Credit markets seek redemption, shadowed by banks

By Al Yoon and John Parry - Analysis

NEW YORK (Reuters) - Agreement by U.S. lawmakers to lift $700 billion in troubled debt from the financial system will relieve markets from short-term corporate debt to muddied mortgage securities, but may keep money managers on the defensive.

Legislation hammered out by Congress in a grueling weekend session maintained the meat of the bill proposed by the U.S. Treasury a week earlier, adding strings that are not expected to erode its effectiveness, analysts said.

By focusing on illiquid debt that has crippled financial companies for a year, the plan may removed burdensome assets from bank balance sheets and make banks more willing to perform a crucial lending role as the economy heads into a tailspin.

Even though the bill goes to the core of the credit crisis, it won't fully ease shaken investors in the short-term markets.

Money market assets that theoretically carry low risk have been shaken by the failures of issuers such as American International Group Inc., and that caution will linger with more uncertaintuncertaintyly swirling around big banks such as Wachovia Corp., investors said.

"I think there will be immediate thawing of credit markets, but then the water will never quite get warm," said Tony Crescenzi, chief bond market strategist, Miller, Tabak & Co., in New York.

Lawmakers face what could be the most serious financial crisis since the Great Depression of the 1930s, with the $700 billion price tag bigger than the cost of the Iraq war and topping all International Monetary Fund lending to country borrowers since its inception after World War II.

Republicans and Democrats agreed to a blueprint over the weekend, and lawmakers are expected to vote on the bill in the coming days. The U.S. president is expected to sign it into law.

Mortgage-backed and other asset-backed securities that may initially be targeted for purchase by the Treasury have been some of the most toxic debt to own over the past year, trading in the case of subprime bonds less than 10 cents on the dollar.

Indexes benchmarking that debt posted rallies, of sorts, over the past week since the Treasury plan should define a market for the bonds, encouraging buyers off the sidelines.

High-yield corporate debt markets where funding has been slow may improve if new issues can draw premiums, said Martin Fridson, founder of Fridson Investment Advisors in New York.

But treatment of those bonds may be less an issue today than the psychology of investors burned by investment-grade short-term debt that has tumbled, said Jason Brady, a portfolio manager at Thornburg Investment Management in Santa Fe, New Mexico.

A disturbing chill in commercial paper and other money markets after the recent AIG bailout and bankruptcy of Lehman Brothers Holdings Inc. has forced increased injections of cash from central banks as U.S. dollar borrowing rates remained high, particularly for three-month debt.

"If the package allows participants to say 'we're not going to have major bankruptcy in another institution tomorrow,' maybe that helps" credit market sentiment, Brady said.

"We've really seen a shift in who bears the loss in last few weeks" from equity to debt holders, where money markets faced losses, he said. "When you that that much disruption in the short market, you have significant concerns and say 'why would I give this money to anybody, with the exception of the U.S. Treasury."