The U.S. government is attempting to head off a collapse of the financial system by promising to provide "hundreds of billions" of support for financial markets and institutions by purchasing troubled mortgages from banks and other institutions.

Bush administration officials including Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben Bernanke have briefed lawmakers on Capitol Hill on the "urgent need for Congress to pass legislation approving the federal government’s purchase of illiquid assets, such as troubled mortgages …"

The U.S. government is attempting to head off a collapse of the financial system by promising to provide "hundreds of billions" of support for financial markets and institutions by purchasing troubled mortgages from banks and other institutions.

Bush administration officials including Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben Bernanke have briefed lawmakers on Capitol Hill on the "urgent need for Congress to pass legislation approving the federal government’s purchase of illiquid assets, such as troubled mortgages, from banks and other financial institutions," President Bush said today.

"This is a decisive step that will address underlying problems in our financial system," Bush said. "It will help take pressure off the balance sheets of banks and other financial institutions. It will allow them to resume lending and get our financial system moving again."

The details of the move to create an agency similar to the Resolution Trust Corp., which was created by Congress in 1989 to sell off the assets of failed thrifts, have yet to be hammered out.

Bush and Paulson said the government would also provide insurance for trillions of savings held in money market mutual funds — a critical source of capital for lenders that could disappear if investors panic and withdraw funds.

The U.S. Securities and Exchange Commission also issued new rules temporarily suspending the practice of short-selling the stocks of 799 publicly-traded financial institutions — a move that sent stocks soaring.

At a press conference, Paulson said that Fannie Mae, Freddie Mac and the Treasury Department will boost purchases of mortgage-backed securities to fund new loans but that the government must also take bad loans off the books of banks and financial institutions to unfreeze credit markets.

"We have acted on a case-by-case basis in recent weeks, addressing problems at Fannie Mae and Freddie Mac, working with market participants to prepare for the failure of Lehman Brothers, and lending to AIG so it can sell some of its assets in an orderly manner," Paulson said.

Despite these steps, he said, the government must take "further, decisive action to fundamentally and comprehensively address the root cause of our financial system’s stresses."

Investments backed by mortgages have become difficult to trade and "are choking off the flow of credit," Paulson said. The clogging of financial markets "has the potential to have significant effects on our financial system and our economy."

Investments backed by troubled mortgage loans are "parked" on the balance sheets of banks and other financial institutions, preventing them from financing productive loans, Paulson said. "The inability to determine their worth has fostered uncertainty about mortgage assets, and even about the financial condition of the institutions that own them. The normal buying and selling of nearly all types of mortgage assets has become challenged."

The government, by taking on the assets that are weighing down financial institutions and threatening the economy, can prevent more failures of financial institutions and thaw a frozen credit market that’s unable to fund economic expansion.

Paulson said Fannie Mae and Freddie Mac will boost purchases of mortgage-backed securities (MBS), and the Treasury Department will also boost spending on a program in which the government buys such securities directly.

The Mortgage Bankers Association welcomed that aspect of the plan, saying it should provide support for mortgage rates.

"The fear was that the illiquidity in the financial markets we have seen this week would have reversed the recent drops in mortgage rates," said John Courson, MBA’s chief operating officer.

"The broader steps outlined by Treasury are aimed at ending the further meltdown in the financial markets and are designed to minimize the resulting impact of the market turmoil on the broader economy," Courson said. "It is another step in the long-term process of restoring a balance between the supply and demand for housing in a number of markets and thus addressing the continuing problem of mortgage delinquencies and foreclosures."

Boosting purchases of mortgage-backed securities will provide some initial support of the financial system, Paulson said, but not enough. Many banks and financial institutions hold are stuck with securities that don’t meet the regulatory requirements to be eligible for purchase by Fannie or Freddie, or by the Treasury program.

Congress must authorize the government to buy bad loans, Paulson said, through a "troubled asset relief program" that would likely involve an investment of "hundreds of billions" of dollars.

Bush acknowledged "a significant amount" of taxpayer dollars will be on the line, but that the plan is for the money to eventually be paid back.

"The vast majority of assets the government is planning to purchase have good value over time, because the vast majority of homeowners continue to pay their mortgages," Bush said.

The risk of not acting would be far higher, Bush said, because further stress on financial markets "would cause massive job losses, devastate retirement accounts, and further erode housing values, as well as dry up loans for new homes and cars and college tuitions. These are risks that America cannot afford to take."

Appearing on "Good Morning America," Senate Banking Committee Chairman Chris Dodd, D-Conn., said the United States was "days away from a complete meltdown" of the financial system, which Congress would work to prevent.

After meeting with Paulson and Bernanke Thursday night, House Speaker Nancy Pelosi, D-Calif., said "time is of the essence" and that she hoped Congress would move "very quickly," the Associated Press reported.

Augustine Faucher, director of macroeconomics at Moody’s Economy.com, said that while it’s unclear what mechanism the federal government will use to purchase debt, it’s safe to assume companies unloading illiquid securities on the government would take "huge losses" on the face value of those assets. But taking those losses would allow the firms to continue providing the loans that make the global economy function.

In a column for the Dismal Scientist newsletter, Faucher said the government could dispose of the debts gradually, "without the pressure to dump it all at once and thus push down prices, exacerbating the problem."

Faucher said the reluctance of banks to lend each other money demonstrated that drastic measures were needed. The TED spread — the difference in yields between three-month Treasury bills and the three-month LIBOR banks charge each other for loans — soared above 300 basis points Wednesday, higher even than the aftermath of the stock market crash of 1987, he said.

"In normal times, no one would want the federal government buying hundreds of billions of dollars worth of financial market instruments," Faucher said. "But these are obviously not normal times."

The American Bankers Association was critical of the plan to insure money market mutual funds.

"Today’s action will undermine the role of banks during this current crisis and has the potential to have an extremely negative impact in the future," ABA President and CEO Edward L. Yingling said in a letter to Paulson and Bernanke. "Simply put, the ability of banks to attract and keep deposits is being compromised in a profound fashion. Our bankers are, understandably, very upset by the action."

Faucher characterized the proposal to insure money market mutual funds and the temporary ban on short-selling financial stocks as "minor." What really matters, he said, "is that someone needed to step in and take control, and the Treasury and Federal Reserve have done so."

Writing on his blog, The Big Picture, Fusion IQ Chief Executive Officer Barry Ritholtz called the Bush administration’s plan "the new New Deal," reffering to the government programs created during the Great Depression in the aftermath of the 1929 stock market crash.

"We now see that the grand experiment of deregulation has ended, and ended badly," Ritholz said. Ironically, he said, proponents of deregulation "have effectively turned the United States into a massive Socialist state, an appendage of Communist Russia, China and Venezuela."

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