Thursday, September 25, 2008

Economists Look at Ways to Structure Auctions

(WSJ) 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.

[In the case of the TARP,] 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.

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