The existence of such a significant number of private buyers armed with substantial capital will produce a well-functioning market for troubled assets. This will be a market in which many potential sellers (banks) face a significant number of potential buyers (the funds). The profit share captured by the funds’ private managers will provide these managers with powerful incentive to avoid overpaying for troubled assets. At the same time, the profit motive of the selling banks, coupled with the presence of competition among the private funds, will make it difficult for funds to underpay for troubled assets. As a result, we can expect the market for troubled assets to function well, with prices set around the fundamental economic value of purchased troubled assets.
Remember that old Gary Larson cartoon in which two scientists are standing before a blackboard crammed with math? One furrows his brows and says he has doubts about Step 3. Standing apart from all the Greek letters and operators above and below it, Step 3 says, “And then a miracle occurs....”
This paragraph is Bebchuk’s Step 3. With so much tweaking of fund managers’ incentives needed to get them to participate in the program, it is not at all a given that they will maximize expected profits by bidding to the expected value of the assets on offer. In fact, it is easy to show that, the more dispersion there is in their subjective probability distributions around the assets’ expected values, the more distortion there is in price discovery. Paul Krugman picks a maximally dispersed example (all the density at the two extremes) to demonstrate the problem his post from three days ago.
It’s funny how “competition” can take on magical properties for some people. It seems that Bebchuk was so pleased to have found a way to inject competition into the “bad bank” strategy that he didn’t inquire into how well it would perform.