Managing Markets for Toxic Assets

Christopher L. House and Yusufcan Masatlioglu

No 16145, NBER Working Papers from National Bureau of Economic Research, Inc

Abstract: We present a model in which banks trade toxic assets to raise funds for investment. The toxic assets generate an adverse selection problem and, as a consequence, the interbank asset market provides insufficient liquidity to finance investment. While the best investments are fully funded, socially efficient projects with modest payoffs are not. Investment is inefficiently low because acquiring funding requires banks to sell high-quality assets for less than their "fair" value. We then consider whether equity injections and asset purchases can improve market outcomes. Equity injections do not improve liquidity and may be counterproductive as a policy for increasing investment. By allowing banks to fund investments without having to sell high-quality assets, equity injections reduce the number of high-quality assets traded and further contaminate the interbank market. Paradoxically, if equity injections are directed to firms with the greatest liquidity needs, the contamination effect causes investment to fall. In contrast, asset purchase programs, like the Public-Private Investment Program, often have favorable impacts on liquidity, investment and welfare.

JEL-codes: D53 D82 E22 E44 E5 G01 G18 (search for similar items in EconPapers)
Date: 2010-07
New Economics Papers: this item is included in nep-cba, nep-cta and nep-ppm
Note: AP EFG ME
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Citations: View citations in EconPapers (7)

Published as Christopher L. House & Yusufcan Masatlioglu, 2015. "Managing markets for toxic assets," Journal of Monetary Economics, vol 70, pages 84-99.

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Journal Article: Managing markets for toxic assets (2015)
Working Paper: Managing Markets for Toxic Assets (2010)
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