Feb. 10 (Bloomberg) -- Treasury Secretary Timothy Geithner pledged government financing for as much as $2 trillion of efforts to spur new lending and address banks’ toxic assets, seeking to end the credit crunch hobbling the economy.

“Instead of catalyzing recovery, the financial system is working against recovery,” Geithner said in unveiling the Obama administration’s financial-bailout overhaul in Washington today. “At the same time, the recession is putting greater pressure on banks. This is a dangerous dynamic, and we need to arrest it.”

Stocks slumped, led by financial shares, as investors expressed concern about a lack of specifics on plans for addressing the distressed assets choking banks’ balance sheets. Geithner warned today that it will “take time” for the administration’s strategy to bear fruit.

The main components of the Treasury’s package today are a joint public- and private-sector fund to buy as much as $1 trillion of illiquid assets and a $1 trillion program to supply new credit to consumers and businesses. The administration also will inject additional taxpayer funds into banks, imposing tighter restrictions that will include limits on dividend payments, acquisitions and executive pay.

“I want to be candid: this strategy will cost money, involve risk, and take time,” Geithner said today.

Stocks Slide

The Standard & Poor’s 500 Stock Index slumped 4.9 percent to 827.16 at the close in New York. The S&P 500 Bank index fell 14 percent, with Bank of America Corp. down 19 percent. Regional lender Huntington Bancshares Inc., based in Columbus, Ohio, slid 25 percent to $1.96.

“The lack of clarity” on the public-private investment fund “has the market upset,” said Joseph Keating, who helps oversee $3 billion as chief investment officer at RBC Private Asset Management in Birmingham, Alabama. “Nationalization could have been a better outcome for some banks.”

Today’s overhaul of the Treasury’s $700 billion financial- rescue fund is aimed at addressing the failures of the first phase of the program, which has yet to spur a wave of new lending to companies and consumers. The initial bailout effort, which Geithner helped administer as head of the Federal Reserve Bank of New York, was “essential” while “inadequate” to support the financial system and the secondary-lending market, he said.

More Money

Geithner reinforced President Barack Obama’s signal yesterday that the administration is open to seeking more money for the financial rescue.

“The administration will do everything we can to fix this, and we’re going to keep at it until we fix it,” Geithner said in an interview with Bloomberg Television. Obama yesterday said “we don’t know yet whether we’re going to need additional money or how much additional money we’ll need until we’ve seen how successful we are at restoring a sense of confidence.”

Officials debated the financial-recovery plan for weeks, and encountered the same issues that former Treasury Secretary Henry Paulson did in trying to deal with the toxic assets.

Paulson abandoned an effort to buy the securities after failing to find a quick mechanism for pricing them. He opted for buying stakes in banks as the centerpiece of the first $350 billion of the financial-bailout program.

Geithner today outlined the Public-Private Investment Fund, with an initial capacity of $500 billion that could grow to $1 trillion, to provide financing for private investors to buy distressed securities.

Toxic Debt

“We are exploring a range of different structures for this program, and will seek input from market participants and the public as we design it,” the Treasury chief said today. This fund will be targeted to the legacy loans and assets that are now burdening many financial institutions.’’

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.

Four months after the government’s bailout program was established, 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.

California Hit

The credit crunch and deepening economic recession has hammered borrowers including the state of California, which had its credit rating cut by Standard & Poor’s this month.

The financial rescue needs to create an “improving” credit market to ensure that the administration’s separate stimulus package, in excess of $800 billion, can work, said Bruce Kasman, chief economist at JPMorgan Chase & Co. in New York and a former Fed researcher.

Prime borrowers are still finding access to credit. Cisco Systems Inc., completed the second bond offering in its 25-year history this week, issuing $4 billion.

Officials aim to spur new lending to consumers and businesses with the newly established Consumer and Business Lending Initiative. The effort is modeled on an earlier Fed initiative, backed by the Treasury, called the Term Asset-Backed Securities Loan Facility.

The original $200 billion TALF had up to $20 billion of seed money from the Treasury’s Troubled Asset Relief Program, and was designed to lend to investors in securities backed by student, credit-card and auto loans. The Fed has yet to start the program.

Fed Program

Now, the Treasury will provide up to $100 billion to support the expanded $1 trillion Fed program. The central bank said in a statement that eligible collateral may be broadened to include other newly issued AAA-rated debt including commercial mortgage- backed securities and private-label residential mortgage-backed securities.

Under today’s plan, regulators will subject banks to new tests to determine whether they have enough capital. The Treasury, Fed and other supervisors in the President’s Working Group on financial markets will develop guidelines for the examinations, which are aimed at ensuring that the country’s largest banks can withstand a worsening economy.

Banks that don’t have sufficient capital will be given additional taxpayer funds in the form of convertible preferred securities. Participants will have their dividends and political lobbying efforts restricted, along with limits on stock buybacks, acquisitions, executive compensation and so-called golden parachutes. Luxury spending provisions must also be disclosed.

Asked in the interview whether the government is prepared to remove executives from their jobs, Geithner said “we have done it already, and we would do it again.”

The Treasury’s new investments in banks will be placed in a new entity called the Financial Stability Trust, Geithner said.

Today’s package includes $50 billion for measures to stem mortgage foreclosures. Banks receiving federal funds will be required to participate in efforts to mitigate foreclosures. The Treasury and Fed will work to reduce monthly payments and establish loan-modification guidelines.

To contact the reporter on this story: Rebecca Christie in Washington at rchristie4@bloomberg.net;

Last Updated: February 10, 2009 16:44 EST

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