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The Real Reason Behind the Central Bank Scramble

Story updated to include additional market reaction in the last two paragraphs and comments from the S&P conference call.

NEW YORK (TheStreet) -- On Tuesday evening, Standard & Poor's downgraded the long-term debt ratings of some of the largest banks in the world.

By Wednesday morning, the Federal Reserve, the European Central Bank and central banks from Canada, England, Japan and Switzerland announced coordinated action to support liquidity in financial markets that mirrors the 2008 financial crisis.

Mere coincidence? Likely not.

Once banks saw their ratings downgraded, it raised the specter that they would have to post billions in additional collateral on trades just as market pressures make it hard for them to replace the funds through a stock or bond offering.

Without the funds to trade, banks could further pull back in lending to each other, causing borrowing rates like the London Interbank Offered Rate to rise. A precipitous rise could be costly to banks, corporations and even consumers who rely on trillions in variable borrowing. Additionally, increased bank risk would also make it harder for European banks to access dollars to pay maturing debts.

Today's intervention by the Fed and other central banks tries to the alleviate those problems which already began to spiral out of control.

Earlier in November, the cost for European banks to borrow overnight in dollars touched on levels not seen since the crisis, while the overnight bank borrowing of dollars was closing on post crisis highs. Wednesday, when Eurozone leaders couldn't agree on an effort to increase the ESSF, or the European bailout fund, the price paid by European banks to borrow dollars rose to three year highs.

At the same time, ratings agencies S&P, Moody's and Fitch were all in the process of downgrading major banks like Bank of America (BAC), causing shares to touch on 2011 lows.

Bloomberg reported on Tuesday that in regulatory filings, Bank of America said that with ratings downgrades it might need to post nearly $5 billion in additional collateral, while Morgan Stanley (MS) would need to post $1.29 billion and JPMorgan Chase (JPM) would need to post $1.5 billion.

The liquidity support announced by central banks today is a move to lower the price for banks to borrow overnight dollars, easing pressure on their capital. The so- called dollar liquidity swap arrangements almost halves the price that central banks offer short term funds to the U.S. dollar overnight index swap rate plus 50 basis points. It means that even if banks don't lend to each other, they can get overnight funds from central banks for rates that aren't crippling to their capital base.

Many of Wednesday's moves closely resemble actions first taken in 2007 as ratings agencies downgraded thousands of sub-prime mortgage bonds, which precipitated funding shortages -- and exposed cracks in the health of banks.

Stock quotes in this article: GS, JPM, MS, C, BAC 

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