The Bush administration sent a proposal for the unprecedented bailout to U.S. lawmakers this weekend to tackle the nation's worst financial disaster since the Great Depression.
The government has a tightrope to walk. It wants to buy assets cheaply enough to make sure taxpayers don't lose too much money, and perhaps even make money when markets stabilize, but at a high enough price to avoid hurting banks any more than necessary.
An auction process would make sense, because it would allow the banks with the best information about the securities to determine the price, said Peter Cramton, a professor of economics at University of Maryland who has set up auctions for governments globally. But competition among sellers would prevent banks from setting too high a price.
Cramton believes a "reverse descending clock auction" is ideal in this situation. Through that process, the government would announce a target for how much of a particular security it is seeking to buy in dollar terms, and an initial buying price.
Sellers would indicate how much they would sell at that initial price, and if there were too many sellers, the government would lower its price until the amount of securities that banks are willing to sell equals the government's target.
"I've conducted dozens of these auctions for assets valued at billions of dollars, and they are extremely effective in determining a competitive market price," Cramton said.
But there are drawbacks. A reverse descending clock auction would work best for securities held by multiple banks, but not as well for securities that are owned by just one or two institutions, Cramton said.
In that case, there would be less competition to sell. The price might be higher than the assets end up being worth, costing the government money.
Banks believe there are differences among their securities. For example, Merrill Lynch & Co Inc (MER.N: Quote, Profile, Research, Stock Buzz) agreed in July to sell $30.6 billion of repackaged debt known as collateralized debt obligations at 22 cents on the dollar. That is well below where Citigroup Inc (C.N: Quote, Profile, Research, Stock Buzz) marked its securities in the second quarter. If Citi embraced Merrill's pricing levels, the bank could have another $7 billion of charges in the third quarter, Deutsche Bank analyst Mike Mayo estimated this summer.
And if auctions do attract a large number of sellers, competition may push prices down to low levels, forcing other banks to write down the value of their mortgage bonds to those prices.
Those write-downs could force banks to seek new capital, which has difficult to raise in the current environment. If raising capital proves too hard, more major banks could fail or get pushed into shotgun marriages, potentially worsening the financial crisis.
"Recognition (of losses) brings capital shortfalls into the open," wrote Jan Hatzius, an economist at Goldman Sachs, in a note on Saturday.
Also worrisome is the speed at which this auction will be set up, because of the complexity of the securities being sold.
"Nothing on this scale has ever been done before," said Eric Maskin, professor at the School of Social Science at the Institute for Advanced Study, who won a 2007 Nobel Prize for economics and has conducted extensive research into auctions.
But even with these concerns, such an auction can likely be done, and there may not be another choice, Maskin said.
Banks must purge bad assets before they can raise the new capital they need, or find other institutions willing to buy them. After the failure of Lehman Brothers Holdings Inc (LEHMQ.PK: Quote, Profile, Research, Stock Buzz) last week, investors have grown increasingly suspicious of U.S. financial institutions.
"You might not like the consequences of an auction, but it seems like the least of all evils," said Lawrence Ausubel, a professor of economics at University of Maryland.