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WASHINGTON, DC-After taking a number of measured–albeit worth billions of dollars–steps in recent weeks, the federal government has revealed a comprehensive rescue plan that it hopes will attack the root cause of the significant stresses in the financial markets.

Friday morning Treasury Secretary Henry Paulson outlined a multi-step strategy that will ultimately cost taxpayers “hundreds of billions” of dollars–but will also be comprehensive enough to ferret out and neutralize the toxic assets currently choking off credit in the system. “To restore confidence in our markets and our financial institutions so they can fuel continued growth and prosperity, we must address the underlying problem,” he says, in a prepared statement.

The crux of the plan is a ‘troubled asset relief program’–a program in which the government will presumably relieve lenders of illiquid mortgage securities. Few details of this program were revealed this morning, other than Treasury plans to approach Congress with a proposed legislative package to flesh out the details over the weekend, with a goal of taking action on legislation next week. Paulson also revealed some concrete steps the government will be putting into place immediately.

For starters, it is establishing a temporary guarantee program for the US money market and mutual fund industry. In recent days it had become clear that money market funds–once considered as almost as safe as Treasury bill–were also at risk to the financial contagion. The government is devoting $50 billion to temporarily protect investors from money market losses.

Paulson also revealed that Fannie Mae and Freddie Mac, will increase their purchases of mortgage-backed securities. “These two enterprises must carry out their mission to support the mortgage market,” he says. Furthermore, he continued, to increase the availability of capital for new home loans, Treasury will expand the MBS purchase program it first announced earlier this month.

However, these two are not enough, he says. “Many of the illiquid assets clogging our system today do not meet the regulatory requirements to be eligible for the purchase by the GSEs or by the Treasury program.” The third leg–and most fundamental to the rescue effort–of the federal plan is the troubled asset relief program.

“The federal government must implement a program to remove these illiquid assets that are weighing down our financial institutions and threatening our economy,” he says. “This troubled asset relief program must be properly designed and sufficiently large to have maximum impact while including features to protect the taxpayer to the maximum extent possible.”

The immediate reaction in the markets was one of relief–indeed in late afternoon trading on Thursday, the Dow soared by 410 points on rumors that such a plan was in the offing. “The moves Secretary Paulson announced today to increase GSE and Treasury purchases of mortgage-backed securities should provide support for mortgage rates,” John A. Courson, COO of the Mortgage Bankers Association, says in a prepared statement. “The fear was that the illiquidity in the financial markets we have seen this week would have reversed the recent drops in mortgage rates. The broader steps outlined by Treasury are aimed at ending the further meltdown in the financial markets and are designed to minimize the resulting impact of the market turmoil on the broader economy.

“It is another step in the long-term process of restoring a balance between the supply and demand for housing in a number of markets and thus addressing the continuing problem of mortgage delinquencies and foreclosures,” he concludes.

It was clear that Thursday’s move by the Federal Reserve and other Central Banks to inject $180 billion into the system would only partly address the financial market woes. “Injecting liquidity in a traditional capital markets implosion … slows the descent of business activity,” Lawrence Selevan, principal with the New York City-based merchant investment bank firm Chesterfield Faring, tells GlobeSt.com. “However, in a capital markets meltdown that is caused by fear and panic of greater losses, the contagion cannot be exacted as prescribed by cold remedies; it must be a full restoration of the health in the belief in the viability of the credit markets.”

Lowering rates or increasing liquidity does not show strength in the credit markets but weakness that they are required, he explains. “The key is [to] take the riskier pieces of the credit markets and place them in an isolation chamber then slowly ease them back into the marketplace.” With such a “good bank-bad bank” structure in place, the market can assume all the bad paper is finally isolated, he says. “The RMBS and CMBS markets are dependent on having qualified buyers that belief the risk equals the return. This has not been apparent now for two years.”

Selevan hopes this strategy will be replicated on a global scale. “The G-8 nations must form a global clearinghouse institution with the combined influence and powers of the IMF, World Bank, and central bankers that become the recipient of all of this paper and can cause an orderly repricing and liquidation through a global funding mechanism.”

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