BBC BLOGS - Newsnight: Paul Mason
« Previous | Main | Next »

Can an auction find the longterm price for financial junk?

Post categories:

Paul Mason | 19:02 UK time, Wednesday, 24 September 2008

Okay I am going to try to address the question of "hold-to-maturity" prices for America's bad mortgage debt, on which the world-saving Paulson Plan revolves.

The principle behind it is painful but laudable: to reward the banks for their reckless risk taking in order to avoid crashing the real economy, by spending $700bn on financial junk. The issue is can it work? I've been gaming it out in my head and this is how far I have got.

First let's define the dilemma: there is a large amount of bad debt in the system - let's say $2 trillion dollars' worth (Nouriel Roubini's estimate on Newsnight 16 Sept 2008).

If they had to sell a portion of that debt now? Well suppose Bank A says, I've got $2m of bad mortgages I want to get rid of, what will Bank Z pay? Right now Bank Z has no money. It has switched its cellphone to "reject all calls" and is watching a DVD box set of The Wire with a case of Sierra Nevada in its luxury loft apartment with the blinds drawn. Banks B to Y likewise. Nobody is buying....

So the value of Bank A's $2m is, on a "mark to market" basis, is anything from zero to the notional amount the Bank A decides if it has to do its accounts today (the higher the figure, the louder the laughter of impartial market commentators - Ben Bernanke acknowledged this yesterday: "nobody trusts the banks' own valuations").

This price, between zero and "duh" is what Bernanke calls "the firesale price". And he pleads, not unreasonably, that if the banking sector is forced to sell at firesale prices, the whole system will become mired in losses and seize up even further; and that firesale prices, like house repossessions, cause an unnecessary downward spiral.

So instead there is the "hold-to-maturity" price. If I have a 20 year mortgage for $100k, then the "hold to maturity" value of that $100k mortgage is the what it will be worth to Bank A over the next 20 years. That has to be calculated for each mortgage: it's not just the 100k plus the compound interest. The risk of default has to be factored in as well, and the loan to value percentage. Today "hold to maturity" is going to be more than any "mark to market" price estimated by either the bank or the government. But what is the price?

Bernanke's suggestion is to design an auction to find out. The market, according to theory, should determine its true "hold-to-maturity" price. It would be a reverse auction, with Bank A competing with Banks B to Z to unload its bad debts. But, as Forbes reports...

"neither Bernanke nor Treasury Secretary Henry Paulson offered any details of exactly how the auction process would work. Paulson told the committee that it is not possible for he or the senators to design the process, and said it would be left to 'experts'."

OK here is a quote from a dummies' guide to tactics in reverse auctions, aimed at companies participating in procurement bids. Here are some possible tactics in a reverse auction according to the guide:

  • To come in second (or third) while keeping the price high,
  • To come in second while driving the price down to unprofitable levels for the winner,
  • To bid down to a certain price and stop, regardless of winning position and potential profitability,
  • To keep the price high even if you would lose the auction at a profitable price,
  • To abstain from participation in the auction.

I will summarize this. In a reverse auction many of your options include shafting your rivals by losing the bid. Or shaping the next auction while losing the bid. Not included, but very relevant, is collusion to mess up the entire auction. There is a whole subset of game theory devoted to who wins in reverse auctions and, I am sorry to say, it is not always the buyer. Experience of online reverse auctions suggests any saving to the buyer (ie to Bernanke/Paulson) is usually only 10-20% of the market price.

So problem number one is that you have to assume the banks do not game the auction. May I suggest that, on current form, that is not a 100% safe assumption.

Problem number two is bigger. Is the Fed/Treasury trying to get the best possible deal for the taxpayer in these auctions or not? Is it trying to do what GE or Ford does with its suppliers, by getting them to compete so as to drive their prices down? If so, it may be my stupid brain, trained as it is only in Baroque counterpoint and media law, but it seems to defeat the object.

