The Markets Solution

The New York Times reports that the Obama administration will soon announce a new bank bailout plan that that features the establishment of an "aggregator" bad bank to rescue the U.S. banking system from its huge, and rapidly growing, overhang of "toxic" assets. The good news appears to be an inclusion of some encouragement to the private sector to invest alongside the government. Unfortunately, early indications are that the scale and true risk of private capital will be very limited, putting private investors in a passive role in those elements where they can make the greatest contribution—valuation and work-out management. If so, it's likely that the bad bank structure will fail for the reasons the earlier approaches have failed—lack of transparency, of competition, of clear principles and incentives, and of true private at-risk capital. As such, a bad bank would be yet another expensive lost opportunity to restore the private financial sector and its essential flow of funds to enterprise and consumers. We would suggest an alternative approach: make the participation of private capital the centerpiece of any bailout plan, using it in full partnership with government funds to buy the toxic assets through a broad group of newly capitalized secondary financial institutions. By establishing these new "TARP Investment Companies" ("Tarpics"), the government would achieve faster and more efficient valuation of the toxic assets, a greater range of options for banks seeking liquidity, significant support for restarting the critical secondary markets, and proper incentives for managers to maximize toxic asset value. Done properly, it would reduce both the amount of taxpayer funds required and the duration of the rescue. The original TARP legislation of last fall envisioned the government buying toxic assets, but that idea was quickly set aside for a fundamental problem: How and at what price should the government purchase bad loans and other toxic assets? If the price were at "market," all financial institutions would suffer meaningful asset impairments, and many would become instantly technically insolvent. Of course, any price above "market" would have come at taxpayer expense, as a real subsidy to the financial sector. In addition, bad assets are diverse and disparate, so the original idea of a seller's auction had no practical meaning. The asset-pricing problem remains insolvable, but, we argue, it's essentially irrelevant. If banks are to resume their role as loan generators, these assets must be removed from their oversight, and the sooner the better. At any reasonable asset valuations, many of these institutions are already essentially insolvent and require recapitalization, regulatory forbearance, or both. Hiding an implicit capital infusion in an administered price for toxic assets further muddles the accuracy of bank accounts and prevents the re-emergence of asset markets. Only greater transparency and confidence in the restoration of true asset markets will entice private capital back to the banking sector. Far better to utilize decentralized private capital and resulting competition to push up the price of the toxic assets. By some estimates, there is upwards of $400 billion of private capital available either in limited partnership fund commitments (which will be surrendered by general partners if not utilized in the next few years) or with institutions searching for a way to capitalize upon the distressed loan markets.   Instead of a centralized TARP or guarantees against losses, the government should encourage decentralization and clear capital commitments, offering to match the equity capital provided by any reputable for-profit managers in forming these new investment vehicles. If necessary, the government could offer to match Tarpic private equity on a two-to-one, three-to-one, or greater basis. It could also lever equity returns by purchasing subordinated debt of the new entities. The key is speed and simplicity; the plan will marshal private capital quickly only by establishing a clear template (including meaningful private investment minimums) under which the government will match investors' funds in creating the Tarpics. This approach is not without precedent. The Small Business Administration has a long-standing program of partnering with private equity managers to deploy capital to small businesses through Small Business Investment Companies, or SBICs. Various structural protections for the government in the SBIC program, such as fees for capital commitments, redemption periods and priority of capital, can be incorporated as appropriate as private capital begins to compete for access to Tarpic capital. The key to our plan is that the government would be utilizing its TARP capital in the manner most likely to maximize the value of the toxic assets and the speed of their ultimate resolution. By contrast, establishing the federal government as lead buyer of bad loans and securities will invariably politicize the clean-up of toxic assets. Instead of bringing to bear the creativity of private managers in maximizing value, the government's so-called bad bank will at least have to navigate the political optics of—if not the actual political interference in—its decisions. Imagine trillions of dollars in bad residential and commercial real estate mortgages, consumer loans, and corporate debt from every region of the U.S. being worked out by a federal agency under the interested eyes of hundreds of congressmen, senators, and governors, plus unlimited numbers of mayors and political contributors. At best, an aggregator bad bank will be hampered by the inevitable oversight questions—as to dispositions, corruption, choice of contractors, conflicts of interests, and "fair" representation of interest groups in the process. At worst, political interference and genuine corruption will increase the cost and timetable of the bailout. Whatever one may think of the theory of a government bad bank, in practice a bureaucracy managing trillions of dollars of heterogeneous assets is a recipe for disaster, and a likely drag on the re-establishment of functioning markets and new lending for many years. A government bad bank will further crowd out private capital when we need to encourage its deployment to restart lending. To date, bailout efforts have been focused on major banks and other large traditional financial institutions. The government's efforts may have prevented a complete seizure of credit markets, but they certainly have failed to re-start credit growth. Perhaps this is no longer a realistic goal for traditional financial institutions. Before our year of collapses, banks increasingly made mostly loans they could sell; it was the vigorous secondary market that provided the assurance of liquidity and valuation needed for the banks to fulfill their role of primary generator of assets. The Tarpic plan we propose will re-start the secondary market that is now fundamental to the health of the entire financial sector. These new Tarpics may well become the successor healthy institutions that ultimately drive new credit growth. The government's goal in any effort to work out toxic assets must be to save our financial system, not to save particular banks. Saving the system means restoring as quickly as possible and at lowest possible costs to the taxpayers the flow of credit to businesses and consumers. Tarpics will be a key first step in the essential process of coaxing private capital back into the financial system for risky assets. Most importantly, for us taxpayers, it will decentralize the monumental task of financial cleanup, offering us our best hope of maximum recovery, quickest resolution, and lowest cost.Related LinksFannie Mae's Last StandWorst of TimesDefending TARP