Auction Basics: Background for Assessing Proposed Treasury Purchases of Mortgage-Backed Securities

The CRS recently released Auction Basics: Background for Assessing Proposed Treasury Purchases of Mortgage-Backed Securities (October 14, 2008)(OpenCRS). From the summary:

To address the turmoil in financial markets, the Emergency Economic Stabilization Act (EESA; H.R. 1424, P.L. 110-343), enacted on October 3, 2008, authorizes purchases of "troubled assets." The act passed the Senate on October 1, 2008, passed the House on October 3, 2008, and was signed into law the same day. The Administration proposed using reverse Dutch auctions to purchase troubled assets -- primarily mortgage-related securities from financial institutions. In reverse Dutch auctions, a buyer purchases multiple objects from private parties at a price set by the last accepted bid. The government has used reverse auctions since the Revolutionary War.

Designing efficient reverse Dutch auctions may present some tradeoffs between enhancing competition among bidders and overpaying for assets relative to their quality. Careful auction design, however, can help minimize these problems. Auctions are especially useful for selling assets whose value to potential owners is unknown to the seller. Reverse auctions are useful when a buyer does not know what value sellers place on assets. Auction results could clarify the market value of troubled assets. The price discovery properties of auctions could stimulate trading by reducing private traders' uncertainty about the value of troubled assets. A reverse auction program essentially swaps Treasury securities for troubled mortgage-backed securities.

If Treasury securities are exchanged for troubled assets at prices close to those assets' current market prices, costs to the taxpayer would be minimized. Financial institutions, however, may gain some liquidity, but might not receive much additional capital. Some economists have argued that other means of injecting capital into the financial sector, such as purchases of preferred stock or capital injections balanced by equity warrants (i.e., options to claim an equity stake), might be a better strategy.

Since passage of EESA, the U.S. Treasury has been working to design methods to inject capital into firms and restore market liquidity. The heterogeneity of troubled assets may present challenges to the Treasury auction program. The reverse Dutch auctions would need to be adapted to buy highly diverse and relatively small-volume securities, in a way that minimizes risks of trading manipulation. Reverse Dutch auctions may be vulnerable to adverse selection, meaning that the average credit quality of submitted assets of a given type may be systematically worse than the average credit quality of all assets of that type.

Auction mechanisms might be designed that could mitigate these problems. Recent academic research in auction theory and in experimental economics has examined how various types of auctions work. Auctions may capture higher revenues for governments and can often allocate scarce resources more efficiently than traditional methods of selling or purchasing. Different policy problems, however, call for different types of auctions. Government economists involved in designing reverse auctions to buy troubled assets have drawn upon academic research and internal Treasury research.

[JH]