Buying the Bad Stuff: Implementation Considerations For The Paulson Plan

Originally published 27 September 2008

By Dr. Chantale LaCasse, Dr Marcia Kramer Mayer, Dr Arun Sen and Dr. Elaine Buckberg

The Reverse Auction: NOT a simple case of (reverse) engineering

The Department of the Treasury intends to rely on auctions to price the mortgage-related assets for which it will be a purchaser. The US Treasury is and has long been a frequent and massive seller of US government securities at auction. It obviously has extensive experience in implementing auctions in which it stands alone on one side of the market. Is the only difference between the usual Treasury auctions and reverse auctions for mortgage-related assets the side of the market where Treasury stands?

Hardly. Multiple factors distinguish the nature of the auctions that we can expect in this new realm from those routinely used to market new issues of Treasury securities. We highlight some of these key factors below.

Design Considerations for the Reverse Auctions

An auction design is only as successful as its ability to meet its objectives. One objective here will be establishing the true worth of mortgage-based assets. Auctions, with Treasury as the buyer, create a market with transparency and guaranteed liquidity. If successful, the auctions would effectively establish a market value for mortgage-related assets for which there is currently no market. Banks that are now hampered by fear and uncertainty surrounding the value of their holdings could be strengthened either by selling securities at auction or by holding on to these assets, but at marks validated by the auction price. (See our brief, The Paulson Proposal: Economists' Views for further discussion.)

The prices from the auctions might be higher or lower than the marks banks currently have on their books. These prices may or may not reflect the "hold-to-maturity" value that in some statements Fed Chairman Ben S. Bernanke appears to identify as the objective.² Setting up a market through an auction means, in part, letting the competition of bidders and their estimated valuations determine the price.

Nevertheless, how the auction is designed affects the incentive of bidders to compete and the degree of price discovery that results. Some of the design choices that Treasury would make and that deserve special attention are as follows:

• Packages. The broader the definition of the package—what particular assets a seller may offer at a given auction—the greater the quantity that is likely to be put up for sale and the more holders are likely to participate in the bidding. Treasury will have to balance the enhanced price competition and improved price discovery that broad package definitions will elicit against the adverse selection that such definitions will also engender. The adverse selection problem refers to the fact that, when the allowable product is more heterogeneous, relatively inferior product will be 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 for much of it. Adverse selection also spells trouble for institutions holding package-eligible product of a generally superior quality; if their bids reflect the relatively superior quality, those securities may not sell at auction. Yet those entities may have to mark their books to the relatively low auction-clearing price that the generally inferior product sold for.

• Single versus Multiple Rounds. An auction can take place in a single round with each bidder submitting a bid—observable only to the auctioneer—that specifies both price and quantity. The auctioneer can then accept the lowest bids until the quantity it is willing to buy is reached. An auction can also take place over multiple rounds with each bidder getting information over time about what its competitors collectively did in the previous round. In the first round, the auctioneer specifies a price (intended to be high) and bidders state the amount they are willing to sell at that price. If there is excess supply at this initial price—that is, the amount that bidders are collectively willing to sell exceeds the quantity that the auctioneer is willing to buy—the auction proceeds to the next round. The auctioneer gives bidders information about the amount offered at the initial price and specifies a new, lower price for the second round. In the second round, bidders state the amount they are willing to sell at this new, lower price. The process continues, with the auctioneer successively stepping down the price until one is reached at which bidders are willing to offer just the quantity that the auctioneer has pre-committed to purchase.

• Package Order. With a single-round approach, the sequence in which different packages are auctioned has implications for the success of the program. Leading with packages of securities that have severely depressed prices, relatively simple features, and substantial face value owned by critically-situated financial institutions (for example, straight pass-through securities with subprime mortgage collateral), Treasury would stand the best shot of having a successful auction and providing the most relief to asset holders. It would also enhance confidence in the entire process, thereby improving the environment in which it would eventually auction less ideal products. The same general considerations apply to a multiple-round approach, except that package order may not be as critical because the approach lends itself well to auctioning many packages of various mortgage-related assets together. Holders would make a determination, based on the specified prices of packages being auctioned in tandem, as to which packages they wanted to sell and which they would prefer to keep. By being able to respond in successive rounds to relative prices, holders in such auctions would likely make better decisions, further aiding in price discovery.

• Quantity Determination. Treasury has announced a total budget for the purchase of mortgagerelated assets. Whether Treasury uses a single or multiple-round format, it will have to apportion this budget among the different packages in such a way that there is genuine competition for each of them. If Treasury were committed to purchasing the entire quantity offered of a given package, no sane bidder would submit a realistic bid; each could bid high, knowing that Treasury would purchase regardless. The program would not only run out of money fast but cause the government to overpay. To protect against such an outcome, Treasury will have to pre-announce a commitment to purchase only some portion of the potentially available product to ensure that holders will compete to sell. Deciding what the purchase commitment for each package should be, in units, is among the challenges that the auctioneer will face.

Less critical issues that will also have to be decided include the following:

• Whether to permit parties other than Treasury to participate on the buy-side; and
• Whether to permit, in the context of a single-round format, non-competitive bidding (in which would-be sellers commit only to a quantity and agree to sell it at whatever price is decided upon) in addition to competitive bidding (in which would-be sellers specify their minimum price as well as the associated quantity). Both types of bidding are permitted in auctions for Treasury securities.

Along with determining the prices at which auctioned assets would trade and at which institutions continuing to hold those assets would value their positions, auction results just might throw enough sunlight onto the valuation of mortgage-related products to jump-start the stalled over-the-counter markets, sparking them to get back into the business of price discovery. This might be the best of all possible outcomes, as it would conserve public cash once private markets began digesting the product that today no one can sell.

To maximize the prospects for this sort of outcome, it is essential that all auction results be publicly disseminated. The poor transparency that has characterized markets for many mortgage-related assets to date must give way to total transparency (at least with regards to the market-clearing price and quantity traded, if not the price and quantity of individual bids) if the taxpayer and financial markets are to derive all the benefit that they might from the auction program.

This transparency should extend to those products that the government may choose to purchase directly, without the benefit of an auction. Holding an auction may not be feasible if ownership of a distinctive and therefore unbundleable asset is too concentrated. For these non-auctioned assets, financial or statistical analysis may be used to estimate the value. This would involve calibrating pricing models to the newly available market data generated by auctions, 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.

If such an approach is used, it is essential that the best statistical techniques be employed for generating the fair value formulas, and that the formulas themselves be in the public domain. This would enhance transparency, and aid private players in the valuation of holdings still on their books. Indeed, lack of reliable data to calibrate complex pricing models is one of the reasons the private market has had so much difficulty in assessing the value of mortgage-related assets.

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Footnotes

^{1. Here we use the term mortgage-related asset to refer to any asset with mortgage collateral based on the Paulson Plan definition of Troubled Assets as "residential or commercial mortgages and any securities, obligations or other instruments that are based on or related to such mortgages."}

^{2. Fed Chairman Bernanke's reference to "hold-to-maturity prices" likely refers to the discounted present value of the future stream of cash flows (DCF) from the securities at some "normal" or expected future discount rate.}

^{3. These types of auctions are currently used in energy and telecommunication markets.}

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