U.S. bank bailout encourages risky behavior: watchdog

WASHINGTON (Reuters) - The U.S. taxpayer-funded rescue program set up to save banks from collapse during the financial crisis makes future reckless behavior more likely, the government's bailout watchdog said in a quarterly report.

A quarterly report to Congress on the $700 billion Troubled Asset Relief Program, or TARP, made available in draft form late on Saturday, said financial firms seen as too big to fail before 2008 have only grown larger as they feasted on subsidies from the bailout program.

"To the extent that institutions were previously incentivized to take reckless risks through a 'heads I win, tails the government will bail me out' mentality, the market is more convinced than ever that the government will step in as necessary to save systemically significant institutions," the report from the Office of the Special Inspector General for the Troubled Asset Relief Program, said.

The office, headed by Neil Barofsky, acts as a watchdog for taxpayers over how TARP money the Treasury Department administers is used.

The report said little has been achieved in terms of correcting underlying problems that helped create the financial crisis.

"Even if TARP saved our financial system from driving off a cliff in 2008, absent meaningful reform, we are still driving on the same winding mountain road, but this time in a faster car," it warned.

The report noted that TARP, which was originally pitched to Congress as a way to help banks by buying toxic or unwanted assets and then, when Congress approved it, turned into a plan for injecting capital into banks, is changing again.

"Treasury has stated that, going forward, TARP will focus on foreclosure mitigation efforts, small-business lending, and a continuation of support for the asset-backed securities markets," the report said.

With some banks already repaying TARP capital, it appears that taxpayers' ultimate costs may be less than initially feared but many of the program's goals are not being met.

The report noted, for example, that while TARP was supposed to encourage banks to increase financing for U.S. businesses and consumers, lending is actually decreasing on a month-by-month basis.

While preserving homeownership and promoting jobs were "explicit purposes" of the Emergency Economic Stabilization Act of 2008 that enabled TARP, the unemployment rate remains at 10 percent and only a small fraction of troubled mortgages have been permanently modified to lower borrowers' monthly payments.

The report suggested that Treasury's ability to wring concessions from banks that benefited from bailout money was rapidly disappearing just when consumers and businesses need increased access to credit and relief on mortgage loans.

"To the extent that the government had leverage through its status as a significant preferred shareholder to influence the largest TARP recipients to carry out such policy goals, it was lost with their exit from TARP," the report said.