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With trillions of dollars in U.S. government funding already committed to combating the worst recession since World War II, regulators are increasingly enlisting private sector support.

Along those lines, lawmakers and Treasury officials are reportedly listening to—and in some cases soliciting—outside views from key leaders in the financial sector.

Asset managers focusing on exchange-traded funds are being included in this movement to broaden the scope of U.S. economic recovery plans. As detailed in an IndexUniverse.com analysis of key developments in the effort to thaw credit markets, large ETF sponsors as well as small-yet-influential players are involved.

(The full 21-page Special Report, three months in the making, can be viewed here.)

Two ETF Plans Emerge

At the heart of the issue is resolving so-called "toxic" debt related to mortgage-backed securities. That alone is estimated to represent more than $1 trillion of regulators' efforts. MBS markets are made upon debt obligations that "represent claims to the cash flows from pools of mortgage loans, most commonly on residential property," according to the Securities and Exchange Commission.

The Treasury's plan to breathe new liquidity into this market is called the Public-Private Partnership Investment Program, or PPPIP. While the Treasury was developing the PPPIP program, which was unveiled in March, ETF companies began working on an alternative.

Over the past two months, two plans have emerged: One from Invesco (NYSE:IVZ) PowerShares and the other from Murray Stahl (CEO of Horizon Asset Management) and Robert Holderith (CEO of Emerging Global Advisors).

The PowerShares initiative actually started earlier this year when it filed papers with the SEC to launch two new funds. These would be the first ETFs to target non-agency residential mortgage-backed securities (RMBSs).

The ETF giant's filing targets only the two top credit categories in RMBS-Prime and Alt-A—and only focuses on the top tranches in each of these market categories. These are not the toxic MBSs that people talk about, as these markets are still functioning well.

Still, it raised an interesting idea: What if you could package together the truly toxic debt into ETFs and trade them on the open market?

The products would open the market to a whole new class of investors currently excluded from participation in PPPIP: individuals.

In addition, if the ETFs were successful, they would create liquidity in the underlying securities, because investors would have to trade those securities into and out of the ETF to allow it to function properly. Investors would demand transparency so that they could know what they were buying (ETFs publish their holdings on a daily basis). And the ETFs themselves could become the source of price discovery, with trading of the ETF shares providing a live, liquid market where "mortgage-backed securities" as an asset class could be properly valued.

PowerShares is also working on an alternative plan that will build on its original MBS ETF filing in January. In that initiative, the government (or possibly banks) would support the creation of a series of MBS ETFs targeting several different points of the credit spectrum. Those include: Prime, Alt-A and subprime; AAA, AA/A and junk (BBB or lower); and different tranches within each category.

Under the proposal, the government would seed the creation of these ETFs by providing $10 billion for each category. It would receive shares in the ETF in exchange, and would work with market makers to make those shares available to the market based on demand, eventually recouping some or all of its initial outlay.

(It's important to reiterate that the plan discussed here has no bearing on the existing PowerShares filings, which focus on the relatively liquid markets for senior and super-senior, high-quality RMBS.)

Once the $10 billion worth of ETF shares were created, market makers would be tasked with finding a market for those securities. They would test the market at a given price, and if they didn't find demand, drop the price until they did. At some point, the thinking goes, the tax-free yield and limited principal protection would be enough to entice investors into the space, allowing the market makers (and by extension, the government) to sell out the full $10 billion allotment.

The Stahl Plan

Meanwhile, a so-called "Stahl plan" being advanced by both Stahl and Holderith also calls for the U.S. Treasury, with Congress' approval, to make all interest income from primarily short-term MBS securities tax free (based on specific provisions).

In other words, if the banks agree to make it easier for mortgage holders, the government will make it easier for the banks, by boosting the value of their MBSs by making interest payments tax free. Of course, the government will lose revenue due to the tax forbearance.

Once this change is in place, the government would then suspend the mark-to-market accounting rule until "available public market ... (is) established with proper price discovery." The thinking is that the changes (extending the terms and making interest payments tax free) would eventually boost the value of these securities, encouraging private capital to flow into the markets. Once this new market is established, the mark-to-market rule would be reinstated and bank balance sheets would look healthier.

To help foster the development of this active market, the Stahl plan turns to ETFs to spark trading and private interest in MBSs. The Treasury would create an ETF Committee, supervised by the Secretary of the Treasury and the SEC's chairman, to oversee the development of this market.

