Wall Street: Us Government Taking Steps to Clean Up Mortgage-related Debt

The US government is floating plans to create a federal entity to mop up billions of dollars of mortgage-related debts in an effort to stem a collapse of confidence which has shaken the banking system to its core.

Lawmakers in Washington were briefed on the idea today by the treasury secretary, Henry Paulson, prompting a remarkable rally which sent Wall Street stocks flying to their biggest one-day percentage gain since October 2002.

Paulson met President George Bush tonight to discuss the creation of a body similar to the Resolution Trust Corporation – an organization established under the Reagan administration to hoover up devalued assets in the "savings and loan" crisis which brought down scores of banks during the late 1980s and early 1990s.

Although there was no official Treasury comment, the Democratic senator Charles Schumer, who chairs Congress's joint economic committee, confirmed the plan was under discussion.

"The Federal Reserve and the Treasury are realising that we need a more comprehensive solution," said Schumer, who advocates an alternative solution in which the government would pump liquidity into banks in return for equity.

As news of the potential rescue plan seeped into the market, there was immediate relief for Wall Street's two remaining standalone investment banks, Morgan Stanley and Goldman Sachs, which had been struggling to arrest a collapse of confidence among investors.

After falling by as much as 42%, Morgan Stanley's stock recovered to end the day with a slight gain. Goldman Sachs closed down 5% on persisting doubts about the viability of "broker-dealer" investment banks which lack a network of high-street branches.

In a day of wild swings, the Dow Jones Industrial Average dropped more than 150 points in the morning before powering upwards, gaining 410 to close at 11,019.

Having suffered torrid drops on Monday and yesterday, the US market is still down for the week. The volatility index, known as the "fear gauge", is at its highest for six years.

President Bush, who has been criticized for his silence during the week's financial turmoil, canceled a political fundraising trip to southern states and emerged from the White House to offer some brief words on the "serious challenges" facing the markets.

"The American people can be sure we will continue to act to strengthen and stabilize our financial markets and improve investor confidence," said the president.

In the wake of Lehman Brothers' collapse and Merrill Lynch's hasty takeover by Bank of America, pressure has intensified on Morgan Stanley and Goldman Sachs, both of which blame malicious rumor-mongering for undermining confidence in their finances.

Morgan Stanley's chief executive, John Mack, tried to reassure his staff of 48,000 through a company-wide recorded message in which he said he still hoped the bank could hang onto its independence.

But by the end of the day, Morgan Stanley had progressed to advanced takeover talks with Wachovia, a North Carolina-based bank with 3,300 retail branches across the US.

As an alternative plan to get the doubters off its back, Morgan Stanley has been discussing a possible capital infusion from Beijing's state-owned China Investment Corp which could significantly increase its 9.9% stake in Morgan Stanley. "We're dealing with a completely irrational market reaction," said a source at one major bank. "But if you live by the market, you have to accept that markets can occasionally be irrational."

After bailing out the insurer AIG on Tuesday, the Bush administration is keen to avoid any further situations in which it has to decide whether to allow an institution to sink or swim.

A group of conservative Republicans in the House of Representatives wrote to Paulson and to the Federal Reserve chairman, Ben Bernanke, demanding that they refrain from any "additional government-financed bailouts for large financial firms".

Experts said that a herd mentality was setting into the markets. In a research note, Citigroup's chief US equity strategist, Tobias Levkovich, wrote: "Fear seems to be overtaking any rational discourse, with the credit crunch slipping into crisis proportions and the desire to be in cash overwhelming any willingness to remain invested in equities."