Tapping the Private Sector

A critical feature of the new plan is its attempt to harness private money, which was not part of TARP when it was approved by Congress and President Bush last fall. The government wants private sector involvement, according to Wharton finance professor Richard Marston, "because of the obvious reason that this stretches TARP funds [and] it gets the private investors to value the assets."

Under current conditions, market prices for many of these assets are extremely low, but many are sure to be worth much more if held until they mature—when all the homeowner payments have been made. Encouraging private investors to buy should help set prices somewhere between these two extremes, Marston says. "By getting the private sector involved in pricing and by subsidizing the private sector and perhaps taking on the downside risk, you get prices that help the banks while jumpstarting the markets." Still, he worries that in the wake of the AIG bonus controversy, financial players will be reluctant to get involved in the asset-purchase program for fear of government conditions such as restrictions on executive pay.

While taxpayers will have hundreds of billions of dollars at risk, they will lose money only if investors badly misjudge the assets' values, according to Siegel. "The government doesn't have to put out any money unless these assets get purchased at prices which are substantially higher than what they are worth," Siegel says, adding, "I don't think taxpayers are going to take a bath on it."

Though the market for toxic assets is sluggish, it does exist, providing a starting point for establishing values. "For many of these toxic assets, there are markets and there are market prices," Blume notes. But "those are fire sale prices [and they are]  lower than what the banks want to sell the assets for. That is the basic issue. Now the government is giving a valuable subsidy to buyers of these assets."

In many cases, accounting rules allow the banks to use their own mathematical models to value these assets when they account for them in their financial statements, and these "mark-to-model" prices can be substantially higher than current market prices. Selling for less—at "mark-to-market" prices—forces an accounting of the sale at the lower price, weakening the bank's financial performance and perhaps causing it to fall short of capital-reserve requirements.

By offering low interest rates, allowing loans to be carried for long terms and insulating borrowers from big losses, the government may induce investors to bid up asset prices, Blume estimates. In addition, he suspects the government, which regulates the banks, may be making "suggestions with a hidden threat" to encourage the banks to sell assets for less than they would like.

Still, there is plenty to worry about, including the long-term damage to the economy if the new toxic asset programs end up adding to the country's ballooning debt.