November 29 2007: 4:23 PM EST
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Cure for pain

Banks are finally taking the tough medicine they need. Will the Fed get in their way?

By Peter Eavis, senior writer

NEW YORK (Fortune) -- At last, we have the beginnings of a cure for the credit crunch - though it could cause plenty of pain in the short run.

For instance, to strengthen their balance sheets, Citigroup and Freddie Mac this week raised substantial sums of new capital, even though such a move can hurt existing shareholders because their stakes get diluted.

In addition, banks have started to value their assets more appropriately, even if it means losses.

And they're showing a readiness to sort out messes that they'd previously hoped to keep off their balance sheets.

As encouraging as these first steps are, the road to a sounder financial system could still be undermined.

The biggest obstacle could be the Federal Reserve. If the Fed continues to cut interest rates - as looks likely - it would make it easier for banks to forgo or slow down some of the important changes they're making.

Also threatening true reform are the ratings agencies, Moody's and Standard and Poor's. They contributed to the credit meltdown by attaching unrealistically high ratings to debt securities that quickly blew up. But neither has announced meaningful changes to their procedures.

But, make no mistake, the beginnings of a credit cure are here.

Banks issue large amounts of equity only as a last resort. The move says capital - the net worth of the bank - has gotten dangerously thin. And it hurts existing shareholders.

So when it happens, it shows management is facing up to problems. So, full marks to Citigroup (Charts, Fortune 500) for taking a $7.5 billion capital injection from the Abu Dhabi Investment Authority, and to Freddie Mac (Charts, Fortune 500) for seeking this week to quickly raise $6 billion in fresh capital, and to eTrade (Charts) for agreeing to a $2.5 billion cash infusion from hedge fund Citadel.

Expect there to be plenty more banks doing the same by the end of the year. Fannie Mae (Charts), also thinly capitalized, will almost certainly be next to tap the market for new equity.

The other landmark event this week was the news that HSBC was going to take two affiliated leveraged bond funds - called structured investment vehicles - onto its own balance sheet.

One of the reasons the credit mania got so out of hand was that banks were able to keep so much of their business off their balance sheets. That reduced their wariness of risk.

The new era of banking we're moving into will result in banks doing more business on balance sheet, and they will be forced to consolidate large amounts of assets and liabilities they've managed to keep off their books.

But here's the thing: The strong banks can do that without issuing large amounts of new capital, but the weaker ones can't.

HSBC took its SIVs on balance sheet without a large issue of new capital - even though it meant consolidating $45 billion of assets and agreeing to supply up to $35 billion of credit. But if Citigroup ends up taking its seven SIVs with $83 billion of assets on balance sheet, it may have to go back to the market for more equity.

Another salutary development is the much more realistic pricing of assets on banks' balance sheets. One of the reasons the Japanese financial system was in the doldrums after a crash in the late 1980s was that banks held off on attaching proper values to assets. That delayed the work out of bad loans that had to happen to re-ignite lending.

For the U.S. banks today, there are plenty more writedowns to come. But banks have started to make realistic estimates for the value of their dross.

Importantly, they've stopped using high credit ratings as an excuse to mark bonds at prices that they'd never fetch in the market. For instance, the enormous CDO losses reported by Merrill in the third quarter and those to be reported in the fourth quarter by Citigroup are predominantly on AAA-rated debt.

Banks are much more likely to keep taking steps like raising capital if they feel that they won't be getting much more help from the Federal Reserve.

One of the reasons that the credit bubble happened was that the Federal Reserve consistently moved too quickly to pump liquidity into the financial system, fuelling reckless risk taking in the process. The good thing about a Fed that does the opposite is that it forces banks to be much more efficient in their lending - exactly what the financial system needs now.

But the Wednesday speech from Federal Reserve vice-chairman Donald Kohn takes the view that the Fed has to always be ready to cut the cost of banks' borrowing whenever problems occur within the banking sector. However, cheaper money allows banks to drag their feet on sorting out their problems, as was the case in Japan for most the of the 1990s.

So, yes, the credit cure has begun. But, incredibly, the only people standing in its way are at the Fed, an institution mandated to ensure the health of the U.S. financial system. To top of page