U.S. exit from bank bond program to go smoothly

NEW YORK (Reuters) - The U.S. government is expected to pass the first test of its ability to exit emergency lifeline facilities for the banking system without disrupting credit markets with flying colors next month.

The Temporary Liquidity Guarantee Program for bank bonds, one of the many emergency measures implemented to save the financial system from implosion last year, is scheduled to begin winding down in October.

With investors appearing more comfortable with bank debt amid signs of an economic recovery, the withdrawal of the program -- under which the Federal Deposit Insurance Corp. (FDIC) pledged to guarantee up to $1.4 trillion in debt issued by banks -- is expected to go well, analysts say.

While it is still more expensive for large banks to issue stand-alone debt, the decline in the spread of yields of bank bonds over their bonds guaranteed by the government since the darkest days of the banking crisis provides a strong signal of improved confidence in the banking system.

Yield spreads of stand alone bank bonds over government-guaranteed bank bonds, which indicate the perceived level of risk of an investment, have halved from a spread of roughly 10 percent in March when investor confidence in banks hit an all-time low.

"The capital market is functioning better," said Sung Won Sohn, professor of economics at California State University in Camarillo.

"The large mega banks, which the government termed too big to fail, won't have problems raising capital and the additional cost won't be that large" of selling their own unsupported bonds, Sohn said.

Most analysts believe the Temporary Liquidity Guarantee Program, or TLGP, has served its purpose, and that banks and credit markets are weaning themselves off government support.

TLGP was launched nearly a year ago, after Lehman Brothers' collapse deepened the global credit crisis, in an effort to get credit flowing again after last year's crunch. So far, banks have sold just over $300 billion of government-backed bonds.

The program offered banks a guarantee from banking regulator the FDIC for issues with a maturity of up to three years.

Analysts say that one sign that credit markets will be able to survive without government support is the resilience of the U.S. government bond market since the Federal Reserve's announcement in August that it plans to stop its purchases of Treasuries by the end of October.

Bank bonds have also performed strongly, reflecting growing confidence in the sector.

Even bonds issued by Citigroup (C.N), seen as one of the big banks most damaged by the credit crisis, are faring better.

Spreads on Citigroup's 8.5 percent notes due in 2019 have tightened to about 301 basis points over Treasuries from 496 basis points in late May, according to MarketAxess. Spreads tightened further on Tuesday after sources said the U.S. Treasury Department is talking to the bank about how to sell the roughly one-third stake the government acquired as part of its bailout of Citigroup.

However, the government is still underpinning large parts of the financial system, analysts point out.

"Investors absolutely do believe that big banks can and will stand alone without explicit government assistance because they believe there is implicit government assistance," said Jack Malvey, a New York-based capital markets consultant and formerly Lehman Brothers' chief global fixed income strategist.

And others argue that the end of TLGP is not a conclusive test of the government's exit strategies.

The corporate bond market has shrugged off the expiration because massive financial support from the Fed's near-zero interest rates and many other government lifelines still leave banks awash with cheap money, they say.

"We're still in a very dangerous situation that we've covered up by giving them cheap funding and government guarantees," said Janet Tavakoli, president of Tavakoli Structured Finance in Chicago.

If the economy slips into recession again, burdening banks with a second round of losses, confidence in the financial system may sag, analysts warn.

The phasing out of the FDIC's guarantee for bank bond issuance is effectively eliminating "what is now a welfare program for banks," said Haag Sherman, co-founder and managing director of Salient Partners, a Houston based investment firm.

"The real test will be the withdrawal of government deficit spending and stimulative monetary policy."

(Additional reporting by Dena Aubin; Editing by Leslie Adler)