Massive bailout plan won't work overnight

John W. Schoen Senior producer • Profile • E-mail

When Treasury Secretary Henry Paulson asked Congress for authority to take over ailing mortgage lender Fannie Mae in July, he said the move would provide the government with a “bazooka” to fight the unraveling financial crisis. Today, government officials unveiled what amounts to an atom bomb.

Details are still being worked out. And it remains to be seen when, how — or if — the plan will work.

In a nutshell, the new "atom bomb" approach hopes to mainline a massive amount of capital into the nation's largest banks to jolt the ailing economy.

As a signal the government was using every weapon in its arsenal, the plan was announced in an extraordinary joint statement by Treasury Secretary Hank Paulson, Federal Reserve Chairman Ben Bernanke and Sheila Bair, the head of the Federal Deposit Insurance Corp. and a handful of other top economic advisers of President Bush. Bush spoke separately at a Rose Garden news conference.

The centerpiece of the plan is a move by the government to partially nationalize the banking system, buying up stock in some of the largest banks.

Treasury officials said that the first purchases of stock from the nine major banks will begin within days and will total $125 billion. The government expects to spend the entire $250 billion slated for the bank stock purchase program by the end of the year.

In addition to the stock purchases, the FDIC will temporarily provide insurance for loans between banks, charging the banks a premium for doing so.

The FDIC is also guaranteeing all bank deposits for businesses.

“We're seeing a lot small banks, frankly, lose their small business accounts to much larger competitors, because of public confidence issues,” Bair told CNBC after the announcement. “These smaller banks are quite viable, but this is creating a liquidity drain, losing these small business accounts.”

Deposit insurance limits for consumers have been increased to $250,000.

The government’s move to inject capital in the banking system follows months of efforts to get banks to borrow the money voluntarily from the Fed. Even in the best of times banks are reluctant to step forward asking for help, fearing such a move will be taken as a sign of weakness by shareholder, depositors and competitors. With the banking system in the grips of a full-blown global panic, there was an even greater stigma attached to stepping up to the borrowing window.

To break the logjam, Paulson summoned top executives of the nation's biggest banks to a historic meeting Monday and essentially told them they had to go along.

By force-feeding money into the biggest banks, the Treasury is hoping to overcome several  obstacles to its effort to battle the financial crisis. Paulson's original plan — which is still ongoing — was to buy up bad loans from any bank that came forward. But under that scenario it is likely that the first takers will be the banks in the weakest position — so weak they may be beyond saving.

The weakening economy means there is likely to be less demand for lending, forcing the weakest banks to find stronger banks to merge with or buy them out. The massive injection of capital into the biggest banks may help jump-start that process, allowing the banking industry, rather than the government, to undertake the process of saving faltering banks.

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