Managing Markets for Toxic Assets

45 Pages Posted: 7 Jul 2010 Last revised: 14 Aug 2010

See all articles by Christopher L. House

Christopher L. House

University of Michigan at Ann Arbor - Department of Economics; National Bureau of Economic Research (NBER)

Yusufcan Masatlioglu

University of Michigan

Date Written: July 2010

Abstract

We present a model in which banks trade toxic assets to raise funds for investment. The toxic assets generate an adverse selection problem and, as a consequence, the interbank asset market provides insufficient liquidity to finance investment. While the best investments are fully funded, socially efficient projects with modest payoffs are not. Investment is inefficiently low because acquiring funding requires banks to sell high-quality assets for less than their "fair" value. We then consider whether equity injections and asset purchases can improve market outcomes. Equity injections do not improve liquidity and may be counterproductive as a policy for increasing investment. By allowing banks to fund investments without having to sell high-quality assets, equity injections reduce the number of high-quality assets traded and further contaminate the interbank market. Paradoxically, if equity injections are directed to firms with the greatest liquidity needs, the contamination effect causes investment to fall. In contrast, asset purchase programs, like the Public-Private Investment Program, often have favorable impacts on liquidity, investment and welfare.

Suggested Citation

House, Christopher L. and Masatlioglu, Yusufcan, Managing Markets for Toxic Assets (July 2010). NBER Working Paper No. w16145, Available at SSRN: https://ssrn.com/abstract=1635668

Christopher L. House (Contact Author)

University of Michigan at Ann Arbor - Department of Economics ( email )

611 Tappan Street
Ann Arbor, MI 48109-1220
United States

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Yusufcan Masatlioglu

University of Michigan ( email )

611 Tappan Street
Ann Arbor, MI 48109-1220
United States

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