Why Treasury Is Changing $700 Billion Bailout Fund

The Treasury is revamping how it uses the $700 billion financial bailout fund, focusing on relatively healthy consumer debt rather than the toxic mortgages that triggered the credit crisis in the first place.

As Treasury Secretary Henry Paulson acknowleged during a news conference on Wednesday, the initial decision to buy troubled mortgage assets of financial institutions was "not the most effective way" to use the $700 billion bailout package.

Instead, the Treasury will now use the money to buy securities backed by credit card debt, student loans, auto loans, housing and government agency debt. The intent is to help unfreeze those markets, where interest rates have soared and consumers often are unable to get credit for purchases.

Paulson said that 40 percent of US consumer credit is provided through such securities. "This market, which is vital for lending and growth, has for all practical purposes ground to a halt," Paulson said.

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The Treasury also plans to continue injecting money directly into troubled banks as well as nonbank financial institutions. There is one change, however: the banks may have to raise funds privately in order to get government money.

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So how exactly would the new plan work?

According to economists, the Treasury would simply go out and buy some of these consumer-debt securities whenever the price fell far enough to push the yield up to a certain level, say 9 percent.

Like Treasury bonds, these debt securities have a fixed interest rate, so their yield changes according to whatever price investors are willing to pay for them.

If investors knew that the government would enter the market whenever the yield on these securities hit 9%, the theory goes, that would encourage them to buy up the debt as well.

That would push the price of the securities up and send the yield lower. The market for such securities would unfreeze and make it easier for consumers to get a loan for college or a new car. Credit card rates also would decline.

Video: Reaction to the revised Treasury plan.

"We'll see if it's successful," said Tom Higgins, chief economist at Los Angeles-based Payden & Rygel.

"The key reason why they're approaching it from that angle is the other program of purchasing the illiquid assets seemed unworkable," he added. "It was difficult to determine the price you're going to pay. This way, they're buying assets that anyone could buy in the open market. You have less political obstacles to this type of strategy."

One question, however, is whether $700 billion is enough to really make an impact in a $7.9 trillion market for government agency backed securities, which includes Fannie Mae and Freddie Mac.

"I don't know if that's enough to meaningfully move those markets," Higgins said. .

Higgins believes Congress will have to allocate more money on top of the $700 billion already earmarked. But he believes Congress will be agreeable to do so because of the multiple benefits the new plan provides.

Still, some criticized the Treasury's change in direction, which they said signaled weakness and uncertainty from the government that was continuing to rattle the markets.

"I think it shows that there was really no thought-out strategy. It was just a panic move," said Tom Busby, CEO at the Day Trading Institute, a trader education center. "It really scares you when you think one of the most powerful men in the world reacts to a crisis this way."

Busby said the government instead should be focusing on tax strategies and other incentives to get business moving again, rather than ineffective monetary policy.

© 2008 CNBC.com