The Treasury Department should consider expanding programs to cleanse troubled assets from bank balance sheets if current efforts fail to restart markets or if economic conditions worsen, a U.S. bailout watchdog panel said on Tuesday.

The Congressional Oversight Panel said in its latest monthly report that toxic loans and securities continue to pose a threat to the financial system, particularly for smaller banks that face mounting losses on commercial real estate loans.

These banks may need similar stress tests and capital support afforded to larger institutions, the panel added.

It also advocated that stress tests for the largest 19 institutions be repeated if the economy worsens beyond the worst-case assumptions used in initial tests conducted in April.

Despite improved financial market conditions, the panel said a continuing uncertainty is whether the troubled assets that remain on bank balance sheets can again become the trigger for instability.

Treasury must assure robust legacy securities and legacy loan programs or consider a different strategy to do whatever can be done to restart the market for those assets, the panel said.

The report comes as the Treasury is preparing to launch a significantly scaled-down version of its toxic asset program, a series of public-private investment funds to purchase toxic mortgage securities with $30 billion in government subsidies.

Last October, the entire $700 billion U.S. bailout program was aimed at buying up the toxic assets that threatened to bring down the financial system. But due to the plan's complexity and with market confidence rapidly deteriorating, then-Treasury Secretary Henry Paulson quickly shifted gears to use the money for direct capital injections into banks.

Since then, Paulson's successor, Timothy Geithner, announced plans to entice private investors to buy legacy securities and whole loans from banks. But accounting forbearance that allowed banks to avoid recognizing losses on these assets combined with capital raisings by large institutions following regulator stress tests in May reduced investor angst over toxic assets.

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The Congressional Oversight Panel said, however, that smaller U.S. banks faced billions of dollars in losses from delinquent commercial property loans and were far less able to raise capital and absorb losses than their larger counterparts.

An analysis done by the panel showed that under a scenario 20 percent worse than assumptions used in the Federal Reserve's stress tests, about 719 banks with assets between $600 million and $100 billion would need to raise some $21 billion in new capital to offset loan losses.

Treasury must be prepared to turn its attention to small banks in crafting solutions to the growing problem of troubled whole loans, the panel said, adding that it should consider using similar stress tests -- along with pledges for additional capital -- on smaller institutions.

It said triggers for further supportive actions could come if unemployment remains high and residential foreclosures continued to mount.

The five-member panel approved the report by a 4 to 1 vote, with a dissent by U.S. Rep. Jeb Hensarling, a Texas Republican and the committee's only sitting congressman.

Hensarling said he could not approve the report because it advocated intervention with additional government funds when that may not be necessary.

It is possible that the toxic asset market is already beginning to heal itself and that the intervention proposed by the Panel could be inappropriate -- if not counterproductive.

For this reason, I think it premature to endorse one or more of the approaches proposed by the Panel, but, instead, suggest that Treasury and the Fed continue to monitor the toxic asset market, Hensarling said in an addendum to the report.

(Editing by Kim Coghill)

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