How to Make TARP II Work

Treasury Secretary Geithner announced a plan, which the Treasury is willing to finance with up to $1 trillion of public funds, to partner with private capital to buy banks' troubled assets. The Treasury has not yet settled on the plan's design, and its announcement has encountered substantial skepticism as to whether an effective plan for a public-private partnership in buying troubled assets can be worked out. This paper argues that, yes, it can. The paper also analyzes how the plan should be designed to contribute most to restarting the market for troubled assets at the least cost to taxpayers. The government's plan should focus on establishing 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. 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. 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. The paper builds on and develops the proposal for using privately managed funds for buying troubled assets I first put forward in <em>A Plan for Addressing the Financial Crisis</em> (Harvard Law & Econ. Discussion Paper No. 620, 2009), available at <a href="http://papers.ssrn.com/abstract=1273241" target="_blank">http://papers.ssrn.com/abstract=1273241</a>. The analysis of this proposal is further developed in “<em>Buying Troubled Assets</em>, <em>Yale Journal on Regulation</em>, 2009, available at <a href="http://papers.ssrn.com/abstract=1392808" target="_blank">http://papers.ssrn.com/abstract=1392808</a>.