How a bad-asset ‘investment fund’ would work, in theory

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The ‘bad bank’ is back on the table as a solution for vacuuming toxic assets from ailing lenders’ balance sheets.

But now the government is calling it a ‘public-private investment fund’ that would be organized by the Treasury, the Federal Reserve and the Federal Deposit Insurance Corp.

Treasury Secretary Timothy Geithner provided only the bare bones of an outline for the fund in his speech this morning. He talked about an initial size of $500 billion for the fund ‘with the potential to expand up to $1 trillion.’

That would not be all government money. The idea would be for the government to seed the bank with capital -- some analysts are guessing about $100 billion -- then draw private investors in to leverage that seed money.

Then, the idea would be to use ‘public financing’ to further leverage the seed capital, according to the Treasury’s fact sheet on the plan. Presumably, the Federal Reserve could provide loans to fund investors, or they could borrow via FDIC-guaranteed bonds.

With the initial capital and loans, the total of bad assets that could be purchased would be up to $1 trillion. In theory, the investors would be motivated by the idea of paying, say, 20 cents on the dollar for assets that might someday be worth 50 cents on the dollar.

‘Because the new program is designed to bring private sector equity contributions to make large-scale asset purchases, it not only minimizes public capital and maximizes private capital; it allows private-sector buyers to determine the price for current troubled and previously illiquid assets,’ the Treasury says in its fact sheet.

But the question of how, exactly, to price those troubled assets has been a critical issue all along. Treasury offered no hints as to why it would now be less of an issue. . . .

What’s more, one key assumption had been that the government would provide some kind of additional incentive to private investors -- for example, a guarantee that they couldn’t lose more than a specific percentage of what they put up, if the assets turned out to be worth even less than their marked-down prices.

Yet there was no discussion of any guarantees or backstopping in the Treasury’s fact sheet.

If that detail is to come, they should at least have said so. Otherwise, it’s understandable for markets to figure that this is yet another unworkable bad-bank ‘solution.’

Wall Street obviously was looking for a guarantee of some kind. Here’s what the Securities Industry and Financial Markets Assn. had to say in a statement:

The key there, from Wall Street’s perspective, is for Uncle Sam to share ‘downside risk.’

-- Tom Petruno