WASHINGTON — In another breathtaking display of government intervention, top officials at the Treasury Department and Federal Reserve began discussing with congressional leaders a plan to buy up vast numbers of distressed mortgages held by ailing financial institutions.
While the details remain to be hammered out, the discussions could result in the biggest bailout in U.S. history, and the most direct commitment of taxpayer funds so far in the worst financial crisis that Fed and Treasury officials say they have ever seen.
"What we are working on now is an approach to deal with systemic risks and stresses in our capital markets," said Treasury Secretary Henry Paulson. It would be "a comprehensive approach that would require legislation," he added.
Paulson and Federal Reserve Chairman Ben Bernanke presented a "chilling" picture of the state of the financial system, a participant in the meeting, speaking on condition of anonymity, told the Washington Post.
The plan is expected to be loosely modeled on the Resolution Trust Corp. that bought up and eventually sold hundreds of billions of dollars' worth of real estate in the 1990s from failed savings and loans. In this case, however, the government is expected to take over only distressed assets, not entire institutions.
The credit crisis continued to roil the world's markets Thursday, but for the first time in a week of steep downdrafts, U.S. stock prices rallied on news of the government efforts to shore up the global financial system.
The mortgage meltdown has already forced the Treasury and the Fed to bail out four of the country's most prominent financial institutions — Bear Stearns in March; Fannie Mae and Freddie Mac this month; and American International Group, the insurance conglomerate, this week. Now it is contemplating its broadest — and perhaps most expensive — intervention to date.
The urgency has only grown with each intervention because the first three tries have not worked. People are withdrawing their money from money market mutual funds. Banks are refusing to lend to one another. Several big financial companies need money to stay in business, including the bank Washington Mutual.
Regulators and the banking industry are increasingly concerned in particular about customer withdrawals from money market funds. Financial executives have told government officials that the rising pace of withdrawals is the equivalent of a bank run and that, if continued, it will drain a massive and critical source of funding.
Thursday night, the Fed was considering offering backing for money market mutual funds, a source familiar with the discussions told the Washington Post.
Money market funds are particularly important because they buy short-term debt, which is used by financial companies and other corporations to finance day-to-day activities.
Paulson and Bernanke told lawmakers that the consequences would be grave if they failed to pass legislation by the end of next week, according to a participant in the meeting. Senate Majority Leader Harry Reid and House Speaker Nancy Pelosi both committed to meeting that deadline.
The plan emerged on a day when the Federal Reserve poured almost $300-billion into global credit markets and barely dented the panic. The Fed stunned investors before dawn on Thursday by announcing a plan to provide $180-billion to financial markets through lending programs operated by several foreign central banks.
But after an initial sense of relief swept markets in Asia and Europe, the fear quickly returned. The Fed had to inject an extra $100-billion.
Those actions brought little relief, with banks around the world still too frightened to lend to each other, much less to customers. This forced Paulson and Bernanke to think the unthinkable — committing taxpayer money to buy hundreds of billions in distressed assets. That news gave an early boost to Asian markets today.
A growing number of Democratic leaders, as well as many banking executives, have been pushing for a sweeping bargain in which the government would buy up billions of dollars in bad mortgages. As part of the bargain, lenders would negotiate easier loan terms with distressed homeowners. But the scale and complexity of the project are almost certain to create huge philosophical differences among the parties that could make negotiations difficult, to say the least.
President Bush, who has adamantly opposed bailouts, said Thursday that his administration is working feverishly to calm the financial turmoil. He was supposed to spend the day in Alabama and Florida raising money for Republicans and talking energy policy, but canceled the trip to focus on the economy.
On Thursday, the Dow Jones Industrial Average shot up 617 points from its low point in midafternoon, its biggest surge in six years, and ended the day with a gain of 410 points or 3.9 percent. But it was by no means a sign that the crisis on Wall Street had turned a corner.
Analysts attributed the rally not to a fundamental improvement in the financial environment, but rather to reports that the government might be planning to quarantine some of the worst assets held by major banks.
The meltdown on Wall Street threatens to gradually corrode economic activity, mainly by disabling the credit on which everyday transactions depend. Borrowers are finding this week that the nation's lenders are tightening up in numerous ways. American Express, for example, is reducing the maximum credit limit for half of its millions of cardholders.
Also, amid mounting pressure from lawmakers, the Securities and Exchange Commission is considering taking the dramatic step of temporarily banning the routine practice of betting against company stocks, or short selling. A recent wave of the maneuvers — profiting by selling unowned shares of companies in the anticipation their prices will drop — has been blamed in part for the demise of investment firm Lehman Bros.
Information from the Associated Press, Washington Post and New York Times was used in this report.