Paulson Changes Course on TARP

Bailout funds will not go to purchasing illiquid mortgages

Treasury Secretary Henry Paulson said today that he is veering from the original plan to use the $700 billion bailout package to buy up illiquid mortgage assets, and will now spend the money on consumer credit issues and shoring up more capital for non-banks and banks.

In his remarks, Paulson said that while "the actions taken by Treasury, the Federal Reserve and the FDIC in October have clearly helped stabilize our financial system," he said that the financial system "remains fragile in the face of an economic downturn here and abroad, and financial institutions' balance sheets still hold significant illiquid assets. Market turmoil will not abate until the biggest part of the housing correction is behind us. Our primary focus must be recovery and repair."

Paulson said Treasury has evaluated three options "for most effectively deploying the TARP funds." Although the financial system has stabilized, he said, "both banks and non-banks may well need more capital given their troubled asset holdings, projections for continued high rates of foreclosures and stagnant U.S. and world economic conditions." Second, he said, the important markets for securitizing credit outside of the banking system also need support. "Approximately 40% of U.S. consumer credit is provided through securitization of credit card receivables, auto loans and student loans and similar products. This market, which is vital for lending and growth, has for all practical purposes ground to a halt. Addressing these two priorities will have powerful impacts on the overall financial system, the strength of our financial institutions and the availability of consumer credit." The third option, he said, is continuing "to explore ways to reduce the risk of foreclosure."

Paulson's news of refocusing the use of the TARP funds got mixed reviews. Edward Gainor, a partner at the law firm McKee Nelson who focuses on the securitization of financial assets, says that "this shift in emphasis of the TARP should stimulate activity in the distressed mortgage market. Distressed debt funds and others that had been investing in mortgage loans and mortgage-backed securities have been on the sidelines since the TARP was announced, waiting to see what the Treasury was going to do." Now that it's clear that the TARP won't be a significant player in that market, he says, "we should see an increase in purchases of distressed mortgage assets.

Gainor also said that Treasury's "recognition of the importance of the securitization markets is a very welcome development. But it's still unclear exactly how the Treasury proposes to intervene." Paulson's reference "to providing federal financing to investors in asset-backed securities is particularly intriguing. Another step that the Treasury could take to stimulate investment in mortgage-backed and asset-backed securities would be use of its guarantee authority under the TARP to credit enhance pools of troubled assets."

Tim Ryan, president and CEO of the Securities Industry and Financial Markets Association (SIFMA), said he's "disappointed" Treasury is choosing to de-emphasize the asset purchase portion of the TARP program. "Based on my experience with the Resolution Trust Corporation, I believe a key ingredient to a strong recovery is the creation of price discovery through some type of transparent purchase program," he said. "Until we have a functioning marketplace--where buyers and sellers agree on prices and institutions can subsequently judge the value of the assets they hold--uncertainty could keep many financial players on the sidelines, restricting lending capital for the larger economy. Treasury is uniquely positioned to bring these buyers and sellers together."

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