How bad is public-private investment?

The Obama administration is taking some flak from economists for its proposal to finance private purchases of toxic assets using non-recourse loans. I, however, can understand the logic behind the proposal. If you believe that the collapse in credit is overshooting, so that the shrinking of the intermediated money supply is more than would be required in a normal environment, then this policy makes sense. (It seems to me that everyone who supports fiscal stimulus is implicitly taking this point of view.) In short there is some reasonable leverage ratio for non-bank financial institutions where the asset to equity ratio lies, I would estimate, between 4 and 10. If non-bank financial firms are being forced to a leverage ratio lower than this, then an unreasonable amount of leverage is being squeezed out of the financial system, and we are failing to use our savings efficiently. In other words, it is possible that some well-managed hedge funds (et al.) are in fact underleveraged right now. For this reason, the government may choose to step in to support asset values by deliberately increasing the amount of leverage in the financial system.

While this is certainly a somewhat risky position for the government to take, if the policy is implemented with extreme care, it may be successful. Here are the caveats I would propose to help establish "market" prices in our current not-so-market financial world.

(i) The fraction of money that private funds put up needs to be high (25% sounds about right to me) and that private money should be in a first-to-lose, last-to-gain position -- in other words, all income and principle needs to go to the government before the private investors get a penny. Furthermore, there need to be safeguards in place to ensure that the private stake is real. (Maybe, the crisis has made me cynical, but I genuinely wonder whether its possible for the government to be tricked into putting up close to 100% of the funding.)

(ii) No synthetic assets should be funded using this mechanism. If the government wants to support the purchase of synthetics, it should do so only on the basis of full recourse loans to well-capitalized entities. The reason for this is simple: As a matter of market economics, one should assume that on Sept. 17, the day AIG was bailed out, there was a total domino-like collapse of the investment banks and any bank obligation that is not backed by real collateral was left with nothing more than the option value of government intervention. Thus, on Sept. 17 the intrinsic value of all CDS contracts should be assumed to have fallen to the amount of collateral that was posted as of that date.

If the government starts offering non-recourse loans for the purchase of assets that have value only because of the option value of government action, it will be an exercise in the absurd. Effectively the only reason to buy synthetic assets is because the purchaser believes that the government will be so embarrassed by the losses on the nonrecourse loans that will be incurred by a government failure to support the value of CDS that the government will engage in a costly taxpayer funded bailout in order to cover up its own mistakes. Trust me, we don't want to go there.

Update 3-4-09: I reread the post several times yesterday asking myself whether it wasn't maybe a little over the top, but decided to leave it alone. And then today I find that El-Erian agrees with me: “You can no longer predict asset value without thinking about the role of governments. Governments are no longer referees, they are players.”