There are signs that the financial system has stabilized somewhat, unemployment is not rising as quickly as it had been for a while, and there are preliminary signs of economic recovery. But the "toxic assets" bad loans, mortgage-backed securities that were to a great extent at the heart of the problems that precipitated the financial meltdown last September, remain on the balance sheets of financial institutions and could cause more problems in the future.

That's the conclusion of the Congressional Oversight Panel, created as part of the $700 billion Troubled Asset Relief Program and consisting of current and retired legislators, regulators and academics. "The financial system remains vulnerable to the crisis conditions that [the bailout] was meant to fix, the panel wrote in a report issued Tuesday.

The reasons are not difficult to understand. When Congress rushed through the $700 billion bailout bill last fall, proponents said it was needed to take these "toxic assets" off the books of banks and other financial institutions. It wouldn't have been an easy process. Given that there was no market for these troubled loans, nobody knew exactly how they should be priced.

Since it was a hard problem, the government did an about-face and decided not to try. Instead the TARP money was used to inject capital into various banks, whether they needed it or not, and then to bail out failing auto companies (which eventually declared bankruptcy anyway).

Now the oversight panel warns that "financial stability remains at risk if the underlying problem of toxic assets remains unresolved." Smaller banks are especially vulnerable, in large part because they hold greater numbers of commercial real estate loans. Owners of commercial real estate have been defaulting at an alarming rate (we just saw it locally with Maguire Properties defaulting on six prestige properties in Orange County and one in Los Angeles) and if the trend gets worse a new meltdown is likely.

Apparently we haven't learned the lesson Japan took more than a decade to learn that full economic recovery is unlikely until those toxic assets are handled, either through writing them off, selling them at a discount or letting financial institutions fail.

That's what TARP was supposed to do. It's not unusual for government programs to fail in their intended purpose, but this one hasn't even tried.