With economic conditions worsening, the U.S. government has stepped up its bailout efforts - doling out $250 billion allotted under the Emergency Economic Stabilization Act (EESA) for equity investments in financial institutions.

U.S. Treasury Secretary Henry Paulson last week formally shelved the government's plan to use the Troubled Assets Relief Program (TARP), which is part of the $700 billion EESA, to buy troubled assets from banks. Instead, the Treasury has chosen the equity stake route for financial institutions and will focus more on the consumer, attempting to increase the availability of student loans, credit cards and auto loans. It will also encourage private sector involvement by potentially matching private capital with government investments.

Although Paulson said the Treasury is exploring a potential liquidity facility for highly-rated 'AAA' ABS, he didn't elaborate on when a plan would be rolled out. And this change midstream has left securitization industry participants frustrated because the purchase of these troubled assets was expected to bring transparency and liquidity to the capital markets, and equity investments may not be enough to reestablish a market and stimulate lending.

Indeed, TARP was created for price discovery and to get assets, particularly distressed assets, moving through the market by creating prices at which to buy and sell them - and "equity injections draw that out," said Greg Peters, chief U.S. credit strategist at Morgan Stanley and panelist at the Securities Industry and Financial Markets Association's (SIFMA) TARP summit in New York last Monday.

Private Bank Participation

Currently, the Treasury is working to finalize the required legal documents so private banks can participate in the capital purchase program on the same economic terms as public banks. The Nov. 14 deadline will be extended for private banks so they have time to apply, said Neel Kashkari, interim assistant secretary for financial stability and speaker at the SIFMA summit. "A stronger capital base, especially for healthy banks, provides them with additional capacity to lend... healthy banks that take advantage of this program can now service clients that impaired banks, constrained by insufficient capital, cannot," Kashkari said.

U.S. bailout officials also took cues from overseas initiatives. The British, with the rest of Europe following suit, took a different approach to the credit crisis, injecting money directly into troubled financial institutions and not buying troubled assets. This had a direct impact on the U.S. bailout plans, said Barry Metzger , partner at Baker & McKenzie.

"A consensus developed that it was, at this point in time, the appropriate approach to make sure there were a reasonable number of stable institutions within the financial markets in each country to ensure the revival of the credit markets," Metzger said. "Responding to a financial crisis requires flexibility. The good thing about the Treasury not implementing immediately the troubled asset purchases is that, as they saw the situation in the markets, and the government response in other markets, they decided to use the discretion they have under the legislation to make their first priority response the capital purchase program."

Part of the push behind the focus on capital investments is the more "bang for the buck" in starting off the TARP program, said SIFMA summit panelist Randall Guynn, partner at Davis Polk & Wardwell, who noted that equity injections should compel lending.

The focus on the capital purchase plan, and the announcement to hold off on an asset purchase program could also have a positive impact on bringing investors back into the MBS market.

"The market for distressed mortgage assets has been nearly frozen since the TARP was announced, while potential buyers waited to see what Treasury was going to do," Edward Gainor, partner at McKee Nelson, said in an interview. "Now that the TARP is no longer a significant player in the distressed mortgage market, we should see an increase in activity by distressed debt funds and others who are interested in purchasing mortgage loans and mortgage-backed securities."

Bigger Plan, Better Results

But not all market participants are convinced. Panelists at the SIFMA summit last week were not confident that the capital purchase program would provide the necessary boost to the capital markets. "Two hundred fifty billion dollars is sufficient to fill the hole from a macro perspective, but there is no excess equity to reduce the need to curb lending," said panelist Jan Hatzius, managing director and chief U.S. economist at Goldman Sachs.

As dramatic as the government support has been, the scope of losses is incommensurate with the size of TARP, said Randal Quarles, managing director at The Carlyle Group and panelist at the summit. He said it is likely that more support will be needed either through TARP or another measure where the government will need to further open up its balance sheet.

For the most part, panelists did not think the government has the complete toolkit to deal with the drastic economic problem the country is facing. With mounting financial institutions in need of a boost in their balance sheets, the TARP program is likely to go fast.

