I recently participated in an interesting conversation with economist Dr. David Jones, Chairman of Investors’ Security Trust Company, who is also known as the “Fed Watcher” on CNN and CNBC. Jones criticized Treasury Secretary Henry Paulson’s uncertainty how to best utilize the $700 billion Troubled Asset Relief Program (TARP), which, he states, has contributed to the jaw dropping stock market crash.

“At first Paulson was going to purchase troubled assets from the banks, allowing them to establish a price for their illiquid assets and clean up their balance sheets,” Jones said. “Banks can’t lend if their capital base is frozen or has disappeared. This is what led to the credit crunch.”

“But sometime after fashioning the plan, Paulson saw that the problem was much larger than the $700 billion allocated. So he changed course, stating that TARP money would instead be used to purchase equity in national banks as well as community banks. The theory was that this capital injection onto banks’ balance sheets would provide a larger cushion against which illiquid assets could be written down, thereby affording banks the opportunity to lend again.”

Jones explained that the stock market, however, hates uncertainty, which leads to volatility. “The market at first discounted stocks based upon the recession’s effect on earnings and what was expected when firms write down illiquid assets under the first TARP plan.”

“Then Paulson changed course, declaring instead that TARP funds will be used to purchase bank stock thereby injecting capital directly into financial institutions’ capital accounts. Paulson’s sudden change alarmed the markets, causing uncertainty as to whether and when the lending crisis will ease, cascading into questions how to value earnings, leading to a decline in overall stock market valuation.”

Jim Moore, Chairman of locally owned Florida Gulf Bank and a former Miami Director of the Federal Reserve added insight to the Fed’s actions. “They’re asking strong banks, including community banks that have strong CAMEL ratings to participate in TARP, which is counterintuitive. From this you could conclude that in these difficult times, the Fed and Treasury are only interested in assisting those banks that have already demonstrated strong management skills. Particularly in their lending operations.”

CAMEL ratings are supervisory ratings of a bank’s overall condition. The rating is based upon six components: (C)apital adequacy; (A)sset quality; (M)anagement; (E)arnings; (L)iquidity; and (S)ensitivity to market risk. Financial statements reviewed by regulators like the Fed, the OCC and the FDIC are used to determine the bank’s rating.

CAMEL ratings are not available to the general public in an effort to prevent a run on banks whose ratings decline. Moore pointed out that when the Federal Reserve Chairman and the Treasury Secretary made it known that they want stronger banks to participate in TARP, these stronger institutions are faced with a difficult decision. If they take the federal money, then they become subject to a multitude of conditions and regulatory oversight. If they choose not to take the money, outsiders may wrongly view the bank as not having a strong enough CAMEL rating to receive funds, which could damage that institution’s depositor and investor confidence.

My take on this is that Paulson was wise to ask for the $700 billion but even wiser not to ask for the $2 to $3 trillion that will likely be required to fully confront this financial crisis. If he asked for that much initially, it could have created a panic far greater than that already experienced.

It would seem that many of the losses not yet recognized on bank financial statements must be flushed through the system before a true recovery may begin. When that happens is anyone’s guess. The Feds decision not to purchase illiquid assets from financial institutions will mean that balance sheets will have to be cleaned up over time. And perhaps that was Paulson’s thinking. By not forcing the issue now, he appears to hope that the banks and financial institutions holding bad mortgage debt, foreclosed properties and troubled bonds can hold on long enough for the markets to rebound.

The theory therefore appears to be that once this occurs and the banks with stronger balance sheets are able to lend more freely, improved economic conditions result. Let’s hope if that’s the plan, that it’s right.