Paulson Abandons Asset-Purchase Plan, Expands Capital Injection Approach

Treasury Secretary Henry Paulson said the original idea behind the $700 billion rescue package is no longer an effective use of the allocated funds. That approach has been abandoned in favour of the Capital Purchase Plan, which is already directing liquidity into financial firms, he announced Wednesday.

Paulson said that when he originally asked for $700 billion to rescue the financial sector by purchasing illiquid assets from financial firms, he considered such an approach "the most effective means of getting credit flowing again." During two weeks of deliberating with Congress, however, market conditions deteriorated "considerably," and he realized that a more timely approach would be necessary.

"It was clear to me by the time the bill was signed on October 3rd that we needed to act quickly and forcefully, and that purchasing troubled assets - our initial focus - would take time to implement and would not be sufficient given the severity of the problem," he said. "In consultation with the Federal Reserve, I determined that the most timely, effective step to improve credit market conditions was to strengthen bank balance sheets quickly through direct purchases of equity in banks."

The new approach resembles injection plans seen in Europe, particularly in the UK, Ireland, and Germany.

Paulson said that in the past, the Treasury had only ever purchased equity from institutions to rescue them, so he was originally against intervention that would involve the government with solvent firms.

The Secretary was quick to note that this change of course is not a new development, but began in mid-October when the Treasury announced a plan to purchase $250 billion in preferred stock from regulated banks and thrifts. By Oct. 26, the Treasury had agreed to use $115 billion to support eight major banks. Paulson said the quick development of these plans should be commended. He added that government actions to date "have clearly helped stabilize the financial system" and have prevented a systemic collapse, even though markets remain fragile.

Going forward, he said the Treasury's top focus must be restoring the financial system.

"With a stronger capital base, our banks will be more confident and better positioned to play their necessary role to support economic activity," he said. "First and foremost, because the system remains fragile, we must continue to stand ready to prevent systemic failures."

The Treasury's purchase of preferred shares in the failing insurance company AIG is consistent with this approach, Paulson added.

As expected, Paulson said Treasury is developing a matching program to inject capital into non-bank financial institutions, provided that participating firms are also able to shore up capital from private investors.

"Non-bank financial institutions provide credit that is essential to U.S. businesses and consumers. However, many are not directly regulated and are active in a wide range of businesses, and taxpayer protections in a program of this sort would be more difficult to achieve," he said.

In the Q&A following his speech, Paulson was asked why non-bank firms within the financial sector are part of a new approach, but other struggling firms as those in auto manufacturing, are not. The Secretary responded that the auto industry is a key part of the economy and that a solution needs to be found, but he said the TARP is built for the financial industry only.

"I've said very clearly ... the solution needs to be one that leads to viability," he added.

By Patrick McGee and edited by Stephen Huebl
©CEP News Ltd. 2008