Economists Look at Ways to Structure Auctions

What price should the government pay for toxic assets as part of the proposed $700 billion bailout package?

The simple answer -- the cheapest price -- isn't obviously correct. The government isn't just trying to buy low and sell high. It is looking for a price for debt that reinvigorates the financial system -- though not at such a high price that taxpayers feel like dupes.

To find that price, the government plans to turn to an auction.

Associated Press

Federal Reserve Chairman Ben Bernanke, on Capitol Hill Wednesday, is looking for the right pricing balance on buying and selling assets of troubled companies to benefit both taxpayers and the financial system.


Currently, the market is valuing many mortgage securities at what Federal Reserve Chairman Ben Bernanke has termed "fire sale" prices. That is because so many of the financial firms that hold the securities are in trouble, and there are few obvious buyers remaining. Thus, the would-be sellers can't drive hard bargains. In July, Lone Star Funds bought collateralized-debt obligations, complex debt products that originally were valued at $30.6 billion, for $6.7 billion from Merrill Lynch & Co.

Sellers would prefer a higher price, of course. Mr. Bernanke has talked about what is called the hold-to-maturity price -- the value a buyer would place on holding a mortgage security for its interest stream until the underlying debt is paid down. The government hopes that through some sort of auction process, it will be able to pay something between the fire-sale price and the hold-to-maturity price.

The government has a long history of working with auctions, using them to sell everything from Treasurys to wireless spectrum to mineral rights. But the current situation makes setting up an effective auction particularly thorny.

The most likely format would be some sort of reverse auction, in which firms would bid to sell debt to the government. That would leave the government as the only buyer of hard-to-price assets that the sellers are much more informed about than it is, creating a situation in which they could set prices that are far above what the debt would be worth, even in a normally functioning market. "The scope for mischief is incredibly high," said Harvard University economist Jeremy Stein.

Auction experts say the best solution would be for the government to bring experienced buyers into the auction process so it wouldn't be the sole buyer. Absent that, there are techniques the government could use to force sellers to disclose what they believe the appropriate prices are, said University of Maryland economist Lawrence Ausubel.

He said he thinks the government should hold an auction in which it announces its intention to buy some of the amount outstanding of a security -- perhaps half. It would then start the process by setting a relatively high price for a security at which presumably all the firms that hold it would want to sell all they own. Then the government would set the price progressively lower until the holders, either by dropping out or reducing their bid sizes, were willing, overall, to sell no more than half of what they own.

The "winners" of the auction would get to sell, but the losers, who were unwilling to sell cheaply, would benefit as well, because the price the government paid in the auction would help establish what a reasonable price for the security is, helping to re-establish the market for such securities. "Once the government establishes some liquidity, the private market may finish the job," said Mr. Ausubel.

A problem in structuring an auction is that debt securities can be vastly different from one another. Lumping them together could be a mistake, because the government would end up overpaying for the worst securities, said Stanford University Graduate School of Business economist Darrell Duffie.

One solution would be to auction the most widely held securities first, which would help establish a general pricing framework, and auction the rarer ones later.

Another possibility would require sellers to pay the government for losses with an equity stake if the value for a security set at auction ended up being too high. "If you put that in there, it reduces the problem of making the price too high," said University of Chicago Graduate School of Business economist Douglas Diamond.