Government Moves to Buy Bad Debt to Shore Up Markets

The U.S, Treasury will buy up troubled mortgage assets in a plan announced today that provided confidence to financial markets worldwide, according to analysts and the reactions of the markets themselves.

“The underlying weakness in our financial system today is the illiquid mortgage assets that have lost value as the housing correction has proceeded. These illiquid assets are choking off the flow of credit that is so vitally important to our economy.” U.S. Treasury Secretary Henry Paulson said in a prepared statement. “As illiquid mortgage assets block the system, the clogging of our financial markets has the potential to have significant effects on our financial system and our economy.”

As the problems in the subprime market spread into higher-quality mortgages and other types of credit, according to Paulson, it “contributed to excess home inventories that have pushed down home prices for responsible homeowners.”

As a result — with 5 million homeowners now delinquent or in foreclosure, according to Paulson — the government “must implement a program to remove these illiquid assets that are weighing down our financial institutions and threatening our economy. This troubled asset relief program must be properly designed and sufficiently large to have maximum impact, while including features that protect the taxpayer to the maximum extent possible. The ultimate taxpayer protection will be the stability this troubled asset relief program provides to our financial system, even as it will involve a significant investment of taxpayer dollars. I am convinced that this bold approach will cost American families far less than the alternative – a continuing series of financial institution failures and frozen credit markets unable to fund economic expansion.”

The exact approach will be worked out over the next week, Paulson said.

The government most likely will look at an approach similar to what was used to support the banks during the 1930s and the Resolution Trust Corporation that was used to support savings and loans nearly 20 years ago, according to John Jay, senior analyst for Aite Group. In both those instances, the federal government purchased the troubled assets and eventually sold them at a net profit.

More importantly, according to Jay, is the confidence boost the government’s move has provided worldwide financial markets. The Dow Jones Industrial Average soared 410 points Thursday, with most of the gains coming in late trading after the news was announced. The London stock exchange’s benchmark index closed a record 8.8 percent higher Friday.

“Now they can move on,” Jay explained. “The biggest problem has been confidence erosion.”