Back to Purchasing Troubled Assets

The plan proposed by Treasury Secretary Paulson last September focused on the government’s purchasing “troubled assets” from banks and other financial institutions. Critics (including myself) stressed the huge difficulties that would be involved in the government’s placing a value on troubled assets and the risk that the government would overpay for purchased assets, and the administration abandoned its plan to purchase troubled assets in favor of directly infusing TARP funds into financial institutions.

At the time, I put forward, in an article (available here) as well as a WSJ op-ed piece (available here), an alternative plan to Paulson’s for government-funded purchases of troubled assets. Under the approach I put forward last fall, if the government were to provide capital to get additional liquidity for the market for troubled assets, it should invest funds through a multi-buyer competitive process that uses private parties with appropriate incentives.

According to news reports, the new administration is working on a plan that would involve purchasing troubled assets. This time, however, the administration seems to be considering involving private parties. The WSJ reported yesterday that “Treasury Secretary Timothy Geithner is considering a plan to help purge banks of their bad bets by partnering with the private sector to buy troubled assets, according to people familiar with the matter.” Similarly, the New York Times reported on Saturday that the administration is considering providing capital to, or assuming some of the risks of, private investors purchasing troubled assets.

Appropriately designed, a plan based on multi-buyer competitive process that uses private parties with appropriate incentives can provide the necessary liquidity to the market for troubled assets while maintaining the market pricing that is essential to avoid overpaying for troubled assets. Here is a brief description of (one version of) the proposal I put forward last fall:

Suppose that Treasury believes that the market for troubled assets is not functioning properly due to lack of liquidity and that the introduction of buyers armed with $250 billion could bring the necessary liquidity to this market. The Treasury could establish, say, 25 funds with a capital of $10 billion each. The funds could be funded with TARP funds as well as with some borrowed funds from the Fed.

The key is to have the funds managed by private mangers with appropriate incentives. Each fund should be run by a manager verified to have no conflicting interests. The manager would be promised a fee equal to, say, 5% of the profit its fund generates – that is, the excess return (over the yield on treasury securities) generated by the fund during its period of operations.

This system would not equire Treasury officials to place any value outside a market context on troubled assets. It would be effective because:

(1) The competition among these 25 funds would prevent the price paid for the mortgage assets from falling below fair value, and

(2) The fund managers’ profit incentives would prevent the price from exceeding fair value.

For the above approach to be effective, it needs to be appropriately designed. The devil is in the details. Thus, if Treasury does elect to proceed with a scheme involving the use of private parties for purchasing troubled assets, it will be important to study carefully the details of the design it chooses. Given that purchasing troubled assets is back on the table, I am planning to write again on the subject when more information becomes available, and any comments or suggestions would thus be most welcome.