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Paulson cancels key part of bailout

Gosselin and Puzzanghera are Times staff writers.

The Bush administration dropped the centerpiece of its $700-billion financial rescue plan Wednesday, reflecting the remarkable extent to which senior government officials have been flying by the seat of their pants in dealing with the deepening economic crisis.

Treasury Secretary Henry M. Paulson said the administration would scrub plans to buy troubled mortgage-backed securities but continue to devote bailout funds to restore liquidity to credit markets.

The turnabout underscored the challenge facing President-elect Barack Obama in creating a comprehensive and consistent strategy in the face of a roiling crisis.

“You’ve had a tremendous amount of improvisation here,” said Douglas W. Elmendorf, a former Federal Reserve economist and an informal advisor to Obama’s transition team. “Even smart people get things wrong when they have no models to follow and are acting quickly, so it’s natural that there’d be some reworking.”

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Or as Sen. Charles E. Grassley (R-Iowa) put it: “When you see so many changes, you wonder if they really know what they’re doing.”

Paulson, who originally dismissed emergency government investments in financial institutions as a recipe for failure, said most of the first half of the $700 billion had already gone to making emergency investments in banks and other companies aimed at reviving the routine borrowing and lending that are crucial to the economy.

Although Paulson said those actions had helped thaw credit markets and prevent “a broad systemic event” in the global economy, he acknowledged that most financial firms are still deeply reluctant to lend.

“Illiquidity in this sector is raising the cost and reducing the availability of car loans, student loans and credit cards,” Paulson said during a speech in Washington. “This is creating a heavy burden on the American people and reducing the number of jobs in our economy.”

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He added: “First and foremost, because the system remains fragile, we must continue to stand ready to prevent systemic failures. The stability of our system remains the highest priority.”

But the effort to provide that stability is in a state of flux.

“This was an opportunity for Paulson to finally articulate the principles by which the government would aid some firms and not others. He didn’t do it. He is drifting,” said Vincent R. Reinhart, a resident scholar at the conservative American Enterprise Institute and a former director of the Federal Reserve Board’s division of monetary affairs.

Paulson publicly acknowledged not only that the administration had shifted gears but also that the government’s financial rescue mission had entered a “time out” period as Obama prepared to take office. During that interval, Obama and the Congress must decide the role federal officials should play in the housing market, Paulson said.

The Treasury secretary’s views on two key components of that role are at odds with those of Obama and many congressional Democrats.

Paulson said far-reaching proposals to dramatically reduce home foreclosures by modifying existing mortgages would “require substantial government subsidies” that still needed to be justified. And he turned aside calls to use some of the $700-billion Troubled Asset Relief Program fund to aid General Motors Corp. and other tottering U.S. automakers.

“We care about our auto industry in the U.S. They’re a key part of our manufacturing industry,” Paulson said. “We need a solution, but the solution has got to be one that leads to viability. The intent of the TARP was to deal with the financial industry.”

The change wasn’t received well on Wall Street, which this week has been reeling amid deepening economic worries. The Dow Jones industrial average dropped 411.30 points Wednesday, or 4.7%, to close at 8,282.66. Shares of Citigroup, which would have been a chief beneficiary of the buying plan, plunged nearly 11% to a decade-plus low of $9.64.

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On Capitol Hill, reactions ranged from nonplused to I-told-you-so.

“My mouth is open,” Rep. Jane Harman (D-Venice) told a television interviewer, comparing Paulson to a football team’s quarterback changing the play at the line of scrimmage. “It was a very hard vote for many of us who voted for that package, and now all of a sudden we have an audible and we’re spending it on something else.”

Sen. Charles E. Schumer (D-N.Y.) chairman of the Joint Economic Committee, said he was pleased the Bush administration had changed its strategy on how to spend the giant rescue fund. Schumer had been skeptical about the logistics of buying troubled mortgage-backed securities when the legislation was being crafted in September.

He and other lawmakers successfully pushed to give Paulson the flexibility to use the money for other purposes.

“Congress gave the secretary the authority without him asking for it,” Schumer said. “Now I suppose he’s happy we did.”

The $700-billion plan approved by Congress authorized the Treasury to spend half that amount immediately, with additional requirements for releasing the rest.

On Wednesday, Paulson offered no specifics about how he planned to spend the second half of the funds -- suggesting that those decisions would fall to the incoming Obama administration. Senior Democrats on Capitol Hill, however, were clear about where they thought the remaining money should go.

“Obama should tell Paulson, ‘Thank you, but you should ask for the money and use a substantial portion for mortgage foreclosure reduction,’ ” said Rep. Barney Frank (D-Mass.), chairman of the House Financial Services Committee.

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Schumer said he might seek new conditions on how the $350 billion is spent, such as reducing foreclosures and inducing banks to lend.

“If the economy needs it, Congress is going to approve it,” Schumer said of the final installment. “But we might approve it with certain provisos.”

Paulson’s effective scrapping of the mortgage securities buying plan that he sold so passionately only months ago is just one example of the recasting of emergency measures that Washington has witnessed in recent days.

On Monday, Treasury and the Federal Reserve overhauled their aid package to insurance giant American International Group Inc. In September, they gave AIG an $85-billion line of credit to help it liquidate over the next two years, and less than a month later added $37.8 billion to the package.

But with those moves proving inadequate -- the company reported a $24.5-billion loss Monday -- the bailout was retooled and the price tag boosted to $150 billion.

In addition, the Federal Reserve Bank of New York announced it was delaying a plan to help stabilize money market funds by buying up to $540 billion of their short-term debt. The plan, announced last month, was intended to help the funds handle the crush of nervous investors seeking to get their money out.

Lawmakers were reluctant to criticize Paulson, noting the importance of his task to help right the economy.

“The initial reaction that a lot of us had on the Hill was ‘How can we do something like this so fast?’ We took a lot of heat in standing up and saying, ‘Wait a minute,’ ” said Rep. Eric Cantor (R-Va.), who helped lead GOP opposition to the original bailout bill before voting for a revised version.

“I’m very hopeful he has put together a team that knows what it’s doing and can get us out of the mess we’re in as quickly as possible.”

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peter.gosselin@latimes.com

jim.puzzanghera@latimes.com


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