Let’s back up a little bit: first there was the $700 billion in the U.S. Treasury’s Troubled Asset Resolution Program, or TARP. The idea, at the outset, was to clear bad assets off of bank balance sheets and enable to them to focus on moving forward. The program took a twist roughly a week ago, and has since seen a good chunk of its funding put directly towards recapitalizing banks — with the idea that banks would in turn start lending. It’s that last part, however — lending — that’s proven to be more problematic than Bush administration officials clearly expected. Despite the additional cash, banks appear set to hoard the government-infused capital rather than lend it, a move that has irked some policymakers on Capitol Hill. “What we’re trying to do is get banks to do what they are supposed to do, which is support the system that we have in America,” said White House press secretary Dana Perino during a press conference Tuesday, in response to a reporter’s question about banks hoarding capital. “And banks exist to lend money; that’s how they make money. “So we think that one of the things that we have to do is help recapitalize them so they have a capital base so that they are willing to lend money.” That’s the plan, at least. But credit markets seem intent on remaining somewhat frozen, regardless of the bully pulpit — and government officials have limits in terms of what they can and cannot force banks to do. The yield on 3-month Treasury notes was mostly unchanged Tuesday, at 0.77 percent, down slightly from 0.82 percent on Monday; and two-year swaps gapped out slightly to 123.50, up from 117.75 and well above the 75-100 basis point spread range commonly observed before the crisis hit. In other words, credit markets are still on edge. Perino said the Treasury “will be watching very closely and they’re working with the banks” to help ensure the flow of credit, both between banks and to consumers. “But again, the way that banks make money is by lending money, and so they have every incentive to move forward and start using this money,” she reiterated. Lee Farkas, chairman at Taylor, Bean & Whitaker Mortgage Corp., last week decried the continued delevering of bank balance sheets in an interview with Bloomberg News, saying that the additional capital should be used to make loans. “The big banks are acting irresponsibly,” he told the news agency. “They’re continuing to reduce their balance sheets. Period. That’s not what the Treasury wants.” Farkas did not name individual banks. Is hoarding capital such a bad thing? More than a few of HW’s sources, however, noted that continued delevering may say more about the state of the assets already on the books at many banks (even stronger ones); in other words, marks may need to get worse before they get better. “Actions always speak louder than words,” said one source, a long-time ABS analyst that asked not to be identified in this story. “And right now, those actions suggest that the banks need the capital, rather than needing to deploy it.” That said, more direct efforts by the Fed to unlock funding markets may be showing some early signs of working; Bloomberg News reported Tuesday that longer-term commercial paper issuance soared in the past week, as the Federal Reserve stepped in and agreed to aggressively begin buying the paper. Companies sold 1,511 issues totaling a record $67.1 billion of the debt due in more than 80 days, compared with a daily average of 340 issues valued at $6.7 billion last week, the news agency said, citing Fed data. Commercial paper operations are used to finance daily operations at nearly every major financial market maker. “Banks will need to earn their way out of this mess,” said the analyst that spoke with HW. “It’s not a new concept, looking back to other crises.” Acting Treasury under secretary for domestic finance Anthony Ryan, however, suggested Tuesday that the Treasury sees its funding of what he called “strong banks” — funding capped at three percent of risk-weighted assets — as a mandate by the government to begin lending. “As these banks and institutions are reinforced and supported with taxpayer funds, they must meet their responsibility to lend, and support the American people and the U.S. economy,” he said in remarks at SIFMA’s annual conference. “It is in a strengthened institution’s best financial interest to increase lending once it has received government funding.” Despite the hemming and hawing over the matter, lending activity — meaning mortgage lending, corporate lending, and consumer lending — is but one of two key aspects of how “a bank makes money,” to use Perino’s phrasing. The other is from bank deposit inflows. And as investors shift towards quality during an economic downturn, deposits start to look a whole lot sexier than they might have appeared when the system was more leveraged into loans. And eventually, competition for deposits will heat up and put banks back in the lending market to generate returns. “Deposit inflows — spurred by risk aversion in previous cycles and accelerated by higher FDIC insurance this time around — eventually ‘force’ banks back into the lending market,” said FTN Financial analyst Jim Vogel in a report last week. Of course, such a line of thinking assumes that a viable and functioning lending market will actually exist for certain products; for mortgages, much of the grease in the machine has been generated by off-balance sheet securitization. It remains to be seen what, if any, sort of future that particular market yet may have; but that’s an issue for a separate story. Write to Paul Jackson at paul.jackson@housingwire.com.