Paulson tries Plan B

Donna Blockby Donna Blockfrom The Deal.com

You can say this for Treasury Secretary Henry Paulson: He's not afraid to change his mind.

After spending more than a month negotiating with bankers over how to establish a program to buy bad assets and get them off the industry's books, he announced Nov. 12 that he was giving up on the idea. No matter that asset purchases were once the primary focus of the $700 billion financial rescue he convinced Congress to pass. He's got a better idea.

The government is adding stricken nonbank lenders and other financial businesses to the list of institutions that will get direct federal aid.

Paulson, in presenting an update on the Treasury's financial rescue efforts, defended the unprecedented and controversial Troubled Asset Relief Program and said the government's new goal would be to support financial markets supplying consumer credit such as credit card debt, auto loans and student loans, in addition to mortgages.

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To date, no toxic assets have been purchased with the bailout funds, even though that was the centerpiece of the authorizing legislation Congress passed in October. But Paulson said almost as soon as Treasury received the money, things had changed and giving capital to banks in return for preferred stock was a better use of the funds.

"Although the financial system has stabilized, both banks and nonbanks 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," the Treasury secretary said.

Plan B would be a new facility to revive the loan securitization market. Details of how this program would work are still being drawn up but Paulson is considering having companies that accept new taxpayer funding get matching private capital.

"In developing a potential matching program, we will also consider capital needs of nonbank financial institutions not eligible for the current capital program," he said.

Paulson also said support was needed for markets that securitize credit outside mortgage lending. "This market, which is vital for lending and growth, has for all practical purposes ground to a halt," Paulson said, adding that increasing efforts to make investments in financial institutions will give banks a greater degree of confidence.

The facility, which is being designed with the Federal Reserve, is aimed at increasing liquidity for highly rated, AAA asset-backed securities.

This program, however, will take weeks for federal officials to design, and it will take even longer to get it up and running. "These things are complicated," Paulson said, adding that the program would have to be of "significant size" to be truly effective.

Bank executives were at a loss over how to react. "There are not a lot of details around exactly how [Paulson] envisions the program might work," Barry Zubrow, the chief risk officer for J.P. Morgan Chase & Co., told the Senate Banking Committee the day after the Treasury secretary dropped his latest bailout bombshell. "I do think it is important to find a mechanism to bring investors back to the marketplace for asset-backed securities."

Mike Kendall, a partner in the private equity practice at Goodwin Procter LLP, says this is a good move and a way for the Treasury to not only leverage its capital but also its due diligence. "Private sector matching funds has a lot of appeal and will help the market figure out what these securities are worth."

Kendall also says private equity firms can help the Treasury leverage resources since in effect "they will be helping them do their due diligence."

Despite pressure from Congress, Paulson said he wants to draw the line at expanding the TARP program beyond the financial industry. He said the TARP program should not be used to help the ailing auto industry although he agreed those companies were "critical" to U.S. manufacturing.

The Treasury has already committed all but $60 billion of the initial $350 billion Congress allocated. Lawmakers have to approve expediting the remaining $350 billion.

However, Paulson said he has no timeline for notifying Congress of his intent to use the remaining half that is available. He said he's "comfortable" that $700 billion is enough to stabilize the financial system.

Separately, the Federal Reserve and three other federal banking regulators issued new guidelines to institutions to work with mortgage borrowers to avoid defaults. In addition, the guidance encourages banks to set dividend payments for shareholders and compensation for executives with the current crisis in mind.