WASHINGTON — In a stunning turnabout, the Bush administration Wednesday abandoned the original centerpiece of its $700 billion effort to rescue the financial system and said it will not use the money to purchase troubled bank assets.
“Our assessment at this time is that this (the purchase of toxic assets) is not the most effective way to use funds,” Treasury Secretary Henry Paulson told a news conference.
Paulson said the administration will continue to use $250 billion of the program to purchase stock in banks as a way to bolster their balance sheets and encourage them to resume more normal lending.
But he was noncommittal about direct support for the auto industry, saying it was a "critical industry" but that the bailout plan was not designed for them.
Asked about a Democratic congressional leadership plan to rush financial aid to the industry, Paulson cautioned that “any solution has got to be leading to long-term viability” for the automakers.
Stocks, already reeling, ended trading sharply lower, partly because Paulson's comments at a news briefing underscored the extent of the problems in the financial system. The Dow lost more than 400 points.
Investors also were concerned that the Treasury will be investing more taxpayer dollars into the banking sector, which will dilute the value of existing shareholders, said Rudy Narvas, senior analyst at 4Cast Ltd. in New York.
Aides to President-elect Barack Obama have been playing down reports of tension with the Bush administration over help for the stricken auto industry.
Struggling General Motors, Ford and Chrysler are seeking $25 billion in additional assistance on top of $25 billion in federal loans approved in September to help them develop more fuel-efficient cars. GM reported last week that it lost $2.5 billion in the latest quarter and does not have enough cash to make it through 2009, raising the prospect of a potential bankruptcy filing. Company executives say they are determined to avoid bankruptcy.
Democratic Rep. Barney Frank, chairman of the House Financial Services Committee, announced Wednesday he would introduce legislation that would appropriate $25 billion of the $700 billion bailout as loans to automakers in exchange for a government stake.
Paulson on Wednesday said that non-financial firms as well as banks may need additional cash infusions but that he saw “implementation difficulties” aiding companies that were not federally regulated.
Paulson said the administration was looking at a major expansion of the program into the markets that provide support for credit card debt, auto loans and student loans. He said 40 percent of U.S. consumer credit is provided through selling securities that are backed by pools of these loans.
“This market, which is vital for lending and growth, has for all practical purposes ground to a halt,” Paulson said.
Paulson said the massive bailout effort, the largest in U.S. history, was showing results but that more efforts were needed given the most severe downturn being faced in housing.
“Our financial system remains fragile in the face of an economic downturn here and abroad,” Paulson said. “Market turmoil will not abate until the biggest part of the housing correction is behind us. Our primary focus must be recovery and repair.”
Paulson said some of the bailout money also should be used to support efforts to keep mortgage borrowers from losing their homes because of soaring default levels.
He said a proposal to use some of the funds to guarantee mortgages that have been reworked to reduce monthly payments for borrowers is an approach the administration continues to discuss. But he indicated it would not be a part of the rescue program because it went beyond the intent of the legislation Congress passed on Oct. 3.
Asked about what he had in mind to expand the rescue effort to support credit card and other types of consumer debt that is backed by selling securities, Paulson said it would probably take weeks to design the new program and more time to get it implemented, a possible sign that any such proposal would have to be put into place by the incoming administration of President-elect Barack Obama.
Paulson said this weekend’s first-ever summit of leaders of the Group of 20 major industrial and developing countries needs to focus first on how to repair the financial system as a way to bolster the global economy.
Paulson also praised a new set of guidelines issued by the Federal Reserve and other bank regulators, saying that they addressed a crucial issue of making sure that banks continue to lend at adequate levels.
The guidelines urge institutions to continue lending to credit worthy borrowers and to work with mortgage borrowers to avoid defaults. In addition, the guidelines encourage the banks to set dividend payments for shareholders and compensation for executives with the current crisis in mind.
The guidelines address criticism that banks obtaining funds from the rescue plan are simply using the money to replenish their balance sheets and make acquisitions rather than lending more money to businesses and consumers.
“If underwriting standards tighten excessively or banking organizations retreat from making sound credit decisions, the current market conditions may be exacerbated, leading to slower growth and potential damage to the economy,” the regulators said in a joint statement.
The Fed, Federal Deposit Insurance Corp., Office of the Comptroller of the Currency, and Office of Thrift Supervision said all financial institutions were expected to follow the new guidelines, even those not receiving federal assistance.
In addition to the $250 billion committed to the purchase of bank stock, the Bush administration this week allocated another $40 billion toward a $150 billion bailout of troubled insurance giant American International Group.
That leaves only $60 billion of an initial $350 billion approved by Congress under the bailout bill. To access the second $350 billion, this administration or the next will have to make a request to Congress for the money.
The Associated Press and Reuters contributed to this story.