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WASHINGTON, DC-In an extraordinary about-face, the government is injecting $250 billion into the US banking system. The Treasury Department will partially nationalize nine US banks by purchasing minority stakes; in exchange these institutions, which haven’t been named, will jointly receive $125 billion. Treasury will also make another $125 billion available to “a broad array” of banks and thrifts across the country, by purchasing their preferred shares.

Treasury is also temporarily guaranteeing the senior debt of all FDIC-insured institutions and their holding companies. Also, this morning the Federal Reserve Bank revealed additional details about its Commercial Paper Funding Facility program, which provides a backstop for the commercial paper market. Beginning Oct. 27, the program will fund purchases of commercial paper of three-month maturity from high-quality issuers.

News accounts identify the nine banks as Citigroup, Goldman Sachs Wells Fargo, JPMorgan Chase, Bank of America, Merrill Lynch, Morgan Stanley, State Street and Bank of New York Mellon Corp.

Nationalizing–or even partially nationalizing the banking system–is in direct conflict with the free market principals on which the US economy is based. Certainly it is anathema to the Bush Administration, which has traditionally preferred as little regulation as possible in the economy.

Treasury Secretary Henry Paulson did not mince words about this unprecedented move. “Today’s actions are not what we ever wanted to do–but…are what we must do to restore confidence to our financial system,” he says in a prepared statement. Indeed, Pres. George W. Bush emphasized that these measures were for the short-term. “The government’s role will be limited and temporary,” he said Tuesday morning in a press conference at the White House. “These measures are not intended to take over the free market, but to preserve it.”

A big unknown is whether the banks will actually use the capital as the government intended–that is, will they begin to lend to businesses and consumers again, or will they take the capital to shore up their own balance sheets. It is safe to assume, however, that the government will put a lot of pressure on the institutions to loosen credit.

“We must restore confidence in our financial system,” Paulson said at a press conference Tuesday morning. “The needs of our economy require that our financial institutions not take this new capital to hoard it, but to deploy it.”

Unlike other measures that government has taken in the last several weeks–namely interest rate cuts and the roll out of a plan to purchase toxic debt–the markets are responding to this concept. Monday the Dow rose by 11% upon news that European banks would be taking stakes in their institutions. Perhaps more telling–at least for the credit markets–Libor has dropped 50 basis points to 4.08%, after reaching a record high of 4.76% earlier this month.

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