It remains far from clear whether the US government's emergency package will restore stability, writes Arthur Beesley,Senior Business Correspondent, from Wall Street.

RACING TO strike agreement on a risky plan to buy $700 billion (€485.6 billion) in shaky mortgage-related assets from vulnerable banks, US treasury secretary Henry Paulson spent the weekend locked in political negotiation with Congress on the parameters of the emergency package.

After a series of ad hoc government interventions failed to arrest the escalating credit seizure as some of the most illustrious names in US business were wiped out, the new manoeuvre marks an ambitious ploy of vast scale to weed out the source of the contamination by removing distressed assets from the financial system altogether.

The overarching aim of the initiative, the brainchild of Paulson and of US Federal Reserve chairman Ben Bernanke, is to restore confidence in the credit markets.

Crucial for the day-to-day functioning of the economy, these markets practically came to a halt last week as distrust engulfed the system. Investors sought out the safety of short-term government debt and withdrawals from "safe" money market mutual funds shot up, reducing activity even as central banks around the world flooded the system with additional liquidity.

"We need to look at what's going on in credit markets. They are very fragile right now, and frozen," Paulson said yesterday.

Amid rampant fear that the escalating crisis could lead to a severe recession that would hold back the US and international economies for many years, the effort to jumpstart the markets stands as the biggest peacetime expansion of the US government's role in the financial system since the Depression of 1930s.

This socialisation of risk - the assets are to be sold on when the market conditions improve - will see US taxpayers assume a huge quantity of Wall Street's bad debts. However, US president George W Bush said failure to take such action could have grave consequences. "This is a big package because it was a big problem," he said.

"I will tell our citizens and continue to remind them that the risk of doing nothing far outweighs the risk of the package and that, over time, we're going to get a lot of the money back.

"The government needed to send a clear signal that we understood the instability could ripple through and affect the working people and the average family, and we weren't going to let that happen."

News of the initiative sparked a euphoric rally on Thursday and Friday that saw the Dow Jones finish virtually unchanged at the end of one of the most tumultuous weeks in the history of Wall Street.

But even as Paulson hammered out the details with Congress to finalise a package that is to be signed into law this week, it remained far from clear that the gambit would lead to an orderly restoration of stability in the equity markets.

Panic subsided in a two-day uplift that was the largest since 1987, but the potential for further shocks remains.

Indeed, Paulson is reported to have said "we'll still see banks fail in the normal course" during meetings at Congress. He said in an interview yesterday that share prices were "not what we should be looking at" to assess the magnitude of the crisis, adding that the most serious problems were in the credit markets.

Given the $200 billion already committed a fortnight ago to prop up wholesale mortgage giants Fannie Mae and Freddie Mac and the $85 billion cost of nationalising insurance giant AIG, the $700 billion required to fund this plan brings the government's outlay close to $1 trillion.

As the presidential election campaign enters its final weeks, this will add to the fiscal burden either Barack Obama or John McCain will inherit from Mr Bush next January.

Even before last week's seismic events, the incoming president stood to face a deficit exceeding $500 billion next year. The Paulson plan will raise the US debt ceiling to $11.315 trillion from $10.615 trillion.

The Bill grants Paulson sweeping powers, preventing courts from reviewing actions taken under its authority.

"The purchases are intended to be residential and commercial mortgage-related assets, which may include mortgage-backed securities and whole loans," the treasury said.

"The secretary will have the discretion, in consultation with the chairman of the Federal Reserve, to purchase other assets, as deemed necessary, to effectively stabilise financial markets.

"Removing troubled assets will begin to restore the strength of our financial system so it can again finance economic growth . . . The price of assets purchases will be established through market mechanisms where possible, such as reverse auctions."

In such a process, the government would buy from the institution that sells its assets for the lowest bid.

That still begs the question as to whether the government pays more than fair-market value for the assets, exposing taxpayers to potential losses. Implicit here is the argument that taxpayers could be said to be subsidising banks.

The alternative is for the government to bargain the price down, buying assets for pennies on the dollar. This could inflict further damage to financial institutions as they would have to write down the losses, possibly limiting the incentive to participate in the scheme.

While Democrats in Congress pledged to approve the legislation, moves are afoot to include clauses that place strict limits on top-level pay in institutions that seek the protection of the plan.

Whatever the final outcome, the decision to proceed with the plan marked the culmination of a hectic week of unparalleled turmoil on Wall Street.

With new outbreaks of disruption swirling like tornados through the system, markets went into meltdown as Lehman Brothers' insolvency was quickly followed by Merrill Lynch's sale, the rescue of AIG and Morgan Stanley's entry into sale talks.

As the situation in credit markets worsened in the middle of the week, the debate within government quickly shifted to the development of a comprehensive bailout plan.

This represents a big departure from the case-by-case approach that saw the authorities adopt different tactics with Bear Stearns, Lehman Brothers, Fannie, Freddie and AIG.

Will the markets be satisfied? We will learn in the coming days how they respond.