Paulson Changes Terms of Bailout Spending

November 12, 2008

Treasury Secretary Paulson stepped up to the pitcher’s mound Wednesday, and hurled another curveball at investors. He announced that the U.S. government is backing away from buying mortgage assets from banks using the $700 billion bailout fund.

We talked a lot about this plan back in September, when the Troubled Asset Relief Program (TARP) was first proposed as part of a plan to unclog the billion of dollars locked up in mortgage-backed securities that are tainting banks’ balance sheets.

Now Paulson says that instead of buying up these troubled assets, the Treasury favors another round of capital injections into banks. He said the initial plan would have taken too much time, but by buying stakes in banks the Treasury will encourage them to resume more normal lending practices.

Some of the money saved from not buying mortgage assets will now be used to shore up the market for credit-card receivables, auto loans and student loans, Paulson said. "This market, which is vital for lending and growth, has for all practical purposes ground to a halt."

News of this shift in bailout spending plunged stocks into the red in late morning trading. The hurt was compounded by more earnings gloom from retailers like Best Buy and Macy’s. Just days after competitor Circuit City filed for Chapter 11 bankruptcy protection, Best Buy slashed its guidance, warning of a “rapid, seismic” reduction in consumer spending.

Investors are worried that a severe pullback in consumer spending will worsen the global economic downturn, especially considering that consumers account for more than two-thirds of U.S. economic activity.

While these concerns persist and are essentially responsible for the market’s declines on Monday and Tuesday, Paulson struck a sensitive nerve with his remarks about the health of the financial system. Although Paulson indicated that a major shift has occurred in the original bailout plan, I suspect his actions will go a long way in keeping banks afloat and, ultimately, supporting lending.

I’ll keep you posted as this story develops.