Geithner’s Rescue May Determine Impact of Stimulus (Update1)

Feb. 10 (Bloomberg) -- The unprecedented stimulus package that President Barack Obama is trying to wrestle through Congress may end up being wasted unless the administration can find a way to restart stalled credit markets.

Investors are demanding a 5.20 percentage-point premium over U.S. Treasuries to buy bonds sold by companies with investment- grade ratings, more than five times the level of two years ago. The rate on jumbo mortgages is 6.91 percent, almost 1 percentage point higher at than the start of 2007.

The financial-rescue plan that Treasury Secretary Timothy Geithner unveiled today may determine how effective the stimulus will be. Without the ability to borrow to invest in new business projects, or credit for purchases of new cars, homes and appliances, companies and households won’t be able to follow through on Obama’s tax cuts and spending programs, analysts said.

“We really haven’t seen any breakthrough yet in the credit logjam,” said former Federal Reserve Governor Lyle Gramley, who is now a senior economic adviser at Stanford Group Co. in Washington. “We’re going to get limited benefit from the stimulus program unless people can finance their normal operations.”

After weeks of debate, the Treasury today announced plans for a fresh round of injections of taxpayer funds into banks, an expanded Fed-led effort to spur consumer and small-business loans and a “Public-Private Investment Fund” of at least $500 billion to address the toxic assets clogging banks’ balance sheets.

Private Capital

It’s unclear how successful Geithner’s plan will be in restarting markets. Stocks slumped today, led by financial shares, as investors expressed concern about a lack of specifics on plans for addressing the distressed assets. Geithner warned today that it will “take time” for the administration’s strategy to bear fruit.

The illiquid securities, mainly tied to mortgages, have spooked investors away from putting new money into banks and made lenders loath to extend new credit. Rather than borrow at the Fed’s target rate for overnight funds -- now as low as zero percent -- to lend, banks have instead parked a surplus of $793 billion of cash at the central bank itself.

“We have got to fix the financial system -- if we do not deal with this, we will not get anything else done,” Christopher Whalen, managing director of Institutional Risk Analytics, a financial-services research company in Torrance, California, said in a Bloomberg Television interview. “If banks cannot move mortgages off their books, then we have a problem. We will see credit availability much lower” than in past generations.

Restart Market

Whalen said the challenge is for the government to craft its solution so that it becomes a “market maker,” enabling the banks to offload the illiquid securities and put them in the hands of other investors.

Investors offered mixed signals about their appetite for participating in the effort.

“It will be a bad decision for a hedge fund to invest in these illiquid assets,” said Kenneth Windheim, chief investment officer of Strategic Fixed Income LLC in Arlington, Virginia, which manages $1.7 billion in assets and invests with hedge funds. “You’ll end up running into the same problems as the banks. The hedge fund industry is suffering as it is already.”

‘Energize’ Investors

John Snow, a former Treasury secretary who is now chairman of Cerberus Capital Management LP, said that guarantees “might energize the private sector to begin putting in capital.”

Obama warned yesterday in a news conference that the economy faces a “full-blown crisis,” urging lawmakers to approve the stimulus package of more than $800 billion being considered in Congress. The credit crisis “is not over,” he said. The Senate approved a stimulus bill today, clearing the way for negotiations with the House over a compromise plan.

The financial rescue needs to create an “improving” credit market to ensure that the stimulus works, said Bruce Kasman, chief economist at JPMorgan Chase & Co. in New York and a former Fed researcher.

There are signs of a thaw in some markets. Companies sold $146 billion of bonds in the U.S. last month, the most since May, and even high-yield, high-risk junk debt had the best start to a year since 2001.

Procter & Gamble Co., the world’s largest consumer-products company, sold six-year notes last week at a rate more than a percentage point lower than it issued in December.

Cash Crunch

Still, a measure of the appetite for banks to lend to each other remains elevated. The gap between the three-month London interbank offered rate and the overnight indexed swap rate is 0.95 percentage point, down from a high of 3.64 percentage points in October, while remaining distant from the 0.25 percentage point level some analysts regard as indicating a stable market.

Another option that officials and regulators considered was to set up a government-funded “bad bank” that would buy up the toxic debt. New York Senator Charles Schumer said that was “very expensive,” costing as much as $4 trillion, and risked setting values for the securities “so low that every other bank would go bankrupt.”

To help spark new credit, the Treasury plans to work with the Fed to expand the Term Asset-Backed Securities Loan Facility. The program, which has yet to start in its original form, offers funding to investors in top-rated debt backed by “newly and recently originated” loans.

The TALF had initially aimed at providing up to $200 billion of credit, with $20 billion from the Treasury’s $700 billion Troubled Asset Relief Program. It covers education, car and credit-card loans, and borrowing guaranteed by the Small Business Administration. The program may be expanded to as much as $1 trillion and include real-estate debt such as commercial mortgage-backed loans.

“They’re going to have to put a lot more TARP money into that,” Gramley said.

To contact the reporter on this story: Scott Lanman in Washington at slanman@bloomberg.net; Craig Torres in Washington at ctorres3@bloomberg.net.

To contact the editor responsible for this story: Chris Anstey at canstey@bloomberg.net