The government can force banks to write down assets, and then it can buy those assets at a price that will leave a reasonable expected return.

From Andy Harless:

"What are Illiquid Assets Really Worth?

For the most part, I agree with Paul Krugman’s take on the “Bad Bank” proposal. But I think he takes the case a little too far:

It looks as if we’re back to the idea that toxic waste is really, truly worth much more than anyone is willing to pay for it

But isn’t it obvious that the toxic assets are worth much more than anyone is willing to pay? The value of an asset depends on the rate at which one discounts its cash flows. For assets that are risky and illiquid, the discount rate includes a risk( WILL IT GO BAD? ) premium and a liquidity( CAN YOU SELL IT WHEN YOU WANT TO? ) premium. By any measure I can think of, risk premia and liquidity premia today are stratospheric( IRRATIONAL ), which means that asset values in terms of reasonable risk and liquidity premia are much higher than in terms of the wild and crazy premia we’re seeing today.

Moreover, the toxic assets are particularly illiquid – and therefore demand a particularly high liquidity premium – because the technology for valuing them has proven faulty. Over time, presumably, the bugs will be fixed, and some of the liquidity will be restored. And by the way, what better way to fix the bugs than to create a buyer that has $350 billion to spend? Such a buyer – if its objective were to make a profit – could easily afford to spend a few hundred million on research to find out how much it should be paying for the assets.( MAYBE. THE OWNERS DON'T NEED TO AGREE WITH THIS PRICING.)

There remains the philosophical question of how much an asset is inherently worth. But surely to the federal government – which can afford to be patient, and which can afford to absorb a lot of risk, and which can afford to sit on these assets until they mature or until someone is willing to buy them at a profitable price, and which doesn’t have to worry about capital requirements or even about solvency – these assets really are worth a lot more than any private entity is willing to pay for them. ( NOT NECESSARILY. JOHN PAULSON AND OTHERS ARE BUYING THEM. IT DEPENDS UPON THE INDIVIDUAL ASSET AND PRICE. )

Moreover, the government’s risk-free discount rate is probably negative. Today it can print all the T-bills it wants, and there will be no ill effects. At some point in the future (or so one hopes!), the government will once again have to pay for the money it borrows. For the private sector, a negative discount rate doesn’t make sense, because anyone can just hold assets in cash and receive zero interest. But the government cares about the effects its actions have on the economy as well as about its own financial health. It isn’t willing to hold its assets as cash, because that doesn’t help the economy. For the government, a negative discount rate does make sense. So add a negative risk-free rate to some reasonable risk and liquidity premia, and the government should be willing to pay quite a lot more for these assets than the private sector pays. ( NO. THE ASSESSMENT SHOULD BE BASED ON THE ASSETS, NOT THE BUYER. IF THIS GOES BAD, IT'S THE TAXPAYERS MONEY, NOT INDIVIDUALS. )

But should the government actually pay what it should theoretically be willing to pay? I’m inclined to say no, or at least, not necessarily( GOOD ). Demand curves slope downward, supply curve slope upward, and most people, under most circumstances, pay less for whatever they buy than what they would be willing to pay. In a competitive market, buyers pay only as much as the marginal seller is willing to accept. (Granted, the market for illiquid assets is, by definition, not competitive, but if a major buyer emerges, there will be competition among sellers.) If the government pays more than a similarly mandated private investor would have to pay, then it is merely transferring public wealth to the banks’ stockholders. And I’m confident that I speak for the majority of Americans when I say, “To hell with the banks’ stockholders!” What the government should be willing to pay for $350 billion worth of assets is whatever the market price would have been if there were additional $350 billion of private sector funds buying those assets.( GOOD )

And not even that, perhaps( KEEP GOING. YOU'RE APPROACHING MY VIEW. ). Part of the reason these assets are so illiquid is that banks are reluctant to sell them because that would force them to own up to how little the assets are worth( BINGO! ). If the government bid a little higher, presumably, more banks would be willing to sell, but there would still be an incentive for the banks to hold out for book value( YEP ). My view is that banks should get the stick as well as the carrot. Instead of relaxing accounting standards, we should go the other way and be aggressive about forcing banks to write down their toxic assets, so they won’t have an incentive to hold out for unrealistic book values. When all is said and done, the government can recapitalize the banks that survive, and hopefully they’ll be willing to lend again. ( MAYBE )

I think the call that many economists made, when the original TARP came out, for recapitalization rather than reliquification, was misinterpreted. The idea, I think, was that banks need more capital because much of their existing capital will disappear once they write these assets down to a reasonable value( YES ). If you give them a token amount of capital without forcing them to write down the assets, it doesn’t solve the problem: their balance sheets may look good now, but they’re still afraid to lend if they’re uncertain about the value of their existing assets.( THE CALLING RUN CONTINUES AND SO THE TOTAL LOSS IS STILL UNKNOWN )

In any case, the whole enterprise should be, and can be, carried out in such a way as to be profitable – in an average expected return sense – for the government( I AGREE ). The government can force( HOW? ) banks to write down assets, and then it can buy those assets at a price that will leave a reasonable expected return( OK ). The banks that no longer meet capital standards will disappear. Of the remaining banks, many of them will need capital, and those will make up a substantial fraction of the banking sector. Banking – when one is willing to do it – is generally a profitable activity, and over time those banks should generate sufficient profits to compensate the public for the risk it is taking. If there’s anything left over for the stockholders, that’s gravy."

I still doubt the government's ability to buy these assets at a decent price. But this approach has merit, in that it perceives the problems of buying the toxic assets, and has a taxpayer centered approach.