Sunday, September 28, 2008

Why a Reverse Auction Won’t Work

Exhausted Congressional leaders, after hours of testy negotiating, reached a deal on the great Wall Street bailout. The devil, of course, is in the details. But from what I gather, the central feature of the plan was preserved: the Treasury will buy up to $700 billion of bad assets backed by U.S. home mortgages.

The latest version of the plan also requires financial firms to give the Treasury warrants in return for getting rescued. A warrant allows you to buy shares in a company at a fixed price. So if, say, Invest-orama receives a bailout, and then its shares soar from $20 to $40, the government can profit. That’s something at least.

From where I sit though, the troubling problem remains how much to pay for this toxic waste (see my previous blog entry). Warrants don’t eliminate that issue; they just add a complicating dimension to it. A financial firm that might’ve sold a deteriorating bond at 55 cents on the dollar might revise the price upward to 60 cents to account for the warrants.

But how to arrive at that original price, whether it’s 55, 40 or 30 cents on the dollar? There’s a huge spread between what owners of these assets think their investments are worth and what a buyer in the current jittery markets will pay. Fed Chairman Ben Bernanke has floated the idea of a reverse auction. Whereas a normal auction has one seller and many buyers, a reverse auction has one buyer and many sellers.

Reverse auctions make sense for buyer-designed products (a buyer might issue, say, detailed specifications on a car door latch that it wants manufacturers to bid on the right to make) and commodities. If you want to buy 100 barrels of road salt, in a reverse auction there could be 18 sellers that submit continuous bids, each lower than the one before, until reaching the best price.

The problem is that Wall Street isn’t trying to unload barrels of road salt. On the contrary, the toxic financial products held by these firms are complex, hard to value, and often unique. Each mortgage-backed bond is yoked to a specific batch of U.S. homes, and each home in turn has its own history of timely or late payments, its own odds of foreclosure. So Bond A, offered at 40 cents on the dollar, may turn out to be a much riskier (and worse) deal than Bond B at 60 cents.

Also a reverse auction is too scattershot, spraying money through the system without regard to who receives it or how much they get. In a financial crisis, we need a more sophisticated and aggressive approach. Some companies will die; they deserve to. The government should review balance sheets, let insolvent firms perish and pump funds into those that can be rehabilitated (or need to be, for the stability of the system).

I would NOT vote for this bailout plan. A better idea waits in the wings. Check out what the economist Nouriel Roubini proposes; it’s a much smarter way to go and better protects taxpayer funds.

The financial system won’t suddenly implode on Monday without a bailout package. It’s under stress, but we still have some time. Why not do this right?