(Information Processing) How is Treasury going to buy up CDOs and other mortgage backed securities? What is the price discovery mechanism? I've heard discussion about a reverse auction process, in which the government offers a price and owners of the assets decide whether to accept the bid.
But this makes the problem sound much easier than it is. There are no simple or uniform categories for these securities -- no two are exactly alike. I imagine Treasury is going to have to do a lot of homework before each auction, perhaps aided by some sophisticated professionals (Bill Gross of PIMCO recently offered his teams' services). Data on each security is available from ratings agencies like S&P and Moody's (presumably one would supplement this with additional information). After some initial analysis Treasury could set an conservative upper bound (i.e., using pessimistic estimates of future default rates and home prices) on the value of each security in units of the original face value (this one is worth less than 25 cents on the dollar, this is one, 45 cents, etc.). Then, they can publish a list of securities in a particular value category (without, of course, giving out the actual value upper bound) and conduct a reverse auction covering all the assets on the list.
If they can get the assets below the value upper bound, great for taxpayers like you and me. If banks (hedge funds? pension funds? foreign banks? who is really holding all this stuff?) won't sell at prices below the bound, and the auction heads above that price, Treasury should start demanding warrants or equity stakes on some sliding scale. In other words, the bid keeps getting higher, but at some point Treasury starts asking for not only the particular CDO but some additional warrants or stock. (This could also be done on a sliding scale from the beginning of the auction -- Treasury gets an additional x percent of the bid in warrants, where x increases with price.) The equity stake is compensation for the government for having to having to overpay for the security. At this point there is an (expected) flow of funds from taxpayers to recapitalize the seller, but at least we are getting equity in return. It is claimed that there is a range of values (roughly 20 percent of current market prices) over which the seller would be getting more at auction than the market is currently offering, but the government is still getting a good deal on the asset (expects to make money even under conservative assumptions).
Will it work? Who knows, but at least it may restore some confidence to credit markets.