The Bailout's Auction Design: How About a Market?

Ben Bernanke and Hank Paulson spent a bit of time yesterday talking, in pretty vague terms, about auction design and how important it would be to any eventual bailout mechanism. The idea is pretty simple: Assume argumento that "fundamental" prices for banks' mortgage-backed securities are higher than present "fire sale" prices. Then if a transparent auction can persuade the market as a whole that the securities are worth much more than it feared, much of the crisis would simply go away.

Here's how Bernanke put it:

Just as when you sell a painting at Sotheby's, nobody knows what it's worth until the auction is over. Then people know what its worth. I think the same thing here.

If the auction goes well -- and there's a non-zero probability that it will, especially when the US Treasury is in the market with $700 billion to spend -- then it could assuage fears about the valuation of hundreds of billions of dollars of super-senior bank assets.

The practical aspects of this idea, however, have been left very much up in the air. So it's welcome that Gilad Livne and Alistair Milne have come up with a much more specific idea: a central credit exchange.

They explain that credit markets have seized up because banks think their assets are worth much more than anybody's willing to pay for them. So, they say, get a consortium of banks to put up for sale some small percentage of their assets, and start bidding on them in this market.

Under a best-case scenario, the existence of the exchange alone could have a enormous upside with basically zero downside:

Such a trading venue, while it will take some time to establish, has the potential to add about $300bn to the net worth of the global banking sector, without cost to either taxpayers or investors.

I'm glad that we're moving, here, from vague generalities to real ideas. This one has no certainty of working, but the great thing about it is that it has very little chance of doing real harm, especially if the bailout fund is involved in the scheme. Auctions are hard things to design; markets are basically very efficient real-time auctions. If a market for such unique assets as CDOs could really be designed, that could be a great step forward in terms of transparency and liquidity.

Comments

[CPST1:]

2 points!

2008 Sep 24 06:45 PM

[nym:]

Won't "some small percentage of their assets" be their lemons?
seekingalpha.com/artic...

2008 Sep 24 07:39 PM

[EP:]

If this is to work, they need to create classes of shares with exit priorities- giving investors an option of exiting the bailout at a time 24, 48, or 72 months into the future... This would enable some kind of functionality to the whole process. Otherwise is because a voting scheme- and investors don't like voting schemes.

2008 Sep 24 08:35 PM

[EP:]

I apologize, the last sentence should read-

Otherwise it becomes a voting scheme- and investors don't like voting schemes (we already see the weakness in a poorly defined political process that's attempted to describe this proposed entity to the public)

2008 Sep 24 08:37 PM

[Briggsy:]

If by CDOs you mean mortgages, then each one is unique. They are not fungible by their very nature.

We need a small working group to quickly look at the details of each one proposed for auction and rank it for (1) payment history, (2) current loan to value (use Zillow), and (3) credit rating of the borrower.

Numismatic markets depend on an accepted grading system which differentiates gems from common date circulated specimens. If you don't grade the inventory, the pig-in-a-poke problem will persist, and you will not realize full if any value from an auction.

2008 Sep 24 08:43 PM

[CPST1:]

Here's an old article by Felix Salmon and it mentions PIMCO.

seekingalpha.com/artic...


Again, another article currently running in NYT with regard to PIMCO

Managing The Bailout

www.nytimes.com/2008/0...

2008 Sep 24 09:57 PM

[bbzz24:]

what the government is willing to pay with 'free' money by no means implies anything about the intrinsic value of those assets.
example: refueling humvees in iraq at $100 per gallon.

2008 Sep 25 01:40 AM

[mbr:]

Instead of funding the losses of incompetent or corrupt bankers let them go bankrupt. Creditor financial firms of a bankrupt bank would get repaid of what would be left after non-financial creditors have been repaid. Financial firms (banks etc...) should know better than others where to put their funds. In the event non-financial creditors are not repaid for their full deposits after using all available guaranties, a federal fund would finance the difference through a long term loan. Surviving financial firms would also get help from this fund. The obese US financial system would be at long last trimmed to service, not itself, but the producers and the consumers.

2008 Sep 25 03:02 AM

[breck10:]

the point isn't whether the small percentage is their lemons, but rather that a market price will be determined for that group of assets, and it will help everyone extrapolate the worth of the entire institution once more "samples" are truly market tested. This is a great idea. This is much better than what we have had so far, which is that a bank let's a particular investor "under the tent" do analyze the assets and either makes a bid or walks away. There's no information to the market on tat and everyone stays in the dark. We need to shine a very bright light on this.

2008 Sep 25 08:16 AM