Government-Sponsored Investment Funds?

The Wall Street Journal reported yesterday that the Treasury’s leading idea for removing “toxic” assets from bank balance sheets would involve the creation of government-sponsored investment funds. Under the potential plan, the government would purchase $500 billion to $1 trillion worth of bad bank loans and other distressed assets in a partnership with the private sector. The government’s funds would be run by investment managers who place certain amounts of their own capital into the funds, thereby aligning the interests of the government and the managers. Other private investors would also be able to invest in the funds.

The plan to buy up distressed bank assets was originally offered by former Treasury Secretary Henry Paulson, but the first round of bailout funds were instead injected directly into banks in hope of unfreezing the credit market. The main issue that blocked the Treasury’s plan to purchase distressed assets was the pricing of these assets in an illiquid market. Taxpayers do not want the government to overpay for these assets, but banks are not willing to accept the marked-to-market prices for these assets because doing so could annihilate their balance sheets. Additionally, the government wants to make sure that the purchase of these assets provides sufficient capitalization to allow banks to resume lending.

The Obama administration’s idea of the creation of a “bad” bank to purchase these assets would force money into the markets, but pricing of these assets would be problematic because the bad bank would be one of the only participants in the market. The idea of creating multiple investment funds carrying large amounts of government funds potentially solves the illiquid market pricing problem by allowing the private-sector to price the assets through the competition of the funds’ investment managers over those assets.

The creation of this system creates a number of new questions. How many different funds would be necessary to create sufficient competition over bank assets? How will the funds’ investment managers be compensated? What are the performance expectations of the investment managers? Will the funds have boards of directors and who will select the directors? Will taxpayers have any say in this process? If the Treasury does go forward with this plan, it will need to provide a specific plan that covers all of these questions and more or else uncertainty could again cause investors to retreat from the markets as they did last month when Secretary Geithner outlined a plan to fix this problem that was simply too vague.