The Federal Reserve Act confines the System's outright asset purchases to securities issued or guaranteed by the U.S. Treasury or U.S. agencies. Even so, the Fed has the potential to use its balance sheet to restore functioning in other impaired financial markets. The recently announced Term Asset-Backed Securities Loan Facility (TALF) provides a model for doing so. This new Fed facility is designed to spur lending to meet the credit needs of households and small businesses. The facility will support the issuance of securities collateralized by auto, student, credit card, and Small Business Administration (SBA) loans—sectors where the issuance of new securities has slowed to a trickle. The high borrowing spreads on such securities, even when the underlying loans are government-guaranteed—as in the case of SBA and many student loans—suggest not only heightened credit risk but also an impairment of market liquidity which the facilities can address. The inability of financial institutions to securitize such loans, and of potential investors in such securities to borrow against them on reasonable terms, reflects an important breakdown in credit markets. By improving the functioning of markets for securitized assets, the Fed has the potential to boost private-sector credit flows in support of the economy. Under the TALF, which is a joint Federal Reserve-Treasury initiative, the Fed has agreed to provide nonrecourse loans to holders of eligible highly rated asset-backed securities. Cooperation with the Treasury is necessary because the program entails some risk of loss and, under the Federal Reserve Act, all Fed lending must be appropriately secured. The Treasury has committed $20 billion of TARP funds to protect the Fed against losses on the Fed's lending commitment of up to $200 billion.

The Troubled Asset Relief Program (TARP) authorized by the legislation will allow the Treasury, under the supervision of an oversight board that I will head, to undertake two highly complementary activities. First, the Treasury will use the TARP funds to help recapitalize our banking system by purchasing non-voting equity in financial institutions. Details of this program were announced yesterday. Initially, the Treasury will dedicate $250 billion toward purchases of preferred shares in banks and thrifts of all sizes. The program is voluntary and designed both to encourage participation by healthy institutions and to make it attractive for private capital to come in along with public capital. We look to strong institutions to participate in this capital program, because today even strong institutions are reluctant to expand their balance sheets to extend credit; with fresh capital, that constraint will be eased.

With respect to impaired assets, experience reveals that programs to remove nonperforming loans from the balance sheets of financial institutions have proven helpful in resolving a number of earlier financial crises in both industrial and developing countries... To the extent that the prices that the government pays through auctions exceed the fire-sale prices now used to value them, some institutions will see an improvement in their capital.

"I'm working under the assumption that it is most realistic at this stage that there will be no comprehensive program as was envisioned in the Treasury {TARP} proposal," Lockhart told a local group in New Orleans. "The most realist approach is to assume we are moving forward dealing with whatever developments come up on a one-by-one basis," he said.

From the Q&A session, as reported by Dow Jones

[T]he preferred stock or capital injection approach has, in fact, been one of the favorite approaches in previous bank crises, like the S&L crisis, for example, or the Japanese or Scandinavian crises, and others.

Those were situations, however, where the government was dealing with institutions on the brink of failure or already failed. In that case, the only way to keep the institution going, if it's viewed as being appropriate to do so for systemic or other reasons, is to inject capital, wipe out the existing shareholders, and to, you know, impose many conditions on the firm.

We're facing a somewhat different situation, which is firms that are valid going concerns. They're -- you know, while we may have a few companies in --trouble, which might be addressed in the way you describe, companies that are -- that are strong going concerns we don't want to take the risk -- or at least there is a risk; let me just say that -- that if the private markets perceive the government injecting capital into these ongoing -- ongoing concerns, the concern might arise that the government is going to wipe out other shareholders, or take over the firm, or -- or otherwise make it difficult for them to raise new capital.

I would note one -- two things. First, as a minor point, that one of the things that this program being discussed could do would be to purchase second liens, which have proved to be a very significant barrier to the resolution of -- of foreclosures.

...

Well, second liens are selling for a few cents on the dollar. I wouldn't expect them to be worth much more than that.  But I was only pointing out that -- I know this from Governor Duke, who's on the Hope for Homeowners board, that the problem with second liens is a big issue right now, because it prevents renegotiations of the first mortgage.  So I was just saying that a side effect, if we do buy them at market value, a few cents on the dollar, would be to help free up this -- this other issue.

From the Q&A session

If you've got a squirt gun in your pocket, you may have to take it out. If you've got a bazooka and people know you've got it, you may not have to take it out. You're not likely to take it out. I just say that by having something that's unspecified, it will increase confidence and by increasing confidence it will greatly reduce the likelihood it will ever be used.

As reported by Reuters.