The Administration will need to make some critical decisions soon on its plan to create a public/private partnership to buy “toxic assets” from banks. The plan was announced by Treasury Secretary Geithner on February 10th in terms of broad principles, with the mechanisms to be designed over the following few weeks. The idea is to move as many of the toxic assets as possible off the books of the banks, where they have been wreaking havoc by creating massive uncertainty as to the solvency of those banks. The Administration has concluded that there needs to be substantial involvement from private investors, who are collectively the party best able, and most motivated, to evaluate these complex assets. At the same time, the government needs to be involved in order to provide incentives to break the logjam that has held trading volumes in these securities to extremely low levels.
The most fundamental question about the public/private partnership is the proper financial role of the taxpayer. In practice, the government is highly likely to provide cheap financing for the private investors, combined with guarantees of the floor values of the assets, with a minimal emphasis on co-investing by directly purchasing toxic assets.
This answer is consistent with the author’s preference to minimize the potential for losses to the taxpayers from toxic assets, even when this means giving up potential gains, but there is no “right” public policy answer here. The correct solution depends heavily on the risk preferences of the government, and ultimately the taxpayers. Therefore, this paper attempts to frame the risk/reward trade-offs in a clear manner that will assist policymakers in considering how best to invest the taxpayers’ money. It starts with an explanation of the likely financial structure of the public/private partnership and then shows how the risk/return tradeoffs vary between this and an alternative approach centered around government purchases of the toxic assets.
Given the crucial importance of the public/private partnership to reducing the harm done to the financial system by toxic assets, this paper is only the first in a series on the optimal design of that partnership. Later papers will discuss the size and composition of the toxic assets to be covered by the program, the potential for losses, mechanisms to align the interests of the private investors and the government, the possible effects of the new mortgage foreclosure mitigation effort, and other important points. For background on the overall Financial Stability Plan and the role of the public/private partnership, please see “The Administration’s New Financial Rescue Plan,”. As explained there, the proposed partnership is not the author’s preferred approach, since it appears better to mitigate the systemic risks of toxic assets by providing guarantees directly to the banks.
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