The Treasury would decide which banks could participate in the ETF program. It would then set aside $4 billion, which would be used to purchase largely performing, less toxic MBSs from banks. The Treasury would then enlist 10 managers with expertise in the MBS space to manage these assets on behalf of the government. Each manager would receive $400 million worth of the securities, comprising a blend of different credit levels.

These managers could then buy and sell securities to create the most attractive portfolios. ETF shares would be sold to the public, and the money returned to the government, shifting ownership from the public sector back to private investors.

Under the Stahl plan, the government would receive a portion of the expense ratio paid for managing the ETF to offset some of the lost revenue from making the interest income tax free.

Potential Potholes Of ETFs

As attractive as these ideas are, they are not without risks, the largest of which stems from the so-called "creation/redemption" process. This process deals with how new ETF shares are created and destroyed, and it is critical to the proper functioning of the ETF market.

For the creation/redemption mechanism to function well, the underlying securities must be reasonably liquid.

The two ETF plans take different approaches to address this problem. Under the Stahl plan, competitive bidding between different ETF providers would help drive liquidity into the market for the underlying MBS. The banks would be bidding against themselves to create the most liquid portfolios, and so, there would be a live market for the underlying securities.

The PowerShares plan flips that on its head and tries first to drive liquidity into the ETF itself. The key feature of the PowerShares plan is the huge initial funding—$10 billion per ETF—and the government minimum value guarantee.

The PowerShares proposal may also allow for cash redemptions, with either the issuing bank and/or the government standing behind the offering and willing to redeem at NAV as the "buyer of last resort."

Another issue is that in order to function properly, an ETF has to have both an intraday indicative net asset value or iNAV, and an end-of-day NAV at which creations/redemptions can occur. These NAVs reflect the value of the underlying securities. But part of the problem with toxic MBSs is that they do not trade actively and thus their value and price are difficult to discern. So the question becomes, how do you create NAV for a fund whose securities don't trade very often? No one knows what they're worth!

If this sounds redundant, it's because it's a classic chicken/egg problem: You need ETFs to create liquidity and generate accurate pricing in the MBS, and you need the liquidity and accurate pricing in the MBS to support the ETF.

The hope, again, is that the offer price on these ETFs can be adjusted lower by the market makers until they find an appropriate price in the marketplace, one that will engender demand.

A Third Possibility

As attractive as the two ETF possibilities are, a third avenue presents itself: What if ETFs could be used inside the PPPIP structure? A few tweaks might be necessary, but it's not inconceivable, according to an in-depth analysis led by IndexUniverse's Matt Hougan and Dave Nadig.

Here's how it could work. The Treasury would pick an ETF manager as one of its five targeted managers for the Legacy Securities Program. The ETF manager would be tasked with raising significant seed capital to jump-start the ETF. Once the money was raised, the Treasury would match the ETF one-for-one.

Under the PPPIP plan, the government is also willing to loan money to private managers to allow them to leverage up their exposure to the market. In the Hougan/Nadig plan, this loan money would be held in reserve to facilitate cash creations/redemptions in the fund. This would solve the problem of how the ETF would stick close to its NAV.

The plan would require a few changes from the existing PPPIP program—among other things, investors would be allowed to trade in and out of the ETFs at will, in contrast to the three-year lockup in the PPPIP program—but it would use the same general principles and create similar levels of risk for the government.

Can An ETF Plan Really Work?

It's entirely possible that the problems with these platforms are unsolvable and that there is too much risk to follow through and launch an investable asset. It's equally possible that the concept of integrating ETFs into the PPPIP structure is too difficult.

But the concept of using ETFs to solve a major financial crisis is not new. In 1998, in an effort to stem a panic in its equity markets, the Hong Kong government turned to ETFs. It partnered with State Street Global Advisors Asia Ltd. to form the Tracker Fund of Hong Kong. It remains one of the most popular ETFs in Asia to this day.

Proposals have been floated to create traditional mutual funds as a way of allowing everyday investors to participate. But traditional mutual funds come with their own problems: They would be priced once a day based on the issuer's evaluation of the net asset value of the securities, which, as discussed, is highly subject to debate.

And because mutual funds do not provide any real transparency into their holdings, investors would be left relying on the bank to make fair evaluation of NAV. It's a risky proposition for investors, to say the least.

ETF-based solutions would tackle the problem with transparency, while still allowing all investors to participate in the upside. And if they worked, they would drive liquidity directly into the underlying securities in a way that mutual funds do not.

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Source: Plans to Ease Credit Crunch Using ETFs Take Shape