Credit markets seek redemption, shadowed by banks

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."

Short-term debt that typically trades at a slight discount to par, or 100, is seeing a steep discount, discouraging buyers paid not to take risk, Brady said. Wachovia two-month debt recently traded near 70 cents on the dollar, for instance.

Record yield spread premiums over U.S. Treasuries should drop "a little bit" on presumed success of legislation, said David Dietze, chief investment strategist at Point View Financial Services in Summit, New Jersey. The safe-haven bid that boosted U.S. Treasuries last week could fade, he added.

Assuming the credit markets can move out of crisis stage, analysts are quick to point out financial institutions are still facing the toughest economy in years, and a housing market where prices continue to drop. House prices, which many see falling another 10 percent in the U.S, could add to bank losses and increase reliance on the legislation.

"You are probably going to have more equity destruction, more mergers (and) more write offs," said Jim Awad, chairman of W.P. Stewart & Co. in New York. "But if the credit markets can just not get worse then we have a chance of working our way through this."

Investors must hope for a positive reaction in Asia and Europe, Awad said. A negative reaction from overseas markets would be a "nightmare," and damage the sense of stability needed for the plan to work, he said.

It's not all about America, either. Fortis, one of Europe's top 20 banks, was nationalized by Belgium on Sunday.

"That looks like a whopper too," Point View's Dietze said, before the Belgium investment. "I think fixed income investors will be keeping one eye over there to see how European regulators will handle that."

(Additional reporting by Kristina Cooke and Walden Siew)