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Q and A: How the toxic assets plan will work

  • Story Highlights
  • Treasury says up to $1 trillion will be spent on mopping up bad debts
  • Bad debts are preventing banks from lending to each other, slowing economy
  • Plan hinges on government pricing debts correctly
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(CNN) -- The U.S. Treasury Department has unveiled long-awaited plans to kick-start the economy by spending up to $1 trillion removing troubled assets from banks' balance sheets. Here we explain what these assets are and how the plan will work

What are toxic assets?

So-called toxic assets are at the heart of the financial meltdown. These assets usually represent loans held directly by the banks that are not being paid back -- usually defaulted mortgages where homeowners can no longer afford repayments. Sometimes the assets represent securities backed by the loans, such as company pension plans. Prior to the meltdown, banks often listed and traded these bad loans as valued assets, masking their troubled nature on seemingly healthy balance sheets.

What's so toxic about them?

Usually banks can trade healthy assets (such as mortgages where payments are being met) with other banks. When the mortgages are in default -- an increasingly common situation after years of unregulated over-lending to low income families who cannot afford to make repayments -- the loans become bad, weighing heavily on a bank's books. With banks unable to tell how troubled the loans on other banks balance sheets are are, they become wary of lending to each other. With no new loans, the economy grinds to a halt.

So what's the Treasury's plan?

The Treasury says it will buy up to $500 billion of existing assets and loans -- such as mortgages in danger of default. This amount could expand to $1 trillion over time. It hopes this move will cleanse the balance sheets of many of America's largest banks and get them lending to each other again.

Where will the money come from?

The Treasury is committing up to $100 billion from a $700 billion financial rescue fund approved by Congress last October. It hopes this money can be used to induce a larger pot, with the rest made up by financing from U.S. bank regulator Federal Deposit Insurance Corp., the Federal Reserve and cash from private investors. The government hopes to be able to create a separate market for the assets, auctioning them to interested investors.

Will it work?

The plan was well received by Wall Street, which saw stock prices jump on the news -- but markets could be reacting to the possibility of short term gains at the longer-term cost of the government, and ultimately the taxpayers funding its scheme. The plan hinges on the Treasury correctly pricing the bad assets to attract the private investors and persuade the banks to sell. If it pays too little and sells on at too high a price, the banks won't benefit and the economy will remain clogged. If it pays too much, then sells on at too low a price, the public purse suffers.

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