NEW YORK (Reuters) - The United States ushered in a new era in banking on Tuesday with plans to take equity stakes totaling up to $250 billion in financial institutions, an incursion into the private sector that U.S. officials called a regrettable last resort.
Markets initially rallied on the rescue plan, continuing the previous day's rebound, but recession fears soon took over and Wall Street stocks closed lower.
U.S. Treasury Secretary Henry Paulson said government ownership of big stakes in banks was "objectionable" but necessary to head off the financial crisis.
"At a time when events naturally make even the most daring investors more risk-averse, the needs of our economy require that our financial institutions not take this new capital to hoard it, but to deploy it," Paulson said.
Governments around the world have pledged roughly $3.2 trillion in a variety of schemes that guarantee bank deposits, interbank lending and the purchase of new securities to shore up bank capital.
The U.S. Treasury will buy nonvoting preferred shares in major financial institutions, with stakes in each limited to $25 billion. Bank executives must accept standards of corporate governance and limits on their pay.
Paulson said nine banks that he described as "healthy institutions" had agreed to accept government stakes for the good of the U.S. economy -- a government intervention unthinkable before the credit crisis, the worst since the 1930s Great Depression.
"These measures are not intended to take over the free market but to preserve it," U.S. President George W. Bush said.
Bush said the Federal Deposit Insurance Corporation would guarantee new bank debt and that the Federal Reserve would become a buyer of last resort of commercial paper -- the short-term loans that companies use to fund day-to-day operations.
Investors liked the bold government action but recession worries killed a rally in U.S. stocks. The third-quarter earnings season has begun and the U.S. Commerce Department is due to release third-quarter GDP data on October 30.
"The world is not going back to where it was before September," said Andrew Busch, a strategist with BMO Capital Markets in Chicago. "The (credit) freeze has meant that the outlook for the economy has soured and we're still not sure by how much.
The Dow Jones industrial average closed 0.8 percent lower and the S&P 500 was down 0.5 percent. Both indexes on Monday had registered their biggest one-day point gain in the wake of last week's panic sell-off.
U.S. Treasuries fell on worries that the U.S. government would issue bonds to finance the bank rescue package.
Oil and the U.S. dollar fell.
In a sign that lending may be picking up, overnight interest rates for interbank loans fell for the second day in a row.
European shares closed 3 percent higher after Japan's Nikkei, catching up on Wall Street's rise on Monday, climbed more than 14 percent -- its biggest one-day gain in history.
But, in a reminder of the cost of bailout plans, the Treasury Department released scheduled budget figures showing a record $455 billion deficit for fiscal 2008.
And the prospect of huge public stakes in private banks raised questions for European banks.
With three weeks to go before the November 4 U.S. presidential election, Republican candidate John McCain on Tuesday offered proposals to help investors rebound from stock market turmoil.
Democrat Barack Obama, ahead in public opinion polls, proposed a raft of relief measures on Monday.
Obama and McCain will hold their third and final debate on Wednesday night.
The crisis has provided a political boost for British Prime Minister Gordon Brown, who created the blueprint for the United States and other major economies to recapitalize their banks.
Brown, who must call an election by mid-2010, has cut his deficit in the polls to 10 percent from 28 percent.
The U.S. measures are intended to stimulate interbank lending and the commercial paper markets, whose stagnation may have already pushed the U.S. economy into recession. Former U.S. Federal Reserve Chairman Paul Volcker said the world's biggest economy was already in recession.
Reporting by Reuters bureaus around the world; Editing by Gary Hill