Within the last few months, the nine top banks in the U.S., including Citigroup, JPMorgan Chase, Wells Fargo and Bank of America have been given $125 billion.

Just last week, the U.S. Department of the Treasury and the Federal Reserve announced they had replaced American International Group's $123 billion bailout loan with a $150 billion loan package that restructures $60 billion of the original loan, lowering the interest rate to 3% above Libor and investing another $27 billion in the company.

Fannie Mae is also expected to need further government support after reporting a $29 billion loss last Monday. And as of press time, there was talk of amending the government bailout package to assist the Big Three auto makers General Motors Corp., DaimlerChrysler and Ford Motor Co.

While market participants point out that the capital purchase program has already made strides - with one month Libor declining 243 basis points since the announcement of the program, and CDS spreads beginning to contract on the major financial institutions - the ABS market is still seeing signs of strain. "TARP has moved away from its initial intent," Morgan Stanley's Peters said. At that time, he noted that the ABX was still off 10 points and the RPX index, which tracks daily home prices, has reversed on its initial gains.

A Complicated Approach

But part of the hold-off in the asset purchase plan is the complexity of the program. "In retrospect, perhaps it is not all that much of a surprise that the Treasury went in a different direction with the initial deployment of TARP funds," Gainor said.

The stability of the financial system deteriorated far more rapidly than anyone had expected - which could have been driven by the TARP hearings themselves. Treasury did what it thought was necessary to do, as quickly and easily as possible, Gainor said. "It would be difficult to purchase whole loans and even worse, mortgage-related securities in any significant quantity. How do you value them? How do you calculate a price high enough to incent the seller to sell them but low enough so the government is not grossly overpaying?" he said.

Gainor also noted that it would have been difficult to conduct an auction for assets that are differentiated rather than homogenous. "Even after retaining sophisticated financial analysts and asset managers, [the government] would still have needed to go through a rather painstaking process of trying to assign value parameters to these types of distressed securities or pools of distressed loans."

Furthermore, in selling assets off of a bank's balance sheet at 30 cents to 50 cents on the dollar, for example, each of those purchases infuses cash into the bank but depletes the bank's capital to the extent that the bank has not taken a write-down equivalent to the price at which it sold that asset, Gainor said.

There were also human resources constraints in implementing the TARP, as the government worked to build a team of asset managers, and financial and legal advisors.

Before the asset purchase program was shelved, Baker & McKenzie's Metzger accurately predicted: "It is not beyond the realm of possibility that we may never see such purchases, or we may see a program rolled out as a very subsidiary piece of the government's response."

There was uniformity to the frustration expressed last week over the lack of information on how the TARP plan would be carried out. While Paulson said that the asset purchase plan to buy illiquid mortgage assets would not be implemented as initially planned, he did not rule out purchasing assets altogether. "Our assessment at this time is that this is not the most effective way to use TARP funds, but we will continue to examine whether targeted forms of asset purchase can play a useful role," Paulson said in a speech last Wednesday.

Insurance Plans?

Paulson also mentioned that part of the bailout funds could be used to guarantee mortgages that have been reworked to reduce monthly payments for borrowers, although that would not be a part of the rescue program.

The idea of a government guarantee program in lieu of a direct asset purchase plan was discussed at the SIFMA summit last week.

Karen Shaw Petrou, managing partner at Federal Financial Analytics has suggested that the government stick to a guarantee approach over an asset purchase plan, citing the Federal Deposit Insurance Corp. and the Federal Housing Administration's experience in this type of business. "It is the appropriate job for the government to do," she said, and a better use of the funds over a direct purchase program. She had expected that residential assets would be the first chosen.

Jeff Perlowitz, managing director and head of global securitized products at Citigroup, also agreed that insurance would be operationally easier, with a number of ways to go about implementation.

Looking ahead, Paulson will face contention from those who would want to see the implementation of the asset purchase program, or will receive calls for the support of those financial institutions that might not be eligible under the capital purchase program. Most likely though, market participants will simply want some clarity on how exactly the plan is going to be put into action.

(c) 2008 Asset Securitization Report and SourceMedia, Inc. All Rights Reserved.

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