in turn, doling out the dough. Some are holding onto the funds to shore up their balance sheets, experts said. The firms can use the money to buy Treasuries, giving them a steadier stream of earnings than loans, Schlesinger said.

A main reason the Fed's measures aren't having a big impact on lending is because the problem with the markets isn't a liquidity crisis, but a psychological one, said Barry Ritholtz, chief executive of FusionIQ, an asset management firm.

Banks are shying away from offering credit because they fear the rising defaults, and they aren't buying securities backed by loans because they are unsure of the quality of the underlying assets. Even high-quality borrowers could run into trouble if the economy continues to tank.

"The Fed can't make banks lend," Ritholtz said.

Also, the Fed's moves aren't helping an ever greater problem facing many banks: A lack of sufficient capital. A measure of a bank's strength, capital levels indicate the institution's ability to absorb losses. As the value of assets backed by mortgages and other loans plummets, banks have had to raise capital by selling off operations or stakes in their companies.

Another way banks can improve their capital standing is to reduce the amount of loans they keep on their books. Citigroup, for instance, last week called for reducing its loan portfolio by 20% and cut the amount of new loans held on its balance sheet by half.

It's pressures such as these that prevent the Fed's efforts from having a great impact on the credit crunch. "The Fed's liquidity measures are inadequate to address a capital crisis," Todd said. To top of page

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