Now that the TARP bill has passed, Neel Kashkari and his team at the Treasury Department are going to have to very quickly come up with a fair and transparent way of spending $700 billion on a very wide range of complex financial assets. How are they going to do that?

The most detailed public proposal to date comes from Lawrence Ausubel and Peter Cramton at the University of Maryland. In a densely argued 21-page paper, they propose a two-part reverse auction, starting with the more commonly held assets and then moving on to the stuff that is really difficult to value.

The cleverest bit of the Ausubel-Cramton proposal is that it recognizes that banks don't have a single price below which they're unwilling to sell any given asset. Instead, as the price falls, they are still willing to sell some, just not all, of their holdings.

Let's say you're a bank with $100 million, face value, of a subprime-mortgage-backed security. You would love to get that asset off your balance sheet, since the market is worried that if it turns out to be worthless, you might be insolvent. But, at the same time, the bond is still paying out money, and according to your best estimate of its expected future cash flow, if you hold it to maturity you should get a present value of 60 cents on the dollar.

Right now, you can't mark the bond to market, because there is no market for such instruments. The only people remotely interested in buying up subprime-mortgage bonds are the distressed-debt hedge funds, and they're looking to make annualized returns of more than 30 percent.

Enter the Treasury. Kashkari puts you into a virtual room with a handful of other financial institutions that hold that same bond: All of you own $1 billion, face value, of it. He announces at the end of the auction that he's going to buy half of the bonds in the room. And then the reverse auction starts.

The bidding starts high: at, say, 100 cents on the dollar. At that point, you're more than willing to tender all your bonds to be sold—and so is everybody else. So you bid 100 percent of your bonds at 100 cents on the dollar, everybody else does too, and the total quantity of bonds tendered comes to the full $1 billion. Supply ($1 billion) exceeds demand ($500 million). And so the price gets brought down a notch.

At 90 cents on the dollar, everybody's still interested in selling all their bonds. And the same thing happens at 80 cents. But at 70 cents, something interesting happens: Not all the bonds are tendered. You're still happy to sell your full $100 million holding at that point, but when the bids are tallied up, it turns out that only $950 million of bonds have been tendered. Some bank has started paring back its bid.

At 60 cents, you still bid the full $100 million. You think that the bonds are probably worth that much, but you'd much rather have $60 million in nice liquid cash than $100 million face value of bonds you think are probably worth 60 cents on the dollar. Most of your fellow bidders seem to think the same way: The amount tendered at 60 cents on the dollar is $850 million. But it's coming down.

And so the auction moves to 50 cents. Now what do you do? You think that the bonds are worth 60 cents, but the stock market doesn't necessarily believe you, and it would start bidding up your stock price if you said you'd managed to sell off most of your subprime debt at 50 cents on the dollar. On the other hand, you think that the bonds are actually a reasonably good investment at that level. So you tender $80 million of your bonds. That way, you get $40 million in cash—which would certainly be welcome—and you also retain a small $20 million holding in a security which you think will bring in a good 60 cents on the dollar if you hold it to maturity. The holding is small enough that the market no longer worries about your solvency, and everybody comes away happy.

At 50 cents, however, there's still $650 million of bonds tendered. And so the price comes down again, to 40 cents. At that point, you really don't want to sell—you think that there's a lot of upside in the security at that level. But you also need the liquidity, and you want to be able to demonstrate that you've managed to get at least some of your subprime assets off your balance sheet. So you offer to sell Treasury $40 million of your bonds at 40 cents on the dollar. That brings you $16 million in useful cash and reduces your subprime exposure by a significant amount. You don't like it, but it's better than selling nothing at all and ending up where you started.

At 40 cents, the total number of bonds tendered is the magic $500 million, and the auction clears. Some banks will have ended up tendering all of their bonds at that level—maybe they're more pessimistic about that security's intrinsic value, or maybe they just really need the money or to get the bonds off their balance sheet. In any event, there's now a public and transparent price for the bonds: 40 cents. That can be used to mark all the bonds that were not tendered to market, rather than guessing wildly on the basis of credit-default swap prices or some model.

