What seems like years ago, Simon and I wrote an op-ed in which we compared the initial proposal that became TARP to a bad hedge fund – a fund whose purpose was to overpay for illiquid securities and thereby shore up banks. Now that the original plan is dead, I think we can say that TARP has become a bad private equity fund, whose purpose is to buy preferred stock on overly generous terms (compare the 5% dividend taxpayers get to the 10% divided Buffett got from Goldman) in order to shore up banks and bank-like institutions (and maybe others as well). I don’t mean “bad” as a criticism here: the purpose of the Treasury Department is to protect and advance the public good, and that goes beyond the profitability of the investments themselves.

However, I do think it’s a problem that the goals of this private equity fund haven’t been well defined. Right now the bulk of the political pressure seems to be to (a) expand the scope of the bailout to other companies and industries that are being hurt by the recession (which could mean just about everyone) and (b) force bailoutees to do things in the public interest, like increase lending. (See the New York Times on both of these topics.) So the fund is being torn in two directions. To make a very broad generalization, if you want to increase lending, you should give capital to a healthy bank, like Saigon National (in the NYT article); but if you want to keep the financial system from collapsing, you should give it to very large banks (too big to fail) with balance sheet problems, like Citigroup, and they are not going to increase lending, precisely because they need the money themselves.

Paulson’s initial bet, which most but not all observers agreed with, was that the top priority was keeping a handful of core banks – Bank of America, Citi, JPMorgan Chase, Wells – from collapsing. One risk is that to protect that position, they will need more capital for those core banks (especially, apparently, Citi). While these banks were struggling with a liquidity crisis in September-October, now they are struggling with a good old-fashioned recession, in which all sorts of borrowers can’t pay them back, so they could be looking at writedowns for many months to come. (Perhaps as a result, CDS spreads on BofA, Citi, and JPMorgan are all up 30-50% from their lows right after recapitalization was announced.)

So I think Treasury needs to be clear on its goals. We know one goal is to protect the core of the system, which will not necessarily increase lending in the short term. From Paulson’s recent statements, it looks like one new goal is to increase lending. It’s not clear that $700 billion is enough for both of these goals. And $700 billion is certainly not enough to bail out everyone out there who will be hurt by the recession, including smaller banks that are unhealthy but not “too big to fail” – who will, therefore, fail.