The Bailout's Auction Design: How About a Market?

Ben Bernanke and Hank Paulson spent a bit of time yesterday talking, in pretty vague terms, about auction design and how important it would be to any eventual bailout mechanism. The idea is pretty simple: assume argumento that "fundamental" prices for banks' mortgage-backed securities are higher than present "fire sale" prices. Then if a transparent auction can persuade the market as a whole that the securities are worth much more than it feared, much of the crisis would simply go away.

Here's how Bernanke put it:

Just as when you sell a painting at Sotheby's, nobody knows what its worth until the auction is over. Then people know what its worth. I think the same thing here.

If the auction goes well -- and there's a non-zero probability that it will, especially when the US Treasury is in the market with $700 billion to spend -- then it could assuage fears about the valuation of hundreds of billions of dollars of super-senior bank assets.

The practical aspects of this idea, however, have been left very much up in the air. So it's welcome that Gilad Livne and Alistair Milne have come up with a much more specific idea: a central credit exchange.

They explain that credit markets have seized up because banks think their assets are worth much more than anybody's willing to pay for them. So, they say, get a consortium of banks to put up for sale some small percentage of their assets, and start bidding on them in this market.

Under a best-case scenario, the existence of the exchange alone could have a enormous upside with basically zero downside:

Such a trading venue, while it will take some time to establish, has the potential to add about $300bn to the net worth of the global banking sector, without cost to either taxpayers or investors.

I'm glad that we're moving, here, from vague generalities to real ideas. This one has no certainty of working, but the great thing about it is that it has very little chance of doing real harm, especially if the bailout fund is involved in the scheme. Auctions are hard things to design; markets are basically very efficient real-time auctions. If a market for such unique assets as CDOs could really be designed, that could be a great step forward in terms of transparency and liquidity.