Credit crunch rattles system

The credit crunch is shaking the foundations of the U.S. financial system, with increasing losses at banks and thrifts and a rare run on money-market funds that invested small amounts in risky assets like subprime mortgages.

Banks are exposed at many levels to the growing bankruptcies and dislocations in financial markets, from making and purchasing mortgages — nearly half of bank holdings are in mortgages — to providing loans to the dozens of mortgage companies that have gone bankrupt this year. Government reports this week showed that losses on real estate lending have burgeoned at banks and thrifts this year, but because of ample cash reserves and profits, most of them so far have weathered the storm.

Consumers typically deposit their paychecks into bank accounts or money-market funds, which are offered by brokerages as a kind of substitute for bank savings accounts offering higher returns. But while the deposits and money-market accounts offered by banks and thrifts are government insured, money-market funds at brokerages are not guaranteed, though they still are considered among the safest investments.

The tiny portion of money-market funds invested in subprime and other suspect debt securities this week prompted a rare run on the funds as investors pulled their money out and put it into what they considered the safest haven — Treasury bonds and bills. The flight into Treasury bills on Monday caused the biggest drop in yields on the securities since the October 1987 stock-market crash.

Paul Herbert, an investment analyst at Morningstar Inc., said the flight out of money-market funds does not seem justified, as few of the funds are exposed to losses big enough to cause consumers to lose their money.

“There is no need to panic about money-market funds,” he said. “I can understand why people would want to seek the safest option possible. However, I’m not convinced that money-market funds are that unsafe except in a few cases.”

Though money-market funds have been around since the 1970s, only one has ever “broken the buck” with its share price dropping below $1, and that fund made it up to investors, according to Morningstar.

The flight of some of the 38 million investors in money-market funds is posing one of the most critical problems in the financial markets because money-market funds are the biggest owners of commercial paper — the short-term loans corporations need to pay expenses and roll over their debt.

The sudden pullback by money-market funds and other bond investors has pushed teetering mortgage lenders like American Home Mortgage into bankruptcy and is threatening the solvency of Luminent Mortgage, Thornburg Mortgage and Countrywide, the largest mortgage lender, among dozens of other corporations that rely on funding through the commercial-paper market.

Loans raised in the commercial-paper market come due in as little as four days, and about half of the $1 trillion market comes due within six months. To pay off loans coming due, Thornburg was forced to tap backup lines of credit and sell some of its better-performing mortgage assets at a loss, while Luminent exercised a rarely used option to extend the maturities on its paper — a technique used by American Home Mortgage before it went bankrupt.

Countrywide Financial Corp. last week was forced to draw down an $11.5 billion line of credit with major banks to pay off its commercial paper and avert insolvency. Yesterday, it announced that Bank of America Corp. has made an investment of $2 billion in the company. But those moves now expose the bank lenders to losses if Countrywide is not able to soon pull its mortgage-lending business back together.

In a sign of the stress on banks and their customers yesterday, the four top U.S. banks each borrowed $500 million through the Federal Reserve’s emergency-lending window on behalf of distressed clients. In a joint statement, JPMorgan Chase & Co., Bank of America Corp. and Wachovia Corp. said the move was “intended to display the effectiveness” of the Fed’s discount window.

The Fed in recent days slashed the interest rates and fees it charges on discount loans and has been jawboning banks in an attempt to lure more banks to the window. Banks traditionally are reluctant to seek emergency loans because it gives the appearance they are desperate.

Citigroup Inc., the largest bank, stressed that it “has substantial liquidity and widespread borrowing capacity” for its own purposes, but the loans were needed by customers with less access to credit. “Citi is pleased to inject liquidity into the financial system during times of market stress and to support creditworthy clients,” it said.

With bankruptcies among mortgage lenders snowballing, banks’ exposure to losses is mounting. Moody’s Investors Service yesterday said Citigroup, Bank of America and two European banks may be forced by “swap” arrangements to cover the losses on $1.6 billion of loans American Home is auctioning in bankruptcy proceedings.

Federal Deposit Insurance Corp. Chairman Sheila Bair said the banks face further challenges as millions of home loans in coming months “reset” to reflect higher market interest rates and deferred principal payments. “The market’s going through a period of adjustment. We knew it was coming; it was inevitable,” she said.