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A Decentralized Bailout—A Commentary by Ian Ayres ’86

The following commentary was published in The New York Times on September 25, 2008.

A Decentralized Bailout
By Ian Ayres ’86

Lucian Bebchuk has a powerful idea for improving the government’s purchase of troubled assets: “A Plan for Addressing the Financial Crisis.” (It’s fairly amazing that he’s produced an article of this quality in such a short time.)

The government wants to inject liquidity into the market by buying troubled assets. But how can we be sure that it isn’t overpaying for those assets and bestowing a massive gift on the sellers? In his paper, Bebchuk cites the Treasury’s official statements, which talk about having an auction test:

The price of assets purchased will be established through market mechanism where possible, such as reverse auctions.

This sounds good in normal times, but the very crisis in liquidity might mean that reverse auctions would not produce an adequate price to actually help these firms. If the price is set at what others are willing to bid, then the government is not helping to shore up sub-fundamental pricing.

Bebchuk proposes instead that the government divide its liquidity injection among competing money managers and let them compete with each other to determine the market price. Instead of a single buyer, this could create 20 potential buyers working as independent agents of the Treasury.

Bebchuk describes it this way:

Suppose that the economy has illiquid mortgage assets with a face value of $1,000 billion, and that the Treasury believes that the introduction of buyers armed with $100 billion could bring the necessary liquidity to this market.

The Treasury could divide the $100 billion into, say, 20 funds of $5 billion and place each fund under a manager verified to have no conflicting interests. Each manager could be promised a fee equal to, say, 5 percent of the profit its fund generates — that is, the excess of the fund’s final value down the road over the $5 billion of initial investment. The competition among these 20 funds would prevent the price paid for the mortgage assets from falling below fair value, and the fund managers’ profit incentives would prevent the price from exceeding fair value.