Paulson announces U-turn over US government bailout

Treasury Secretary says funds will be used to buy direct stakes in banks

The US government has staged a U-turn on its plans for bailing out the country's financial system, saying that it no longer intends to buy the toxic mortgage assets at the heart of the credit crisis.

The announcement came less than six weeks after the Treasury won a gruelling battle with Congress for the authority to conduct the purchases. Hank Paulson, Treasury secretary, said that the remainder of the $700bn bail-out fund will instead be used to buy more direct stakes in banks and other financial firms.

As he spoke, the Federal Reserve and other banking regulators made an unprecedented joint statement urging banks to use money already received from the government to issue new loans, rather than hoarding the cash to pay dividends and staff bonuses.

The change of plan reflected the speed with which the credit crisis has overwhelmed government efforts to restore order to debt markets. They continue to be gummed up in a way that is starving businesses and consumers of loans and are throttling the US economy.

Mr Paulson's new statement did little to reassure markets, which remain confused over the scope and ultimate effectiveness of government intervention. "I will never apologise for changing an approach or a strategy when the facts change," he said. "During the two weeks that Congress considered the legislation, market conditions worsened considerably. It was clear to me by the time the bill was signed on 3 October that we needed to act quickly and forcefully, and that purchasing troubled assets – our initial focus – would take time to implement and would not be sufficient given the severity of the problem."

The Treasury's original plan was based on the assumption that removing toxic mortgage assets from banks' balance sheets would finally establish how much they were worth, thereby restoring confidence and enabling companies to raise private money. But Mr Paulson said the Treasury would spend an initial $250bn buying direct stakes in banks before it turned to the mortgage purchases. Economists had argued that directly recapitalising the banks was more efficient, because institutions could leverage the new money to make many times that amount in new loans.

Although the Treasury Secretary said yesterday that there would be a pause to assess the success of the initial $250bn investments, he said that more capital infusions were likely. The scheme would also be extended to non-bank institutions which operate in the securitisation market, buying and selling portfolios of credit-card debt and student and car loans. This securitisation market has also ground to a halt, with knock on consequences for consumer spending, and for colleges and the car industry.

However, Mr Paulson stopped short of agreeing to Democrat demands that Tarp funds be used to inject money into near-bankrupt car makers. He said other programmes should be used for helping companies such as GM and Ford, as they struggle to cut jobs and retool factories to make more popular, fuel-efficient cars.

The first tranche of Tarp funds were handed to nine of the country's biggest banks on 14 October, but the money came with few strings attached, and critics say the firms have hoarded. The regulators' joint statement yesterday was an attempt to cajole banks into responding.