Jean Tirole has written the best theoretical analysis I have seen of the role of government intervention to revitalize frozen asset markets.  The key idea in this paper is that investors need to finance their next project and are unable to do this by selling their “legacy” assets because adverse selection has frozen the market.

A government buyback of these toxic assets attracts the bottom tail.  The government of course is losing money on all of the assets it buys.  But the payoff is that it rejuvinates the market:  private financiers will now step in and buy the assets of those who refused the government offer.  It’s a surprising result but ex post its pretty easy to understand.

If the government is offering a price p for the legacy assets, then the value of the marginal asset sold is equal to p + S where S is the value of going forward with the newly funded project.  Investors with legacy assets worth just more than that refuse the government’s deal.  Now private financiers can get them to accept an offer them a price a bit higher than p.   And this is profitable for the financiers because the assets have value p + S.  This proves that the market for private finance will become unstuck.

All that was required was that the government price p was high enough to allow those who accept to finance their project and earn S.  (Tirole points out that this is an argument that buybacks must be of sufficient scale to be effective.)  This value S becomes a wedge between the value of refinance to the investors and the value of the legacy asset to financiers.

The paper then goes on to study the optimal intervention when the market is not restricted to simple buybacks. The optimal scheme is a mix of buybacks and partial transfers of legacy assets that keep “skin in the game” to reduce the downstream adverse selection problem.  The government is trying to minimize the cost of the intervention by spurring as much activity as possible from the private finance market.

This paper is worth studying.