updated 10/17/2007 7:58:14 PM ET 2007-10-17T23:58:14

A lifeline banks are extending to owners of mortgage-backed securities that have plunged in value will avert a near-term crisis but not necessarily a painful reckoning long term.

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At some point, banks and others will have to update their balance sheets to reflect huge losses from the collapse in subprime mortgages extended to risky borrowers during the housing boom.

Yet Citigroup Inc., JPMorgan Chase & Co. and Bank of America Corp., with approval from the Treasury Department, have devised a scheme to spread out the balance sheet losses over time and prevent dramatic swings in asset valuations that could unbalance financial markets.

The banks hope the creation of the Master Liquidity Enhancement Conduit or M-LEC, will prevent turmoil in mortgage-backed securities from further spilling into other parts of the credit market. Not controlling the spillover could force a fire sale of distressed assets, making borrowers more reluctant to lend. The result: higher interest rates and slower economic growth.

The jury is out on whether M-LEC will be successful, especially over the long haul. Some analysts argue it simply delays the inevitable, as banks will eventually have to mark down the value of securities backed by subprime mortgages now in default.

“They’re just trying to buy time,” said Christopher Whalen, managing director of Institutional Risk Analytics, a consulting firm.

Others, though, say M-LEC is a crucial step in restoring calm to a market near chaos.

In just the past few months, leading banks and investment houses, such as Citigroup and Merrill Lynch & Co. Inc., have already reduced the value of asset-backed securities on their books by approximately $30 billion, said Brian Bethune, U.S. economist at Global Insight, a consulting firm.

More writedowns are coming but “it’s just not appropriate to have it all in two months,” he added.

At the same time, M-LEC gives the market some time to assess the extent of the problem in asset-backed securities. No one is quite sure how many of the securities are in trouble.

Part of the reason is because about $400 billion of the securities are held by banks in off-balance sheet funds, known as structured investment vehicles or SIVs.

The SIVs sell short-term debt to investors and use the proceeds to buy longer-term, asset-backed securities, which earn higher yields. As investors became aware of the problems in mortgage-backed securities, they began to steer clear of short-term debt sold by SIVs.

M-LEC will purchase securities held by the SIVs that aren’t in trouble, strengthening balance sheets of the SIVs and restoring confidence in the market so that investors will be willing to buy short-term debt from them.

Critics of the plan though say all that’s happening is postponing the re-pricing of the most troubled assets, which could prolong problems in the credit market.

“Liquidity crises last longer if there’s something truly wrong with the collateral that needs to be worked out,” said Joseph Mason, a finance professor at Drexel University. The banks’ plan “will continue to prevent” accurate accounting of the losses, he added.

Accounting regulators have yet to weigh in on the proposal, which was the result of brainstorming sponsored in recent weeks by Treasury Secretary Henry Paulson. Of some concern, analysts say, is whether securities purchased by M-LEC will be accurately priced at the time of sale.

The answer to that question will determine how much confidence investors will have in M-LEC’s ability to be effective, says Tanya Azarchs, managing director for S&P’s Financial Services Ratings Group.

David Resler, U.S. economist at Nomura Securities, said M-LEC might also delay the accurate accounting of the value of the securities it buys as part of the effort to buy time for a distressed market. “If (the SIVs’ securities are) selling for fair market value, then why do they need” the fund, he wondered.

Azarchs, who says she thinks the transactions will be done at fair-market value says: “How the current market prices will be determined will be key to this whole thing.”  

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