If the Fed/Treasury are trying to get the best possible deal for the taxpayer, then they should buy at firesale prices. They have already said this will damage the economy systemically, and that the banking industry needs to be able to be rewarded in the bailout process.

So I contend that they will have to design the reverse auction to prevent it achieving the true "hold-to-maturity" value.

Here's why: Suppose now I replace Bank A with a recently acquired part of Lehman Brothers (call it Ex-Lehman), and Bank Z with AIG.

Last week Lehman and AIG were valuing their distressed Alt-A debt at 39 cents on the dollar and 67 cents on the dollar respectively. Suppose they log on to the reverse auction site and say, "hey Bernanke we will sell Paul Mason's $100k mortgage at 39c" (Ex-Lehman) "or 67c" (AIG). Bernanke's gavel hits the wood so fast it makes even the sleepiest Senator wake up:

"Bang! Sold to Ex-Lehman. Here is $39,000 dollars, gimme the documents on that mansion - by the way, AIG, you wanna sell at 39? Going, going?"

For now only AIG has lost, but they are feeling sore. But...

Instead Bernanke waits, gavel poised, using his "For Dummies" guide to reverse auctioneering, until one player undercuts the other. Let's assume the book value of the mortgage really is (39/100) $39,000. With reverse auctioneering, Bernanke should be able to strip 20% off that, says the theory: so now both Ex-Lehman and AIG have to dump my mortgage at, say $35,000.

"Boo, hoo", says one or both. "We're not playing anymore. You're hurting us too hard here. We are gonna stop lending to each other again like we did in August 07 and September 08".

At this point, the rationale falls apart. The whole rationale for rewarding banks with an above-market price is to keep the system working. And it's a laudable rationale. But, call me stoopid, I cannot see how a reverse auction works for this unless it is specifically designed not to depress the price of the toxic debt.

Therefore I propose a reverse auction cannot find the true hold-to-maturity value of the morgage, no matter which expert designs it, because of this moral hazard injected into the design of the auction.

Basically, as Henry Blodget points out (in a post which also contains some realtime commentary on the Paulson/Bernanke testimony), the whole rationale for not forcing a firesale is that they have to involve the banks in sorting out the system. It is a market solution to a market-created problem and the "reverse auction" must have seemed like an elegant solution.

It is not just me who thinks there are problems with it. Here's Krugman, Council On Foreign Relations, and Buiter.

The emerging alternative, in the Dodd Plan and from numerous commentators, both on the re-regulationist and freemarket side of the debate, is for the government to enforce a firesale, enforce a massive loss, then force the banks to raise new capital. This is guaranteed to deliver returns to the taxpayer at the end of the process, just as did RTC and HOLC designed in the 80s and 30s respectively. I am not advocating either course of action. I am simply trying to get my head around them, Of course the problem with the latter course is that one or more banks goes bust and the USA ends up, like with the Nordic banking crisis, owning much of the sector.

If I am wrong, kick my head in on the Comments. If you are a reverse auction expert, feel free to submit your design to me here and I will see if the BBC competition guidelines allow me to offer some kind of Blue Peter Badge.


  • Comment number 1.

    The way of Homer is to describe things by asking 'what is it like'. Then through mean analogies one can discover unknown terms from the known.

    ie a:b :: c:d
    [e.g shepherd : sheep :: ruler : subjects].

    So what is the financial situation like? Is it like going into Iraq 'to bring democracy'? A land run by a despot [greed] with no regard to law [unregulated markets]?


    despot : law :: greed :: unregulated markets.

    if that is true then all the things that happened in iraq ie insurgency, looting, militias, civil war, ied's, abu gharaib, etc will have their equivalent in trying to deal with this 'land' of unregulated markets.

    So Fed wants lots of 'troops' [money] to dominate the ground. Yet we hear in the same way 'you can do it with less' from politicians. He wants a surge others want the 'local iraqis' [banks] to do it etc.

