How much should the Treasury pay for distressed assets that nobody else wants?

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Oct. 13 2008 3:43 PM

How the Bailout Auction Should Work

How much should the Treasury pay for distressed assets that nobody else wants? A Bils-Kremer auction could set a fair price.

The Bush administration, which is changing its bailout plans every day, now intends to buy stakes in major American banks and perhaps guarantee their loans, but it's also still proceeding with Treasury Secretary Henry Paulson's original idea, which is to buy up a bunch of assets that nobody else wants. The big question about those distressed assets is: What price should Treasury pay for them?

You might reasonably say that the fair price for an asset nobody wants is zero. But bailout proponents tell us that these assets are plenty valuable; it's just that nobody's stepping up to buy them because it's hard to borrow right now. So how do you set a fair price for an asset that nobody else is bidding on?

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Last week I couldn't have answered that question. Today, thanks to a conversation with my University of Rochester colleague Mark Bils, I can. Bils proposes to adapt an auction scheme designed (in an entirely different, currently irrelevant context) by Harvard professor Michael Kremer.

Here's (roughly) how a "Bils-Kremer" auction would work: First, put 10 similar distressed assets (such as a series of collateralized debt obligations) up for auction. At the close of the auction, the Treasury pays the winning bids for nine of these properties. The 10th property (chosen randomly) gets sold to the winning bidder.

The advantage of a Bils-Kremer auction is that the Treasury buys assets and recapitalizes the firms holding those assets while paying only what some private bidder thought each property was worth. Now repeat with 10 more properties. And so on. Under this plan, nine-tenths of the liquidity comes from the Treasury, but ten-tenths of the price setting comes from the assessments of private investors with the incentive to bid judiciously. In other words, the prices can reasonably be considered fair.

You'd have to worry about auction-rigging, in which leading bidders collude to bid high, but there are ways to discourage that—say, with a sealed-bid auction in which the winner pays not his own bid but the fourth highest. (This need not depress the sale prices, because people bid higher in such auctions.) To rig that auction, you'd need the top four bidders to collaborate. If you're still worried, change "fourth highest" to "eighth highest."

Even with legislation in place, nobody (including the Treasury) seems to know how the Treasury will be setting asset prices. The Bils-Kremer auction could work.

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