The Back Alley Archives

The Obama team announced its intention to partner with the private sector to buy $500 billion to $1 trillion of distressed assets as part of its revamping of the $700 billion bank bailout last month. It's central to the administration's efforts to unglue credit markets, alongside a Federal Reserve program aimed at spurring consumer lending in areas such as credit cards and home loans that will be officially launched Tuesday.

{. . .} one leading idea is to establish separate funds to be run by private investment managers. The managers would have to put up a certain amount of capital. Additional financing would come from the government, which would share in any profit or loss.

These private investment managers would run the funds, deciding which assets to buy and what prices to pay. The government would contribute money from the $700 billion bailout, with additional financing likely coming from the Federal Reserve and by selling government-backed debt. Other investors, such as pension funds, could also participate. To encourage participation, the government would try to minimize risk for private investors, possibly by offering non-recourse loans.

{. . .} the government wants to encourage private investors to buy up the assets in a way that would come closer to setting a market price where no market currently exists.

{. . .} Many details remain unclear, in particular, how the government and the private sector will share the risk. An administration official said a key goal is to provide investors with "price safety" so they feel safe enough to get back into the market.

Under the Fed's program to jump-start consumer lending, known as the Term Asset-Backed Lending Facility (TALF), investors, including many hedge funds, will get access to cheap loans from the Fed to purchase securities backed by consumer debt like car loans and credit-card receivables.

By offering low interest non-recourse loans, these public-private entities can pay a higher than market price for the toxic assets (since there is no downside risk). This amounts to a direct subsidy from the taxpayers to the banks. It is amazing how many different ways they've tried to recycle the same bad idea.

So if we want TARP II to work, it has to make it easier for buyers and sellers to agree on prices. Lock-up provisions could help, but presumably if there are private investors willing to agree to three-year lock-ups, then private fund managers could raise money from them right now. What is Geither’s public-private partnership going to change? In order to get to a price that buyers and sellers can agree on, buyers have to be willing to pay more than they are currently willing to pay (because the banks aren’t selling at their current willingness-to-pay). There’s only one way the government can do that: by sweetening the deal.

Here is Bebchuk’s example of how this might work:

Consider a $1 billion fund established with a $50 million equity investment contributed by the private manager and $950 million in debt financing from the government’s Investment Fund. In this case, while the private manager will be the first to bear any losses of the portfolio, the private manager’s potential loss from the fund’s $1 billion portfolio will be capped at $50 million. On the upside, however, the private manager will fully capture any profits that the government’s capital of $950 billion generates above the loan’s low interest.

Let’s say that I’m a fund manager, and without government money I’m willing to pay 30 cents for some asset. That means that when I run my valuation models, there is some chance I will be able to sell it for more than 30 cents, and some chance that I will have to sell it for less, and those distributions balance each other. Government money doesn’t change that distribution of outcomes; it just changes the share of the gains or losses that I incur. In Bebchuk’s example, out of those 30 cents, only 1.5 cents (5%) are mine, so I don’t have to worry about the risk of the price falling below 28.5 cents. But I still get all of the upside. You can see how that shifts my expected outcome in my favor. Because my losses are capped at 5% of my purchase price, I might be willing to pay 40 cents intsead of 30 cents: even though my chances of making money are small (the distribution of eventual sale prices hasn’t changed), my losses are capped at 2 cents (5% of 40 cents), so I don’t need a lot of upside to compensate for my limited downside.

In short, the larger the proportion of government funding, the higher my willingness-to-pay. The purpose of Bebchuk’s auction is to find the fund managers willing to do the job with the least government funding.

This all makes sense, but here are the issues. First, the government financing in this example is a government subsidy. If the taxpayer is taking on the downside (after the first 5%), but none of the upside, and charging the fund manager a low interest rate, then that’s a losing proposition. Looked at from another perspective, if the fund manager’s expected take has gone up, then someone else’s expected take has gone down. Maybe it’s a subsidy we have to grant for the public interest, but there’s still no free lunch. (The government could contribute some capital instead of debt, but then the government’s capital has the same characteristics as the private capital, and the same amount of debt will be required to sweeten the deal sufficiently.)

Second, it still might not work. We don’t really know what the gap right now is between buyers’ willingness-to-pay and sellers’ reservation prices. A government sweetener will increase buyers’ willingness-to-pay, but there is a limit: if buyers think that an asset is worth 30 cents, and the chances of it ever being worth more than 50 cents are infinitesimal, then they will never pay more than 50 cents - and we don’t know if that’s enough to get the banks to sell. So it’s possible that we could set up the most efficient possible mechanism for distributing government financing to the most well-incented fund managers, and the market could still fail.

Either way: bottom line is that investors, even without government help, are seeing and picking off opportunities. It's the banks that want government help to get the prices they want.