Some of the roles letters of credit (L/Cs) played in the credit crunch that started in the US sub prime mortgage market last year are beginning to emerge.

One such role featured L/Cs backing risky investments, an activity that appeared to cause some panic in the market.

Market collapse

"Foreign banks were earning fees by providing backstop L/Cs to commercial paper facilities in the US," chief economist at New York-based Fact and Opinion Economics, Robert Brusca, recently told the Associated Press news agency.

"When the commercial paper asset backed market collapsed for housing related paper [these] facilities were drawn en masse and without much notice," he said.

Policy changes

Last year the market was concerned that banks did not have sufficient funds to meet obligations under the L/Cs used to back risky investments, a scenario that the US Federal Reserve fortunately picked up on.

It modified its policies governing discount window borrowings to make sure that US banks had the funds they needed to meet L/C obligations.

Investment risks

The Structured Investment Vehicles (SIVs) that played such a central role in the credit crunch by underestimating the investment risks in complex securities routinely employed L/Cs in their programmes.

If investors want to sell their commercial paper and the SIVs fail to sell it on, then they will draw on these L/Cs.

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