Treasury Secretary Henry Paulson said Tuesday the Treasury has decided not to spend any more of the money allocated through the Troubled Assets Relief Program or TARP, which means the government won’t be buying toxic assets.

In testimony in front of Congress Tuesday, Paulson said it’s “only prudent to reserve our TARP capacity, maintaining not only our flexibility but that of the next Administration.”

Paulson said the Treasury has identified the priorities that he thinks the government will next need to address through TARP, including investing a “relatively modest share” of TARP funds in a Federal Reserve liquidity facility, which he said could improve securitization and have a “significant” impact on the availability of consumer credit.

“We recognize that a troubled asset purchase program, to be effective, would require a massive commitment of TARP funds,” said Paulson. “It became clear that, while in Mid-September, before economic conditions worsened, $700 billion in troubled asset purchases would have had a significant impact. Half of that sum, in a worse economy, simply isn’t enough firepower.”

According to Paulson, while the initial $700 billion TARP legislation called for the government to buy toxic asset from financial institutions, by the time the legalization passed the global market crisis was so broad and so severe that the Treasury had to take quick steps to stabilize the markets and get credit flowing. He said an asset purchase program would not have been effective enough so the Treasury instead moved to inject $250 billion into financial institutions by buying equity shares in the companies. He said at the time the Treasury expected to follow that with a program to buy troubled assets.

“There is no playbook for responding to turmoil we have never faced,” said Paulson. “We adjusted our strategy to reflect the facts of a severe market crisis always keeping focused on Congress’s goal and our goal to stabilize the financial system.”

During a grilling by Congress Paulson defended his stance that money from the TARP shouldn't go to bailout Detroit's three car makers. According to Paulson he wants to stick with the intended purpose of TARP. "The purpose is stabilizing and strengthening our financial system and I've said to you very clearly, that I believe that the auto companies fall outside of that purpose."

Although some in Congress are calling on TARP funds to be used to reduce the flow of home foreclosures, Paulson said in his testimony that current housing programs are more effective in preventing foreclosures than would have been achieved through big purchases of mortgage related securities with TARP money.

“The most important thing we can do to mitigate the housing correction and reduce the number of foreclosures is to increase access to lower cost mortgage lending,” said Paulson. “The actions we have taken to stabilized and strengthen Fannie Mae and Freddie Mac, and through them to increase the flow of mortgage credit, together with our bank capital program. Are powerful actions to promote mortgage lending.”

Meanwhile Federal Deposit Insurance Corp. Chairman Sheila Bair told Congress that while the government has taken steps to prevent foreclosures, enough hasn’t been done.

“No single solution or silver bullet can address the adverse effects of the deficiencies that have contributed to the current market turmoil,” said Bair. “However, as foreclosures escalate, we are clearly falling behind the curve. Much more aggressive intervention is needed if we are to curb the damage to our neighborhoods and broader economic health.”

Bair called on Congress to approve the FDIC’s proposal for the government to create standards for loan modifications and provide for sharing of losses on any default by modified mortgages meeting the set standards. She said that would enable unaffordable loans be converted into loans that can be handled over the long term.

“We believe this program could prevent as many as 1.5 million avoidable foreclosures by the end of 2009,” said Bair

Paulson, addressing a question from Congress reiterated that stabilizing Fannie Mae and Freddie Mac has been critical in helping the housing market. "There  have been real steps that have been taken that make a difference, more needs to be done.  I hear your frustration, more needs to be done, and we’re going to keep working on it," said Paulson.

In Paulson’s testimony, he said that while the effects of TARP won’t happen overnight, an improvement in the economy will happen much faster than if Congress didn’t approve TARP.

“If Congress had not given us the authority for TARP and the Capital Purchase Program and out financial systems had continued to shut down, our economic situation would be far worse today.”

Indeed Federal Reserve Chairman Ben Bernanke, who also testified in front of Congress Tuesday said the actions implemented so far are resulting in some signs the credit markets are improving. He said interbank short-term fund rates have declined since mid-October, there’s greater stability in money market mutual funds and the commercial paper market, and interest rates on higher-rated bonds issued by corporations and municipalities have fallen a bit while bond issuances have risen.

“The ongoing capital injections under TARP are continuing to bring stability to the banking system and have reduced some of the pressure on banks to de-leverage, two critical first steps toward restarting flows of new capital,” said Bernanke. “Credit conditions are still far from normal, with risk spreads remains very elevated and banks reporting that they continued to tighten lending standards through October. “ Bernanke said there has been little to no bond issuance by lower-rated corporations or securitization of consumer loans in recent weeks.

When asked how much the Fed is willing to commit and potentially expose taxpayers to liabilities, Bernanke said whatever it takes. "I think we need to do what we need to do to keep the U.S. credit system working and to try and create a recovery in the financial system," he said.

FDIC’s Bair noted that the bulk of U.S. banking industry is healthy and remains well-capitalized. She said the banking industry does have a liquidity problem.