Lucian Bebchuk: In Defense of Private Funds for Jump-Starting the Market for Troubled Assets

Lucian Bebchuk defends his plan to "jump-start the market for troubled assets":

In Defense of Private Funds for Jump-Starting the Market for Troubled Assets, by Lucian Bebchuk: After the WSJ reported on Tuesday that the Treasury is now considering a plan for restarting the market for troubled assets that would be based on providing public capital to privately managed competing funds, initial reactions among economics and finance bloggers – including Paul Krugman, Calculated Risk , Tim Duy, and Simon Johnson – were negative.

In my view, any governmental effort to restart the market for troubled assets should indeed focus on providing funding to competing privately managed funds. I put forward this idea (as an alternative to Paulson’s plan for the government’s directly purchasing such assets) in an article published last September (seems so long ago…). I also proposed a detailed design for a public-private partnership in creating such funds in a paper issued last month, How to Make TARP II Work (summarized in an op-ed piece here). As supporter of such a program, I would like to respond to the skepticism expressed about the competing private funds idea:

(1) Does the Market for Troubled Assets Need Jump-Starting?

Krugman and Duy are concerned that the Treasury is overly optimistic in believing that the troubled assets have fundamental values exceeding the low prices banks can now get for such assets. Duy, and Krugman who quotes him, believe that policymakers “seem incapable of envisioning a world in which this is not the case” and that “[f]or Bernanke and Geithner, there are no bad assets, only misunderstood assets.” On the view of James Kwak, the belief that troubled assets have fundamental values exceeding current market prices is “wishful thinking.”

But while policymakers might not be justified in assuming that current prices must be below fundamental value levels, they are justified in believing that this might be the case. To begin, it is now widely believed that we had in the recent past a bubble in which market participants attached to the assets now labeled troubled assets valuations exceeding fundamental values. We should similarly be willing to accept the possibility that market processes are again not working well, but now in the opposite direction.

The “limits to arbitrage” literature teaches us that prices of assets can substantially deviate from fundamental values. This can happen when money managers with expertise in valuing such assets are unable to get sufficient capital that investors would commit to keep with them until fundamental values are realized. (If money managers can only raise capital that investors are allowed to withdraw after, say, a year, the managers might be reluctant to invest in troubled assets that they know will produce high returns after, say, five years out of fear that they would have to liquidate their portfolios at a loss after one year.) If “limits to arbitrage” lead to prices that are below fundamental value levels, then a governmental program for introducing more capital into the market will be useful.

(2) Enriching Money Managers?

Simon Johnson and others seem to be concerned that the considered program would greatly enrich the private managers (and their affiliated investors) running the funds. But it is possible to design the program to prevent the private side in the established funds from making more than competitive risk-adjusted returns – and thus to ensure that the program’s cost to taxpayers will not exceed the minimum necessary for jump-starting the market for troubled assets. The key is to have private managers compete upfront for participation in the government’s program.

Here is how it could work (I provide fuller details in my paper): Suppose that the government will begin with a "pilot" round in which private funds with an aggregate purchasing power of $200 billion will be established. And suppose that the government will provide capital contributions in the form of debt financing (the design can be adapted to allow for equity participation by the government). The government should invite bids from private managers (and any private investors affiliated with them) seeking to participate in this round.

Each bid should indicate first the maximum fraction of the fund's capital that the private side commits to contribute as private equity capital (rather than using debt financing from the government for this purpose) 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 under the program 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.

The competition among private groups seeking to participate in the program will eliminate, or at least substantially limit, the ability of the private side to make abnormal returns. To be sure, skeptics might be concerned that there might be a limited amount of capital willing to contribute capital to the funds to be established under the program and that, as a result, the competition for participation in the government’s program would be weak. But if the amount of capital that would be willing to enter the market for troubled assets even with government debt financing is so limited, then we have strong reasons for worrying about the current functioning of this market and for wanting to do something about it.