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Wednesday, March 04, 2009

"Jump-Starting The Market For Troubled Assets"

Lucian Bebchuk describes his plan to establish a public-private partnership to restart the market for troubled assets. This plan was first described in a discussion paper “How to Make TARP II Work.”

The main selling point of the proposal is the introduction of a competitive process to minimize the costs of the program. Under the proposal, funds to buy troubled assets are established in the private sector, and the managers of newly established funds compete in two ways – "first, to participate in the government's funding program, and subsequently to buy banks' troubled assets."

In an email, Lucian Bebchuk also emphasizes that a recent WSJ story on the Obama administration's interest in using privately managed funds to buy troubled assets raised concerns about the possibility of over-paying for the assets (and hence excessively subsidizing private fund managers). He argues that an advantage of the competitive process embedded within his proposal is that it would "ensure that the program’s costs are kept at the minimum necessary to restart the market for troubled assets":

Jump-Starting The Market For Troubled Assets, by Lucian Bebchuk, Commentary, Forbes: Four weeks ago, Treasury Secretary Geithner announced the administration's interest in developing a plan ... with up to $1 trillion of public funds to partner with private capital to buy banks' "troubled assets." The announcement has met with substantial skepticism...

Despite the widespread doubts, an effective plan for a public-private partnership in buying troubled assets can be designed. The key is to have competition at two levels. First,... the government’s program should focus on establishing many competing funds that are privately managed and partly funded with private capital--and not creating one, large "aggregator bank"...

Second, at the level of allocating government capital among the competing private funds, potential fund managers should compete for government capital under a market mechanism resulting in maximum participation of private capital and minimum costs to taxpayers. ...

One approach under consideration is that of a public-private partnership in a large "aggregator" bank (the "bad bank"), funded with both public and private money. Because private managers will run it, the bad bank could arguably produce a lower risk of overpayment than would direct purchases by the government.

The main problem with an aggregator bank is that it adds only one additional buyer, albeit a big one, to the market. ... Instead, plan for restarting the market for troubled assets should be based on establishing a significant number of competing funds. Each of these funds should be privately managed and financed with both public and private capital, and the funds should have sufficient aggregate capital. ...

The existence of such a significant number of private buyers ... will produce a market for troubled assets with many potential sellers (banks) facing a significant number of potential buyers (the funds). And the profit share captured by the funds' private managers will provide these managers with powerful incentive to avoid overpaying for troubled assets. ...

The question that remains is how to induce the participation of sufficient private capital... This can be done by having the participating public capital assume more downside risk or, alternatively, capture less of the upside. And the critical issue is how to do so to the minimum extent necessary to obtain the desired capital.

To ensure that the government does not overspend, private managers should ... also compete upfront for the right to participate and receive funding from the government's program. Such a market mechanism can ensure that the government provides funding at a level and under terms that will be least costly to taxpayers...

Consider a simple scheme whereby the government's program provides capital to new funds in the form of debt financing ... with a non-recourse loan. ... To understand how such debt financing can induce private capital to invest in the private funds participating in the program, imagine that the government sets a very high level of 95% for the fraction of the participating funds' capital to be provided in such debt financing. With such large government participation, it will presumably be easy to get the private side of each fund ... to contribute the remaining 5% of the fund's capital as equity investment. In this case,... potential loss will be capped at 5% of the fund's capital...

While providing 95% of a participating fund's capital in the form of governmental debt financing is thus likely to be more than sufficient to attract private capital..., doing so would likely impose on taxpayers a higher expected cost than is necessary. How then should  ... the fraction of participating funds' capital that the government will fund with debt financing--be determined? It should be set through a competitive bidding process. ...

The government should invite bids from private managers seeking to participate... Each bid should indicate first the maximum fraction of the fund's capital that the private side commits to contribute as private equity capital ... and second, the size of the fund the private side seeks to establish. ...

Once the bids are made, the government will set the level of its participation ... at the lowest level that can be set while still allowing for establishing funds that collectively have the total target capital for the program's initial round. Thus, for example, the government will set the equity contribution percentage at 40% and the government's debt financing at 60% if, given the received bids, the 40% level, but no higher level, will result in establishing private funds that collectively have the target level of aggregate capital. ...

By inducing private managers to compete at two levels--first, to participate in the government's funding program and subsequently to buy banks' troubled assets--the design proposed above can deliver the results the Treasury seeks. It will effectively restart the market for troubled assets and do so at the least cost to taxpayers.

    Posted by on Wednesday, March 4, 2009 at 09:09 AM in Economics, Financial System, Policy | Permalink  TrackBack (0)  Comments (19)

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