A new bailout entity

After a series of ad hoc, multibillion-dollar rescues — from mortgage giants Freddie Mac and Fannie Mae to global insurance giant AIG — the panic in the credit markets has not subsided.

On Friday the Bush administration, which is now working with Congress on a more long-term solution, unveiled four new measures aimed at restoring order to financial markets:

A new bailout entity
On Friday, Treasury Secretary Paulson announced plans to form a separate entity to buy up bad mortgage-related debts, reminiscent of the Resolution Trust Corp. that cleaned up the widespread failure of savings and loans in the late 1980s. The new entity, which would require congressional approval, would buy up bad debts at a deep discount from struggling financial institutions. By providing a market for the troubled securities, the plan would allow banks and brokerages to remove the assets from their balance sheets and provide a final value on losses.

In theory, the Treasury has unlimited capital to buy up bad debts. No one knows how much money will ultimately be needed; Paulson said that “we are talking hundreds of billions of dollars.”

Details are still sketchy. Treasury and Fed officials were expected to meet with congressional leaders over the weekend to work out specifics.

One likely point of contention: Democrats want any master plan to include relief for homeowners struggling to keep up with unaffordable mortgages. One proposal, which Democrats had tried unsuccessfully to include in this summer’s housing relief bill, would let bankruptcy courts modify loans terms. So far, such modifications have been voluntary on the part of lenders.

Protection for money market funds
The Treasury announced it will guarantee money market mutual fund deposits with $50 billion tapped from the Exchange Stabilization Fund, a Depression-era agency intended to stop panics in foreign exchange markets.

Money market funds are usually among the safest of investments, with holdings in Treasury securities and other debt that is considered ultrasafe, like loans to well-financed companies. But the panic has battered the value of debt issued by even the most creditworthy borrowers.

But this week the nation's oldest money-market fund announced investors will lose money because of a bad investment in Lehman Bros. The value of shares in the Reserve Primary Fund was reduced to 97 cents for every $1 invested.

It was only the second time since money market funds were first set up in the 1970s that a money market fund "broke the buck" the pledge to keep shares steady at $1 a share.

As of Wednesday, money market mutual funds held some $3.4 trillion in deposits — down $169 billion in the last week.

Ban on short selling
The Securities and Exchange Commission issued a temporary ban on short selling of nearly 800 financial stocks. The ban is in effect for two weeks and could be extended another two weeks.

Short selling is the practice of trying to profit from an expected drop in share prices by selling borrowed shares and then buying them back after the price has fallen.

Problems at many major financial institutions have been aggravated by the drop in their stock prices. And there’s ample evidence that part of the reason for the slide in these stock prices is the heavy selling by short-sellers.

In times of panic, selling pressure feeds on itself. Some officials have accused short sellers of spreading rumors that accelerated pressure on financial stocks in the past few weeks.

Critics of the SEC say the agency has not done enough to stem the damage of short selling by strictly enforcing rules designed minimize its impact.

By temporarily banning short selling, the hope is that the stock prices of battered financial firms can recover and their capital base can be rebuilt.

Increased Fannie, Freddie portfolios
The Treasury is authorizing Fannie Mae and Freddie Mac to increase the size of their loan portfolios, allowing them to buy more mortgages. The hope is that as Freddie and Fannie buy more mortgages, new cash will be freed up to lend to new home buyers. This is intended to help revive the struggling housing market

The Treasury has the authority to make this change because it took control of the mortgage giants Sept. 7 in a bailout that could cost up to $200 billion, by some estimates.

On Friday, the Treasury said it would buy $10 billion worth of mortgage-backed securities, upping the $5 billion it pledged to buy when it took over Fannie and Freddie.

It is unclear whether the latest move will help the ailing housing market. The Federal Reserve has already slashed interest rates and flooded the financial system with cash. The concern is that mortgage lending will remain sluggish as long as lenders remain nervous about extending a loan backed by a house that’s falling in value.

Shifting more troubled loans to Fannie Mae and Freddie Mac will also increase the strain on the finances of these government-owned companies, increasing the risk that taxpayers will lose more money if more loans go bad.