Asset Purchase Bailouts and Endogenous Implicit Guarantees

Abstract

This paper shows that bailouts of private agents can optimally take the form of the purchase of a defaulting asset, even if this also means paying off external asset holders. When anticipated, this form of bailouts leads to an endogenous implicit guarantee, where even an intrinsically worthless asset may be traded at a positive price. In the presence of borrowing constraints and imperfectly observable private liquidity needs, direct transfers are imperfect so that, when more constrained agents are also more exposed to a given asset, the compensation through asset purchases becomes optimal. I then show that this possibility of implicit guarantee is amplified by other frictions as risk-shifting and ultimately leads to a coordination problem for selecting stores of liquidity. Finally, I derive policy implications for financial regulation and international capital flows.