The creation of some version of a “bad bank” – that would remove toxic assets from bank balance sheets in order to revive corporate and consumer lending – remains an integral part of the Financial Stability Plan. Amid heated debates on potential implementation challenges as well as philosophical discourses on whether such an entity would interfere with much-needed financial natural selection, an important angle of the entire endeavor appears to have been forgotten.

One of the mission-critical objectives of this program should be the  re-establishment of a market for structured products. Currently these complex instruments are barely traded and are quoted at fire sale prices. It is the absence of a liquid market that both fuels concerns of a continuing asset price deterioration and  prevents banks from leveraging the government-provided capital, defeating the whole purpose of the bailout.

Of course, significant uncertainties related to pricing of these assets remain. While an argument can be made that “intrinsic” prices for these securities (based on conservative assumptions about consumer defaults and other macroeconomic factors) are above the quoted fire sale prices, it is unclear where the banks are currently marking these assets .
Given this uncertainty, one answer that seems persuasive is that fiduciaries (such as professional money managers or analysts) should help the government determine the asset prices, and then the government should buy the assets and hold them until maturity or dispose of them when the market environment improves. The taxpayers would have an opportunity to benefit from any price recovery, and over time the entity that holds them may turn out to be a worthwhile investment. As an added benefit, the government’s mere willingness to buy distressed assets at “intrinsic” values may encourage other investors to enter the market as well, becoming a self-fulfilling prophesy.

This does not, however, seem to be the path under consideration. Instead, the establishment of the public-private investment fund may potentially create a monopoly that both prices assets and invests in them – with lots of room for errors with highly adverse consequences. The stakes are extremely high: a suboptimal implementation of the Financial Stability Plan may potentially hamper bank capital further and expose tax payers to undue risk and a limited upside.  To make it work for all parties, the devil – as always – will be in the details.