    In the same way as any policy in iraq is messy so any policy in this 'financial iraq' is going to be messy. Any policy [reverse auctions, buyouts, buybacks etc] is going to be full of holes.

    Today, in iraq, all the high morals are out the window e.g they are paying sunni insurgents to fight. talking to shia militias, not really worried about democracy etc. Which is where, after perhaps the same 'pain of failure' it will end up in the 'financial iraq'.

    So at some point the politicians will reach the stage when they say so what if 'bankers' make money, so what if there is lots of debt, so what if it takes years. The point is for it to stop ? A whatever it takes policy?

  • Comment number 2.

    Paul, Paul, As someone who doesn't use eBay and who therefore doesn't even understand their auctions, I am struggling a bit here and you will need to give us a few minutes to catch up...

    I think your example of a reverse auction would have made more sense to us thickies if you had started with AIG 'bidding' 67 cents on the dollar, thinking that was the price needed to keep the financial system healthy, and then being 'outbid' [downbid?] by ex-Lehman down to 39 cents..

    Then, crossing the bridge of what happens after the 39 cents is reached..

    But I agree with you, that this 'reverse auction' seems unlikely to give the required outcome.

    Let us for the moment just stick with the 2 figures above rather than stray beyond them. AIG 'pitches' [or accepts] that 67 cents is a value below which it will NOT bid, as they take a circumspect view that if all the banks bid below that level, there will be continued risk and danger of the financial system crumbling.

    So IF everyone else took the same holistic, sensible view, all would be well - they would all 'bid' 67 cents on the dollar, all get paid out, and the system would live to fight another day.

    But of course that wouldn't happen. Let us, for the sake of example, assume that no one bids below 39 cents BUT that those bidding at 39 cents know that 'across-the-board' that amount of money just would not quite be enough to 'solve' the problem.

    They will still end up bidding down to 39c, because they think that is better than nothing, and that despite the other banks possibly suffering because the total sum is at the 'margins of un/acceptability', they will 'look after number one', and just hope for an upturn, and that they will be in the 'top half' that makes the cut for survival..

    The answer to this problem may have nowt to do with 'game theory' and more to do with Nye Bevan when he started the NHS.

    "I stuffed their mouths with gold.." Who now would begrudge that as a solution to allow the inclusion of consultants in the NHS, with all the attendant benefits, after 50 years of hindsight and many lives saved ?? There's no gain without pain...

  • Comment number 3.


    After taking a leaf out of Herod's book, the Emperor was never again subject to claims of nakedness in piping voices. He strutted about for years in his New Clothes, until they were quite old. Then a downturn in the economy found him short of cash, so he visited the pawn broker with the - now threadbare - suit over his arm.
    "Oo dun that stichin' then" said the broker, disdainfully. Can't give yer nuffin' but tell yer wot I'll do."
    A crafty gleam danced in his eye.
    As many clients never return for their goods, and a sizeable proportion of items pawned remain unsold, he was stuck with a load of junk; he would have to pay to have it taken away, but now saw how to clear it for free.
    He drew the gullible Emperor's gaze to the pile and said: "Gi' yer that lot in exchange; fetch good money that stuff."
    Soon after, as a result of climate change, the Emperor died of hypothermia.
    The moral of this tale is: when living inside a lie, in free fall, gravity is undetectable.

  • Comment number 4.

    Yikes ! I had no idea that John McCain had 'suspended' his campaign when I wrote my first reply. This is getting serious, unless it is just a 'play' by McCain to look statesmanlike, and get back in the lead for the White House.

    I guess there will not be a debate on Friday, which can't do McCain any harm - or will Obama turn up without him ?