This is the basis of the Ausubel-Cramton approach. It's quite elegant, in that clearly solvent banks will tend to drop out of the bidding quite early, once it reaches their own estimation of the value of the securities, while more troubled banks will end up selling bonds to Treasury at discount prices. Taxpayers are protected, and although the more troubled banks will end up with more government funds, they'll still be losing out on an intrinsic-value basis.

Once marks are set for a wide range of relatively widely held subprime and other mortgage securities, the Ausubel and Cramton proposal foresees a second round of auctions for less liquid assets, which involves using the prices generated in the first round as inputs to help get at least a rough idea of how much the more complex instruments might be worth. Conceivably, there could even be a third round along similar lines. Eventually, the $700 billion is spent; the government ends up with a large number of mortgage-backed assets, as well as various chunks of bank equity that were extracted along the way from the largest participants in the program.

There is a problem with this model, however.

There's an evolving consensus that we're no longer seeing a liquidity crisis, but rather a solvency crisis. Banks don't just lack cash; they're fundamentally insolvent, with their assets (things like mortgage-backed bonds) worth less than their liabilities (including their deposits). Improving liquidity, through rate cuts or swap lines or discount windows or buying unsecured commercial paper or any other means, can no longer get us out of our present hole. What we need is a recapitalization of the banking system.

The thinking behind the TARP is that the solvency crisis is a direct result of the liquidity crisis. (Remember that it was conceived before the most recent downward lurches in global markets.) Why are banks insolvent? Because they're sitting on worthless assets. Why are the banks' assets worthless? Because there's no bid for them. So create a $700 billion bid for those assets, get a two-way market in them moving again—and presto—the solvency disappears.

There are more than a few problems with this line of thinking. Firstly, the logic is a bit screwy: Even if insolvency was a direct result of illiquidity, there's no guarantee that you can simply run the movie backward and hope that restored liquidity will result in solvency.

What's more, just because the government is willing to spend 40 cents on the dollar for a mortgage-backed bond at the end of a descending clock auction doesn't mean anybody else is: The market won't necessarily really believe those bonds are worth 40 cents. Sure, the banks will use that mark when officially valuing their balance sheet. But investors in the banks' stocks and bonds might well still be skeptical and mark those instruments down accordingly.

In order for people to really start believing in the price, you need a two-way market, with multiple sellers and buyers at or around the 40-cent level. If Treasury remains the only buyer in town, that's not going to happen.

But more important, what if the banks really are insolvent at that level of 40 cents on the dollar? The price revealed by the TARP would make crystal clear what many investors already suspect—that the banks are worthless. Far from rescuing the market from crisis, if the TARP auctions cleared at a very low level, they could actually precipitate it.

In that event, Treasury would have to try a very different tack. They could use the TARP, still, and try deliberately overpaying for bank assets: Instead of paying 40 cents, they'd bid 80 cents. That would help to recapitalize the banking system, since the banks would be getting the fair-value 40 cents for their toxic loans, plus another 40 cents on top, which they could use to stay afloat.

Under that kind of system, Treasury would presumably be much more aggressive in terms of the amount of equity that banks would have to give them in order to participate in the auction. Or maybe the auction would be a decreasing-equity auction, rather than a decreasing-price auction: Treasury would set the bid at 80 cents, and then see if there were any bidders willing to hit that bid and give up 10 basis points of equity per $10 million of bonds sold. If there weren't, they would bring the level down to 9 basis points, and so on.

The big problem with any kind of recapitalization auction, however, where the Treasury deliberately pays above the market rate for toxic securities, is that it defeats one of the main purposes of the TARP: to set a transparent mark for illiquid bonds. If everybody knows that Treasury is overpaying, then no one will believe for a minute that the securities still left on banks' books are worth nearly that much—and the market in such securities will remain frozen.

It's probably much simpler and easier to take the route chosen by Gordon Brown, the British prime minister: Ignore the asset side of banks' balance sheets altogether, and just start writing multibillion-dollar checks to big entities in the financial system in return for shares and/or preferred stock.

That's essentially what the U.S. government did with American International Group; it's a bit weird that it chose a very different route for the banking system as a whole.