Lucian Bebchuk has a powerful idea for improving the government’s purchase of troubled assets: “A Plan for Addressing the Financial Crisis.” (It’s fairly amazing that he’s produced an article of this quality in such a short time.)
The government wants to inject liquidity into the market by buying troubled assets. But how can we be sure that it isn’t overpaying for those assets and bestowing a massive gift on the sellers? In his paper, Bebchuk cites the Treasury’s official statements, which talk about having an auction test:
The price of assets purchased will be established through market mechanism where possible, such as reverse auctions.
This sounds good in normal times, but the very crisis in liquidity might mean that reverse auctions would not produce an adequate price to actually help these firms. If the price is set at what others are willing to bid, then the government is not helping to shore up sub-fundamental pricing.
Bebchuk proposes instead that the government divide its liquidity injection among competing money managers and let them compete with each other to determine the market price. Instead of a single buyer, this could create 20 potential buyers working as independent agents of the Treasury.
Bebchuk describes it this way:
Suppose that the economy has illiquid mortgage assets with a face value of $1,000 billion, and that the Treasury believes that the introduction of buyers armed with $100 billion could bring the necessary liquidity to this market.
The Treasury could divide the $100 billion into, say, 20 funds of $5 billion and place each fund under a manager verified to have no conflicting interests. Each manager could be promised a fee equal to, say, 5 percent of the profit its fund generates — that is, the excess of the fund’s final value down the road over the $5 billion of initial investment. The competition among these 20 funds would prevent the price paid for the mortgage assets from falling below fair value, and the fund managers’ profit incentives would prevent the price from exceeding fair value.
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A brilliant suggestion that would only be so on the rarefied air of academia. The whole purpose of the plan is to pay more for these assets than they are worth. The notion that there are profits to be made, requires either a willful suspension of disbelief or a complete ignorance of basic economics. Good luck finding a fund manager willing to work on a contingent commission.
Will turning a profit be staggeringly difficult with these “toxic” assets? I’d love to sign up for that job. Even growing just 1% annually, at a 5% fee, would entitle the manager to $2.5mm in Year One.
Makes too much sense.
But I like it. +1.
That’s one of the most sensible suggestions I’ve heard for this crisis. Unfortunately, it has the proverbial snowball’s chance of becoming real.
These are valid and reasonable ideas. Considering the government had already mentioend using leading money managers to serve as managers of parts of their portfolios (specifically regarding the FNM/FRE bailouts), I’m sure such an idea has crossed their minds and will be incorporated in any final idea.
In the author’s idea, though–how can you verify that a manager has no conflicting interests? And are there really 20 different managers out there that would be comfortable managing a $5 billion portfolio? That’s larger than the total size of all but a few fixed income funds.
I like this idea. Competition, assuming a level playing field, plus pay for performance is always good.
However, there should be concurrent monitoring systems in place to detect any issues before the taxpayers have to foot the bill again.
A recent email is making the rounds of the Internet where someone suggests the 700Bn be distributed to 200M US taxpayers.
Assuming a 30% tax bracket the IRS coffers will increase and the beneficiaries will be able to pay off their own home mortgages. Can someone on this blog advise me why this idea isn’t as good as giving $$$ to the fat cats to spend?
They should just lend the whole $700 Billion to Warren Buffett at low interest rates on the condition that he buy distressed debt or invest in distressed financial companies with the money.
This idea is good (at least if we’re going to have this bailout, which is still an awful idea), but 5% is way too high a carry. Maybe a .5% carry.