With the world’s attention shifting to London and the upcoming Group of 20 summit, it’s possible that the Treasury’s proposal for dealing with banks’ “troubled assets” will become old news. It shouldn’t. The administration plans to provide as much as $1 trillion to privately managed funds that will buy troubled assets, which is indeed the best way for jump-starting this market. But it is important to add to the program a mechanism that would prevent excessive subsidies to private parties and keep costs to taxpayers at a minimum.
A program of public-private funds should be designed to minimize costs to taxpayers. To attain this objective, the government should base the terms of participation on a process in which private managers compete to be in the program.
If the private side were to contribute only 8 percent of the capital, the government should seek to keep the highest fraction of the upside that would be consistent with inducing such participation. To this end, potential private managers would submit bids indicating the minimum share of the fund’s upside that each manager would be willing to accept for an 8 percent investment, as well as the size of the fund that the manager would establish if accepted into the program. Treasury officials should then set the share of the upside going to the private side in each of the funds under the program at the lowest level consistent with establishing funds that collectively have the aggregate target capital.
Alternatively, assuming that the private side’s share of the upside is fixed at 50 percent, the government should seek to get the largest possible contribution of private capital. Under this scenario, managers would submit bids indicating both the size of the fund each manager would establish and the maximum fraction of the fund’s capital that the manager would commit to raising privately in return for 50 percent of the upside. Based on the bids, the government would set the fraction of capital provided by the private side at the highest level consistent with establishing funds that have the target amount of aggregate capital.
This second scenario would not only keep the government’s subsidy at a minimum but would also induce the largest amount of private capital, thus conserving some of the government gunpowder that the program’s current design would use. Because many banks might well remain undercapitalized even when their assets are valued fairly, restarting the market for troubled assets won’t make these banks healthy; rather, it will make clear the need to recapitalize them and might require the government to inject substantial sums of additional capital.
Establishing privately managed funds that are financed with both private and public capital offers the best approach to restarting the market for troubled assets. Adding a market mechanism for setting the level of government subsidy is necessary to reduce the program’s cost to taxpayers and would leave the government with the most ammunition for the tasks that still lie ahead.
Lucian Bebchuk, a professor of law, economics and finance at Harvard Law School and director of its program on corporate governance, is the author of “A Plan for Addressing the Financial Crisis” and “How to Make TARP II Work,” white papers issued in September 2008 and February 2009 by Harvard Law School’s Olin Center for Law, Economics and Business.
This piece was reproduced here with authors permission and was originally published on the Washington Post at: http://www.washingtonpost.com/wp-dyn/content/article/2009/03/30/AR2009033002607.html.