Reverse Auctions in Bail out – designed to not screw taxpayer?

Reverse Auction Design – will it be in the final bill?

With over 100,000 individual designed  mortgage-related securities, obligations, and other instruments outstanding, further divided  by multiple rated tranches, auctions to price each piece are not workable.  But the Mortgage Bailout Bill depends on price discovery via auction – and as far as I can tell does not have rules for that discovery.  So we are left with “trust me” and regulations to be announced later.  Knowing loan vintage, maturity, loan type, interest rate, location, payment history, FICO score, and initial loan/value ratio will not prevent are narrowly restricted, a package of some degree of heterogeneity in any package of loans.  Prior over-the-counter trading in mortgage-related assets has ended because computer models are no longer trusted for price discovery.

The Paulson program  of auctions for mortgage-related assets seems to be intended to be a one-time event – why I do not know since a standardized investment form and an exchange for that form would seem to be the best way to avoid our current problem in the future.  But as I understand the Bailout Bill, the plan is to have each asset hit the auction block once and then stopping there, or stopping once the money runs out.

In some statements Fed Chairman Ben S. Bernanke appeared to identify as the objective finding a “hold-to-maturity” value – but that means paying a great deal more than market value – later he indicated he was referring to the higher market value post auction because of US Gov ownership of the asset was the value he wanted to pay – this is a major difference – and still sounds like an “auction” with a floor that is above market value.  Will there be anything  in the Bill to address this? Treasury can not just offer to buy the Banks non-saleable assets – a Bank would be a fool if it did not greatly over price those assets in that situation. Treasury can not commit  to purchasing the entire quantity offered of a given package – it must allocate its budget among the various packages available for sale – buying a portion of each package.

The Packages (packages of assets since individual auctions for each asset design is impractical because every asset is an individual design) will give good price discovery, but by definition, the more heterogeneous the package the more likely the US Taxpayer will be screwed because of the adverse selection problem of relatively inferior assets being disproportionately offered for sale at the lowest prices. Treasury will end up buying the worst of the lot and, if a single price is paid for all units, overpaying, with Banks with higher quality assets asking for a higher bid, and finding they can not sell at that higher price – but with the high quality asset bank being screwed as it is forced to mark down its higher quality asset to the price given for the low quality package.

The order of sale of the packages will determine how badly the taxpayer is screwed – Treasury must start with packages of securities having severely depressed prices in their computer model, relatively simple features, and substantial face value owned  (e.g.,  straight pass-through securities with subprime mortgage collateral),  Will this requirement be in the Bill?

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With luck we will be able to end the now stalled “over-the-counter” markets, replacing it with an exchange and standardized packages, with a non-standard package area in that exchange (as exists now at our exchanges).

We will still need to buy and sell some assets purely by looking at the computer model output – but where that output is not trusted today because input parameters are felt to be possibly incorrect, it will be easier to get to a sale once  the newly available market data generated by auctions are used, to estimate the contribution to value of the various asset characteristics. Applying the estimated models to the non-auctioned assets would then yield a predicted price for each asset. Transparency requires that today’s “proprietary” formulas be reveal – they caused this mess and have no value, so with luck they will be donated to Treasury and we will not pay the Banks for that bit of information.