Repost: Harvard Professor’s Plan for Fixing the Banking System

I have never reposted a post on this blog but I am going to make an exception today.

The reason? In mid-February, I blogged about a Harvard professor’s plan to fix the banking system. The essence of the plan was to use public money to subsidize the creation or financing of numerous investment funds that will be privately managed and dedicated to buying troubled assets.

This morning, Treasury Secretary Geithner announced a plan to buy toxic assets from the banks that looks very similar to the plan I touted. More important, the financial markets are applauding the plan and think it could actually work.

The big challenge now is that the public is so outraged at Wall Street that Congress may increase taxes on the potential profits of these funds.

That would be a BAD IDEA for two reasons. One, it would scare away large swaths of the investment community from actually participating in the program. Two, the public already stands to be benefit because the U.S government will be providing up to 50% of the equity capital of these funds. So we are part owners of the funds.

Here is the old post:

Now that Obama has pushed through a stimulus package, his administration has to crack a much tougher nut: Putting the banking system on sound financial footing and re-opening the credit markets.

We all know that TARP I has not worked out as planned. Yes, it averted a total catastrophe. But the banks are still not lending that much and the credit markets remain closed to all but the most stable companies. Our capitalist system remains a giant clogged artery in need of major bypass surgery.

So far, I have not heard any great ideas that could help solve this incredibly complex challenge. And there is no consensus emerging around how to get the banks to sell off the hundreds in billions in toxic assets clogging their balance sheets–unlike the stimulus program, which was a far easier problem. CNBC’s Dennis Kneale just floated an idea from an unnamed stock trader to turn the toxic assets into exchange traded funds.

But yesterday I got an email from Harvard touting a new plan and paper from Harvard Law School professor Lucian Bebchuck. His proposal to establish a “significant number of competing funds that will be privately managed and dedicated to buying troubled assets – not on creating one, large public-private aggregator bank” is the best idea I have yet to hear.

I think it has a shot at working because it designed to introduce much more competition in the market for these distressed securities–unlike one single “bad bank” that would only inject a limited amount of competition.

One myth about the current financial crisis is that there is no market for these troubled assets. That is just not true. Some of the smartest hedge fund managers in the world are trawling through these assets and scooping them up for super-cheap prices. Hedge fund kingpin John Paulson, for example, believes some of the best investment opportunities in 2009 and 2010 are in distressed mortgages.

So there is a market. It just needs to be far far bigger and more active and liquid so the majority of these assets can be bought and taken off the balance sheets of the banks. Bebchuck’s plan to use public money to create 25 or so new subsidized but privately run and financed funds designed to purchase these assets just might be able to spur the creation of that market.

“Establishing competing funds, I show, is necessary both to securing a well-functioning market for troubled assets and to keeping costs to taxpayers at a minimum,” writes Bebchuck.

“Each new fund will be partly financed with private capital, with the rest coming (say, in the form of non-recourse debt financing) from the government’s Investment Fund planned by the Treasury. One important element of the proposed design is a competitive process in which private managers seeking to establish a fund participating in the program will submit bids as to what fraction of the fund’s capital will be funded privately.

The government will set the fraction of each participating fund’s capital that must be financed with private money at the highest level that, given the received bids, will still enable establishing new funds with aggregate capital equal to the program’s target level. Overall, I show that the proposed design will leverage private capital to the fullest extent possible and will provide the most effective and least costly mechanism for restarting the market for troubled assets.”

Click here to read the entire paper.

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2 Responses to “Repost: Harvard Professor’s Plan for Fixing the Banking System”

  1. Charlie Casagranda Says:

    Good article but there is so more much to learn about this that its hard to keep up. <<<< This site helped me a lot – Great info .. Its almost like going to school.

  2. Luigi Fulk Says:

    Great comment about raising private money

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