U.S. pronouncements later hurt bailout: IG report

Senior U.S. officials deliberately created the impression last year that banks receiving huge government cash infusions were healthier than was the case, a Treasury Department watchdog's report released on Monday said.

As a result, the government and the bailout lost public credibility when the financial crisis deepened.

Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben Bernanke said at the time that their dramatic force-feeding of $125 billion into nine banks in October 2008 was a program for healthy institutions.

Privately senior officials worried about the health of some of those firms, Treasury's Special Inspector General for the Troubled Asset Relief Program, Neil Barofsky, said.

By stating expressly that the 'healthy' institutions would be able to increase overall lending, Treasury may have created unrealistic expectations about the institutions' condition and their ability to increase lending, the report said.

Paulson won approval from Congress to spend $700 billion to repair the financial system.

However, the decision to use the money from the Troubled Asset Relief Program, or TARP, to recapitalize banks, rather than to buy assets tainted by association with defaulted credits, was controversial. The New York Fed, which was at the time headed by current Treasury Secretary Timothy Geithner played a key role in developing the capital injections program, Barofsky's report said.

Officials said they shifted strategy because capital infusions were the fastest and most effective way to stabilize the financial system. The report accepts that reasoning.

But privately, officials worried about the health of several of the nine, the report says. Paulson thought one firm, which has since paid back its government infusion, might fail. Banks that caused concern are not named in the report.

The Treasury and the Troubled Asset Relief Program lost credibility when the recipients of those capital infusions failed to start lending again and when firms including Citigroup and Bank of America needed further life support, the report said.

DANGER OF PANIC

Officials were understandably reluctant to stigmatize any bank by saying it was weak, which could have created a panic at an already chaotic time, Barofsky's report said.

However, government officials should be particularly careful, even in time of crisis, of describing their actions (and the rationales for such actions) in an accurate manner, he said.

Fed General Counsel Scott Alvarez, in a response, acknowledged transparency and effective communication with the public were important to restoring and maintaining public confidence during a crisis.

The Treasury official in charge of administering the TARP program, Herbert Allison, signaled dissent from the report's conclusion, saying that people may differ on how comments about the banks should have been phrased.

The report found no indication that government officials advised Bank of America to withhold information about losses at Merrill Lynch, which it bought in January, from shareholders. Bank of America considered walking away from the Merrill deal when it discovered the losses, but came under government pressure to complete the merger.

The possibility that the government may have leaned on Bank of America to keep quiet about Merrill's losses, was the theme of tense congressional hearings this summer and the issue remains in the spotlight.

New York Attorney General Andrew Cuomo last month subpoenaed current and former Bank of America directors and a judge has rejected Bank of America's $33 million settlement with the Securities and Exchange Commission over charges it lied to shareholders about bonuses.

(Additional reporting by Emily Kaiser, editing by Alan Elsner)