Buying Troubled Assets

Abstract

This paper analyzes how government intervention in the market for banks' troubled assets is best designed, and also uses this analysis to evaluate the public-private investment program announced by the U.S. government in March 2009. I begin by presenting the case for using government funds to restart the market for troubled assets. I then discuss the advantages of providing government capital to competing privately managed funds, a strategy I have advocated in past work, and I outline the key elements that such a plan should include.

Based on this analysis, I propose three improvements to the government's current plan:

• Introducing a competitive mechanism that would ensure that the government's subsidy to participating private parties is kept at a minimum; • Redesigning the plan to provide such private parties with incentives aligned with those of taxpayers rather than highly skewed incentives to overpay for troubled assets; and • Precluding banks that hold significant amounts of troubled assets from participating as managers or private investors in funds set up under the program.

The proposed changes would address most of the concerns that have been raised by critics of the administration's program. In particular, they would reduce costs to taxpayers, prevent excessive and unnecessary gains by private parties, and produce market prices that can be relied on for valuing assets that remain on banks' books.

The paper builds on and incorporates elements of my September 2008 and February 2009 working papers on using privately managed funds for buying troubled assets, A Plan for Addressing the Financial Crisis (Harvard Law & Econ. Discussion Paper No. 620, 2009), available at http://papers.ssrn.com/abstract =1273241, and How To Make TARP II Work (Harvard Law & Econ. Discussion Paper No. 626, 2009), available at http://papers.ssrn.com/abstract =1341939.

Keywords: Troubled assets, toxic assets, public-private investment program, bailout, financial crisis, banks, financial stability, U.S. Treasury

JEL Classification: E5, G1, G2, H3, H5, H6, K2, N2