US banks form contingency fund of $100 billion to help sub-prime market

16 October 2007
Banks in the United States and around the world will feel some degree of relief as a contingency fund has been announced, set up by Citigroup, the Bank of America, and JPMorgan, which will provide $100 billion (£49 billion) to improve the sub-prime situation that started in the US and has had a ripple effect through the global economy.

The fund has come about as the result of a meeting between the financial institutions, mediated by Hank Paulson from the US Treasury Department, where discussions threw up ideas for reviving the flailing sub-prime mortgage market that is in crisis and poses a threat to the American economy.

According to the Washington Post, the sub-prime market encompasses $1.5 trillion dollars of loans, and the crisis could see losses of $20 billion. Citigroup has its own interests at heart, in addition to those of the economy at large, as it has just reported a 57 per cent fall in net income – its largest profit drop in three years – as a direct result of having much of its $6.5 billion of writedowns tied up with mortgage-backed securities.

While the situation has improved in certain areas of the mortgage market, there are still fears that some Structured Investment Vehicles (SIVs) may be pushed into forced sales, producing further declines in the price of mortgage linked investments. It is hoped that the SMLEC (Single-Master Liquidity Enhancement Conduit) which will invest in the sub-prime market will prevent the toxic securities from seeping further into wider financial markets.

The sub-prime mortgage crisis was caused largely by the record number of foreclosures in the US, which, in turn led to higher mortgage rates and a wider credit squeeze, and has caused financial institutions to become increasingly unwilling to lend to each other.

The situation has spread internationally – affecting major markets such as UK and Japanese stocks – because sub-prime loans were bundled up and sold abroad, but it is unknown where exactly the bad apples have ended up, and providers are reluctant to start lending between themselves again until these have been sought out.

Because some banks have already started selling their sub-prime investments at a loss, the SMLEC is not proving popular with everyone, but it will mean that future investors will have more confidence in the market and more banks will not have to continue selling investments at rock-bottom prices.

The US Treasury’s Mr Paulson said that “The joint efforts of domestic and international financial institutions, broker dealers, and investors have resulted in a potential structure to improve liquidity in the asset backed commercial paper markets.

“This proposal will complement other solutions investors and asset managers may utilize in committing and deploying capital to support more efficient markets.”

It is suspected that the use of such funds as this will be adopted by UK banks, which the Financial Services Authority has said it would support, but that it is up to each individual bank whether or not they wish to participate.

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