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 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 nonagency 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.

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