Major banks including Citigroup Inc are looking at setting up a roughly $80 billion fund to buy ailing mortgage securities and other assets, in a bid to prevent the credit crunch from further hurting the global economy, sources familiar with the matter said.
Representatives from the U.S. Treasury have organized conversations among top global banks, sources said, as financial institutions grow increasingly concerned that a certain type of investment fund linked to banks may have to dump billions of dollars of repackaged loans onto financial markets.
A fire-sale of assets could lift borrowing costs globally, trigger big losses from investors and force banks to further write down some holdings on their balance sheets. Such sales could trigger huge losses for banks, and in the worst-case scenario tip the U.S. or Europe into recession.
The fund is the latest response to a global credit hangover after at least three years of easy credit that fueled massive mortgage lending in the United States and spurred record levels of leveraged buyouts.
Banks made unwise business decisions, and now they're scrambling to save themselves, said Steve Persky, chief executive at Dalton Investments in Los Angeles, which has $1.2 billion under management.
Citigroup, JPMorgan Chase & Co and Bank of America Corp are involved in the discussions, according to people familiar with the situation. The three banks declined to comment.
The U.S. Treasury is involved in the discussions, but taxpayer money is not expected to be used.
The Financial Services Authority, the U.K. market regulator, has suggested U.K. banks consider participating in the fund, the Wall Street Journal reported on Saturday, citing a person familiar with the situation.
A spokesman for the FSA declined to comment on Sunday. Swiss financial services regulator EBK also declined comment.
Spokesmen for British bank HSBC and Swiss bank UBS had no comment when asked about their involvement. Details concerning the fund the banks are setting up, including its size, are still being hammered out and may change as other banks and investors become involved, sources said.
The fund that is being contemplated would bail out funds known as structured investment vehicles, or SIVs.
SIVs bought assets like mortgage securities from banks, and financed their purchases using short-term debt known as commercial paper. They make money by earning more from their investments than they have to pay to fund them.
But if SIVs cannot sell commercial paper, they must sell their assets, and many of the assets do not trade often and would be hard to sell.
Citigroup has set up seven SIVs with over $100 billion in assets. Those funds have relatively low exposure to the U.S. subprime market, and the funds said in August that they had successfully funded themselves.
Other banks involved in the roughly $80 billion fund have not set up SIVs, and their only possible benefit from participating in the fund would be to generate fees and stabilize credit markets.
The idea for a fund was first broached at a meeting at the U.S. Treasury on a Sunday in mid-September in Washington, D.C., according to a person familiar with the details of the meeting.
That meeting was led by Robert Steel, U.S. undersecretary for domestic finance, and Anthony Ryan, U.S. assistant secretary for financial markets. The informal meeting lasted four and a half hours as banks came up with ideas to jump-start the short-term lending markets.
Outstanding commercial paper has dropped since the summer. According to the U.S. Federal Reserve, there was $1.865 trillion in commercial paper outstanding in the week ended October 10, down from $2.187 trillion outstanding in July.
The government-led discussions are similar to conversations the Federal Reserve Bank of New York conducted in 1998 to help organize the bailout of hedge fund Long-Term Capital Management. Taxpayer funds were not used to bail out Long-Term, either.
Banks including Citigroup, Merrill Lynch & Co, and UBS have in recent weeks announced billions of dollars in asset write-offs and are still struggling to sell off billions of dollars in loans that financed acquisitions globally.
We are coming off the greatest lending bubble ... in U.S. history. We will feel its impact for a very long time, said Robert Arnott, Chairman of Research Affiliates LLC in Pasadena, California, earlier this month.
(Additional reporting by Steve Slater in London and Tom Atkins in Zurich)