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U.S. Banks Offer Plan to Calm Credit Markets

Prof. Peter Morici - 10/18/2007

The creation by Citigroup, JP Morgan, and Bank of America of a special fund to purchase the collateralized debt obligations (CDOs) of major structured investment vehicles (SIVs) should be viewed as good news by the stock and bond markets.

Mortgage backed securities have significant intrinsic value that credit markets cannot reasonably assess but that are certainly present.

Most subprime mortgages will be repaid, either through refinancing or direct servicing. While some will fail, those notes have value, because servicing companies will resell the homes, albeit at discounted prices.

An inability to assess prospective default rates, thanks to imprudent initial bond ratings by Standard and Poor's and others, make it difficult for bond buyers to accurately ascertain the liquidation value of CDOs.

If held to maturity, CDOs have a higher value than credit markets are attributing to them.

The creation of the Master Liquidity Enhancement Conduit is a constructive step toward avoiding fire sale losses and containing the damage to bank balance sheets posed by their SIVs, and this should serve to help stabilize credit markets.

Yesterday's announcement was dwarfed by Citigroup's announced 57 percent drop in third quarter profits. However, the fact that banks are readily acknowledging the impacts of the credit crunch on the income statements and balance sheets should comfort stock and bond investors. We do not appear to be headed for another accounting crisis.

After it has an opportunity to digest this news, the stock market should recovery from yesterday and today's adjustments, and stronger equity valuations should continue.