The U.S. government's $700 billion bailout program helped stabilize the financial system, but has done little to boost lending or stave off millions of home foreclosures, a government watchdog group said on Wednesday.

The Congressional Oversight Panel's new monthly report on the Troubled Asset Relief Program (TARP) came the same day as Treasury Secretary Timothy Geithner moved to extend the bailout fund into October 2010, although he pledged to deploy no more than $550 billion of it.

The 14-month-old bailout fund, which has propped up banks, automakers and insurer American International Group, has failed to resolve key problems in the financial system, including toxic assets still weighing down bank balance sheets, a sharp contraction of credit and the moral hazard associated with bailouts, the panel said.

Consequently, the United States continues to face the prospect of banks too big to fail and too weak to play their role adequately in keeping credit flowing throughout the economy. The foreclosure crisis continues to grow, the panel said in its report.

The report concluded that the stability that markets have enjoyed this year was not solely due to TARP, but to an extraordinary mix of government support, including Federal Deposit Insurance Corp and Federal Reserve asset guarantees.

The removal of this support too quickly could undermine the economy's nascent stability, it said.

The Obama administration has signaled an extension by considering the use of TARP funds to spur small business lending and possible other programs to boost job creation, a move opposed by many Republicans.

Treasury must seek Congressional approval if it wants to funnel some of its $700 billion bailout fund to jobs programs that do not involve financial services firms as intermediaries, a key overseer said on Wednesday.

Elizabeth Warren, chairman of the Congressional Oversight Panel and a Harvard Law School professor, told CNBC television the Obama administration cannot simply spend TARP funds in a jobs program somewhere else.

The oversight panel's lone sitting member of Congress, Rep. Jeb Hensarling, a Texas Republican, voted against approval of the panel's report but agreed with certain criticisms. He called for TARP to be shut down at year-end.

One can not help but conclude that TARP is failing its mandate, Hensarling said in a statement. He added that the Treasury's bailout of General Motors, Chrysler and GMAC were abuses, while TARP's foreclosure mitigation efforts were misguided.

MOUNTING FORECLOSURES

The panel's report also criticized TARP programs aimed at stemming foreclosures, saying they have not yet achieved the scope, scale and permanence to address the crisis.

It said foreclosure starts over the next five years were projected to range from 8 million to 13 million, excluding many more homeowners that have lost homes to short sales or simply walked away from their mortgages.

That is far more than the 3 million to 4 million homeowners the TARP foreclosure mitigation program aims to aid.

Even if every best-case scenario that Treasury has made came true, we're dealing with only about a third of the foreclosures, Warren told reporters in a conference call.

She added that the Treasury was far from reaching its goals, with less than 5 percent of mortgage modifications having led to permanently lower payments. The risk of these loans redefaulting remained high as long as the homes remain worth less than their mortgages, she said.

Reducing loan principal is the only way to eliminate negative equity, so Treasury should consider how its existing programs might be adapted in ways that result in principal reductions, the panel said in the report.

Another panel member, New York state banking superintendent Richard Neiman, said in a separate opinion that the Treasury should expand its foreclosure prevention program and TARP funds should support state emergency mortgage assistance programs to help unemployed borrowers make their payments.

Looking ahead, TARP needs to close the book on large institution support and focus all of its energies on addressing the problems of foreclosures, small business credit, and commercial real estate, wrote Neiman, who voted to approve the report.

(Reporting by David Lawder; Editing by Chizu Nomiyama)

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