Why it's Too Early to Bring in Private Money

Alea has a semi-cryptic note:

This crisis being of a systemic nature, correlation is high, this means equity is risky because yields are lower than normal relative to more senior tranches and would sell off sharply if conditions were to normalize, a rational investor will bid assuming low or 0 correlation.
So there is likely to be a gap between the mtm value of the toxic assets and what a rational investor would pay, reducing or eliminating the incentive for banks to participate.

The key insight here is that bidders for the banks' toxic assets don't care particularly about the idiosyncratic risks of any given loan portfolio or CDO. Instead, they're worried overwhelmingly about systemic risks associated with the ongoing financial crisis.

Essentially, we are not living in a world where investment prowess is repaid, and the fate of the private-sector participants in Geithner's public-private partnerships is pretty much out of their hands. Either all of these assets are going to appreciate in value, or all of them are going to decline in value. And that's largely a function of what happens to international financial markets and to the global economy as a whole. The potential buyers of these assets can do all the homework they like, trying to bid on slightly better assets rather than slightly worse ones, but the big risks -- to both the downside and the upside -- are systemic.

In other words, the private participants in the Treasury plan aren't really adding value, they're just gambling that things are more likely to get better than they are to get worse. For this we need to pay them much more of the profits than their share of the total investment?

Eventually, if things get better, then this kind of plan might make sense: correlations will come back down from 1, where they are presently, and private investors will be able to play a useful role in separating the wheat from the chaff when it comes to those legacy assets. For the time being, however, the days for such sifting remain far in the future. And it's not at all clear why it pays to bring private investors in at this stage.