Will Banks Lend, or Hoard, the Treasury's Money?

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What did Paulson expect to get from the big outlays?

First, he was hoping to avoid an actual contraction of bank loan portfolios, a likely outcome without government intervention. That is, facing the prospect of big losses on mortgages and other loans, bank executives would almost certainly have pulled back on lending. In addition, banks are under pressure from both investors and regulators to be more cautious. The combination could have reduced lending by $500 billion or more, which would have been an economic disaster.

Paulson's big investment dramatically reduces the odds of such a contraction, for both economic and political reasons. Not only does it give the banks more money; the huge government stake also publicly puts both bank executives and regulators on notice that the banks are expected to lend more, not less. Indeed, John C. Dugan, comptroller of the currency and one of the main overseers of the banking system, recently told his managers that they have to be "careful not to overreact and make problems worse by acting too precipitously or being more stringent than we need to be."

What would count as success for the bailout program?

From 2004 to 2007, the height of the credit boom, commercial banks averaged about $600 billion per year in net new lending. To achieve the same lending expansion over the next year is probably unachievable, given the weakness of the economy.

More realistic would be net lending of about $350 billion. That would expand the loan portfolios of commercial banks by about 5%, or faster than business investment and consumer spending is likely to grow over the next year. To go above that level would almost certainly require a return to the ultra-loose lending standards that landed us in the soup to begin with.

Would $350 billion in new bank lending provide enough credit to avoid a deep recession?

No. The problem is that commercial bank loans account for only about 30% of total lending to households and nonfinancial businesses. Even if commercial banks expand their portfolios, other parts of the financial system, such as corporate bonds and asset-backed securities, are still frozen—and the banks can't make up for that. Banks simply don't have the central role in the financial system they once had.

Should Treasury force the banks to lend more, given the market woes?

The government can probably get better results in the short run by working through Fannie Mae (FNM) and Freddie Mac (FRE). The two mortgage lenders, which have been controlled by the new Federal Housing Finance Agency since early September, have a mortgage portfolio of about $5 trillion. That's comparable in size to the $7 trillion in loans for all commercial banks, giving the government enormous leverage to boost mortgage lending if it wants. So far, however, there is little evidence that the feds are juicing up Fannie and Freddie.

Helping distressed homeowners stay out of foreclosure should also be high on the agenda. The Treasury and the Federal Deposit Insurance Corp. are working on plans to guarantee troubled loans in exchange for lenders reducing payments.

Are there any potential pitfalls in the bailout program?

Several. Politicians and regulators will have to decide whether it is right for the banks receiving the bailout money to continue paying big bonuses and dividends. And if home prices continue to fall, the banks may need even more money—and they'd better be able to show they made enough new loans to justify the first $250 billion.

Mandel is chief economist for BusinessWeek.