As the magnitude of the financial crisis has increased following Congress' passage of the $700 billion bailout plan, the feds have shifted their strategy.
On Wednesday, Treasury Secretary Henry Paulson said the government would use the bailout funds to flush capital into the banks — not to buy up bad mortgage assets through the Troubled Asset Relief Program, or TARP, as originally declared.
The reason for the shift, Paulson told NPR's Robert Siegel, was that it was a "more powerful and quicker way to deal with the problem."
"Seven hundred billion [dollars] wouldn't go far enough in my judgment," Paulson said. "So you get much more leverage by putting capital into the banks. What we were looking to do was to stabilize the system and encourage banks to lend more. And the quickest and most powerful way to do that was with capital."
If the banks have capital, Paulson said, it's "easier for them to write down the value of the securities and to sell them."
The government has been criticized because AIG, Freddie Mac and Fannie Mae all had more debt than the government knew when it took over the institutions. But Paulson defended the Treasury's actions.
"When AIG was on the brink of failing, we didn't have the TARP," Paulson said. "The feds stepped in to save the system and save the American people and make a bridge loan. And if we had had the TARP, we would have put preferred stock in to stabilize that situation along with the feds. This puts the government in a stronger position and gives it more time to sell the assets."
Paulson also called the situation that both Fannie Mae and Freddie Mac were in "a disaster waiting to happen."
"We got in, we saw that they didn't have enough capital and it wasn't a high-quality capital," he said. "We moved quickly to stabilize that situation — I think we successfully stabilized it. I would say earnings announcements reflect what we're seeing, reflect what we saw when we were there. They are performing quite consistent with expectations. And they're stabilized."
Paulson also reiterated that the feds are considering investing in a "relatively small" liquidity program for a host of credit products, but he says they have not made a decision yet.
The idea is that the government's injection of funds would keep consumer credit — that is, money that is separate from the banking system — from collapsing. The program would be aimed at a range of products, such as auto, credit card and student loan securitizations.
"In our country, 40 percent of this financing takes place away from the banks," Paulson said. "That's another form of direct lending. This is about keeping lending going, keeping the economy going. Or conversely, if that market collapses, it will end up to some extent on the banks' balance sheets, and that will restrain other lending."
In regard to automakers and companies such as General Motors that have asked the federal government for money under the bailout plan, Paulson said the industry is "very important." He added that legislation has already passed in Congress to set aside $25 billion for the auto industry, and the Federal Reserve is asking Congress to amend the bill.
"No one thinks that a bankruptcy of any auto manufacturer is something that we'd like to see happen at this time," Paulson said.
But Paulson says the most important action for the feds is to "get lending going again."
Paulson says he believes the banking system, including the major institutions, has been stabilized, but economic recovery has a long way to go.
"It took a long time to build up these excesses. It's going to take a good while to work through this period," Paulson says. "And the first focus should be on recovery and repair."