When a bank makes a loan, it has to have a certain amount of cash to absorb possible losses on a loan. It doesn't have to be cash...other assets will do (such as a jet), but I prefer cash in my analysis because it is the most liquid. Currently, banks have to have 8% of the assets in cash. So, if a bank had $100 in assets the maximum amount of loan is $92 and $8 to back up the loans.
Well, if the value of the loans decrease, they must have more cash to back up the lossess. Say the value of the loans decrease to $60, they now have negative cash. As the loan values continued to be wrote down, cash becomes exhausted. Now when the govt gave the banks money, it went to sure up the balance sheet. Because when banks fail to have enough reserves, the FDIC can pull a kick-door. Not only that, you have other issues with credit default swaps and short selling. Once a bank looks wounded, financial institutions begin ciricling the wagon trying to kill it. First, people quit buying the commercial paper then the banks more or less agree to not loan the bank more money, then people short sell to make the CDS happen. (Think of it like this...your wife takes out a $1MM insurance policy on John Doe, then you shoot John Doe. Different "arms" of the same financial institution work together to cripple a bank. See Leahman Brothers and Bear Stearns. It was like a scene of lions killing a hippo on National Geographic)
So, the money MUST go to securing capitalization. The better choice would have been to do what they said they where going to do....buy the bad loans. Buying the bad loans artificially inflates the value of the loans, but prevents the banks from going under.