Back in September, Simon and I wrote two op-eds on the governance and pricing challenges of buying toxic assets. As many people have noted, those problems have not gone away. The latter, in particular, represents a formidable barrier to Tim Geithner’s latest proposal to create a public-private partnership to relieve banks of their toxic assets. (In summary, the problem is that banks do not want to sell at the price the free market will offer, because (a) they think the assets will be worth more later and (b) doing so would force them to take writedowns that might make them insolvent.)
Lucian Bebchuk also wrote an op-ed on this topic in September, and to his credit he is still trying to turn “TARP II” into something feasible in his new paper, “How to Make Tarp II Work.” The paper has some good ideas but I’m not sure it solves the basic problem, which unfortunately has to do with the laws of arithmetic.
One of Bebchuk’s key points is that there should be multiple funds buying toxic assets rather than one super-aggregator fund, for the basic reason of price competition:
The existence of such a significant number of private buyers armed with substantial capital will produce a well-functioning market for troubled assets. This will be a market in which many potential sellers (banks) face a significant number of potential buyers (the funds). The profit share captured by the funds’ private managers will provide these managers with powerful incentive to avoid overpaying for troubled assets. At the same time, the profit motive of the selling banks, coupled with the presence of competition among the private funds, will make it difficult for funds to underpay for troubled assets. As a result, we can expect the market for troubled assets to function well, with prices set around the fundamental economic value of purchased troubled assets.
More on that last sentence later.
He also has a clever idea for how to create that competition: Have private-sector fund managers bid for government money (capital or loans – more on that in a second) by bidding the maximum percentage of capital they are willing to provide (the rest of the funding coming from the government). The fund managers willing to put up the most of their own money will get the government funding. This will use the market to minimize the amount of government money that has to be contributed.
Bebchuk also recommends lock-up provisions that ensure that investors – whether private or public – cannot withdraw money from the funds for at least three years. This will help fund managers focus on long-term value without having to worry about having to sell assets into an illiquid market in order to meet demands for redemptions.
These are good ideas. But I’m not sure they are enough to make the market work, and this is where the laws of arithmetic come in. In fact, here’s Bebchuk’s statement of the problem:
A well-functioning market will convert some of the troubled assets held by banks into cash and, perhaps more importantly, provide more reliable valuations for the troubled assets that banks will retain. While this might confirm the claims made by some banks about the value of their assets, it might lead to realization that some other banks are insolvent or inadequately capitalized, which would require infusions of additional capital. Thus, restarting the market for troubled assets might well be insufficient by itself to solve banks’ problems.
Even if you have multiple buyers willing to pay “economic value” for the assets, and multiple banks who want to sell them, you could still have a market failure; those banks could refuse to sell because it would force them to recognize losses that might make them insolvent (and no CEO wants to be CEO of an insolvent bank). In fact, this is what many people think is the case right now. All the people who might invest in a public-private partnership could buy those toxic assets right now, but they can’t agree on prices with the banks who hold those assets.
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.
In the end, if Treasury is going to go down the public-private toxic-asset-purchasing path, then I think Bebchuk has some good suggestions. But there’s still no magic bullet here.