Credit

We were hoping that as the year went by the credit crisis would be drawing to a close - but it seems that all of those hopes will be shattered. The credit crisis looks like it may even be taking a turn for the worse if that is even possible.

The first evidence was the announcement by the biggest U.S. banks that they are banding together with the government’s blessing to try to bail out institutional customers — and maybe themselves — stuck with illiquid asset-backed investments. That’s a clear indication that there has been little relaxation in the paralysis gripping debt markets in recent months.

Then Standard & Poor’s made another sweeping downgrade of the credit ratings on mortgage-backed securities worth some $23.35 billion, or €16.34 billion — this time for loans granted since the first of the year, a sign that loose lending standards lasted far longer than many thought. More trouble also surfaced on the housing front, with construction of new homes plunging to the lowest level in 14 years and home builders’ sentiment falling to its lowest on record.

Even the stock market took a pause from its recent bullish run, with investors tempering their buying on concerns that the credit and housing mess would lead to a contraction in third-quarter earnings for the first time in six years. Why else would a consortium of banks — including Citigroup, JPMorgan Chase and Bank of America — be uniting with a plan to keep the housing-related debt crisis from worsening. If they thought conditions in the credit market were about to improve, would they be gathering as a group?

The banks have proposed creating a fund that will buy around $100 billion in debt from structured investment vehicles, or SIVs, in an attempt to break the logjam in the market for short-term debt instruments that hold mortgage-related assets. Banks sponsor the SIVs, contributing longer-tem assets like mortgage-backed securities to the investment vehicle.

The SIV then sells unsecured commercial paper or other forms of short-term debt at low interest rates to the likes of hedge funds and money-market mutual funds hungering for a few extra basis points of yield. Those proceeds are then used to repay the sponsor for its investment.

Accounting rules do not require the SIVs to appear on bank balance sheets, even though they create, run and generate fees from them. But if debt markets seize up and the SIV can’t repay or roll over the commercial paper debt when it comes due, the sponsor then is expected to come up with cash to cover the SIV — or face a big blow to its reputation. For the banks, helping the SIVs could lead to big losses as they are forced to mark down the value of the now-shunned asset-backed securities.

The goal of the new bailout fund is to prevent that from happening. Its plan is to sell short-term notes to investors and then use the proceeds to buy distressed securities from the SIVs that otherwise would have to be sold at fire-sale prices. Eventually, they will try to sell those securities to investors. The fund’s backers are spinning this as a way to save the market from more meltdown, but it really is nothing more than a shell game to try to rescue them from the mess they got themselves into.

It is not even clear if that will do the trick. Given the complexity in valuing the SIVs illiquid securities, there are lingering questions over what price the banks will place on the debt and whether investors will be willing to bite. The fund’s backers also say that they will only buy highly rated assets, a promise investors should be wary of since they’ve seen massive downgrades of the ratings on mortgage-related debt that wasn’t supposed to be risky.