Organizing a Big Bank Bailout

When Lehman Brothers revealed September 18 that subprime-related troubles would lead to a $700 million write-down of its earnings, the market sent its stock soaring some 10 percent. It was a classic case of "bad news is really good news." Investors perceived the hit as a bitter-tasting but appropriate elixir that would relieve the investment firm's mortgage-related headaches and clear the way for future profits.

Treasury Secretary Henry Paulson brokered a deal among three major banks.

And as other investment banking giants—Goldman Sachs, Bear Stearns, Morgan Stanley—followed suit with their own write-downs, many investors finally exhaled, believing the worst of the subprime mortgage mess just might be over. The S&P 500 index rebounded as investors grew a bit more confident that the credit crunch wouldn't smash the economy.

But a recently announced effort to kick-start the corporate credit markets may signal dark clouds ahead for the mortgage industry after all, and indeed stocks sold off last week. "We are probably in the third inning of a nine-inning game," asset management firm Smith Breeden told clients.

Last week, Citigroup, JPMorgan Chase, and Bank of America announced a joint venture to create an $80 billion fund that would purchase higher-quality asset-backed debt—probably no subprime stuff, though—from so-called structured investment vehicles, or SIVs, which are off-balance-sheet entities run mostly by big banks. The collaborative effort, which was brokered by U.S. Treasury Secretary Henry Paulson, formerly head of Goldman Sachs, is an attempt to add liquidity and ease the current strain on major financial institutions so they don't dump their troubled assets into the market at fire-sale prices. That could worsen the credit crunch and damage the broader economy, already slowing.

Subprime debt. Over the past several years, financial institutions have used SIVs to purchase packaged bundles of credit instruments, including credit card and mortgage debt, both prime and subprime. The SIVs financed the purchases by issuing commercial paper, short-term corporate loans. But as subprime borrowers began to default in alarming numbers, the market for asset-backed commercial paper of all sorts evaporated as investors became more risk averse. Now, the bank fund's organizers are hoping they can create a buyer for at least some of the roughly $375 billion of assets that SIVs hold.

And that probably has a pretty good chance of happening. Since the bank fund's commercial paper has the implicit guarantee of the country's three biggest banks, observers expect the effort to draw investors. "You don't have [the backing of] just one bank; you have the whole banking sector," says Robert Brusca, an economist at Fact and Opinion Economics. "What could be safer?"

But the very need for the federal government to referee a collaborative effort among three blue-chip companies suggests that the problems in the mortgage market are far from over.

"Despite what the market perceived in September when investment banks wrote down their subprime holdings, the mortgage and housing markets are sicker than everyone thought," says Peter Morici, a business professor at the University of Maryland. "Homes are worth less, fewer mortgages are refinanceable, and more of those subprime assets need to be marked down."

Morici considers the bank fund an important step to resolving the mortgage industry's problems. But another piece of the puzzle—more Federal Reserve rate cuts—remains missing. Lower interest rates would enable subprime homeowners to refinance into affordable mortgages. Whether the central bank supplies that treat will be determined at its next policy meeting, on Halloween.