  • Comment number 5.

    problem number 3:

    as far as i am aware, mortgage debt is not very "fungible". many of the instruments being sold to the treasury will be highly specific. the underlying mortgages are classified by banks according to risk categories, but who is to say that different banks' classification methodologies have been equally rigorous?

    many of the assets being sold will be highly structured investments (rmbs, cdo tranches, etc). each such structured transaction is typically small, illiquid and very hard to value without owning a proprietary credit correlation pricing model (known in the biz as the "black box" as you literally need a phd in maths to understand what is going on inside it - do we laugh or cry?).

    i don't claim to know the rmbs market that well - i worked in a very different area of banking - but imo it is very tricky to have a proper formalised auction for this debt. either you do it instrument by instrument (which would be incredibly inefficient and would involve minimal numbers of sellers each time), or you go for bigger auctions of broad categories of debt (in which case you have serious quality control issues).

    i think the treasury would probably go for a fudge. they will set some minimum qualifying criteria (especially in terms of complexity and outstanding notional amount). they will then pick a broad category of debt, and invite all banks to offer anything they hold that meets the criteria, along with an offer price. then they will pick out whatever they like (quality as well as price criteria being applied) based on a flexible overall budget for that particular debt category.

    if i am right, the complexity of the debt will make collusion among the sellers very difficult. to collude you need clarity about what exactly you are colluding over. on the other hand, the general relief in the market should reduce the "winner's curse" risk that the winning seller does so because he mistakenly bids at an unprofitable level. as market prices recover, it will put a more realistic floor on auction prices.

  • Comment number 6.

    I know nothing of reverse auctions but have considerable experience of 'real' ones. There were basically two reasons why a piece of real estate would be auctioned. One was the obvious one - when the vendor had a legal obligation to demonstrate that the top price had been achieved. Far more commonly, however, it was in circumstances in which a property was in some way unique and there was no scientifically reliable way of assessing the market value. Much the same has been shown to be the case in the fine art market.

    No vendor goes to auction without having the slightest idea what the property is going to fetch so, even if it is no more than an educated guess, we provide the vendor with a guide price. From this, one calculates a price below which we will not sell in the room. This then becomes the reserve price. If the bids in the room are too low, a skilled auctioneer will 'bounce them off the wall' until the reserve has been achieved. Providing there is a bona fide bidder in the room, you establish a market price even if you do not sell and you can then sell by private treaty later.

    We had to learn all sorts of valuation techniques at uni but the bottom line which our lecturer never tired of telling us was that the only true value of anything is what someone is willing to pay your for it.

    Call me naive but if it works the right way round, why would it not work in reverse? Can they not work out a mechanism whereby they arrive at a reserve - or more correctly two reserves. There will be a figure below which there is no benefit to the bank to offload and a figure above which the taxpayer cannot possibly benefit in the long term. Taking your example above, you have established that Lehmans had proposed 39 cents on the dollar as against 67 cents from AIG. So, purely as an example, if all bidding is limited to a margin of 35 to 70% of "hold-to maturity", there is not only a reasonable chance that an acceptable norm will be established but, in the event that there is 'dodgy' bidding or collusion to fix the price, it will at least be restricted to acceptable bounds.

    If goalposts are not set, you can be sure someone sooner or later will cry foul and before you know it, the Feds will be all over the case muttering fraud and spewing out subpoenas all over the place.

    I stress I am not an expert but it does seem to me that putting clear rules in place from the outset will go some way towards giving it an air of respectability.

  • Comment number 7.


    Very interesting. Would the alternative of letting the banks suffer losses and leaving them to raise new capital really work? Seems to me that while this happens the crisis will continue, the lack of liquidity will continue and there will be serious effects on the real economy - my business is in the process of seeking increased working capital facilities at the moment and it is not easy.

    Where will the banks raise new capital - from Asian banks, Arab sovereign wealth funds, etc? Will they be willing to do so?

  • Comment number 8.

    To bring the problem home to ourselves, we have all been avidly awaiting salvation to be brought to us by those eminent US politicians at the heart of the US financial systems. Whatever the mechanisms, the $700 billion about to be offered was just the tangible evidence that our future lay in their safe hands. Confidence must be the key ingredient of any solution.

    We must have been as mad as them!

    What indeed is needed is stability; with the global economy in safe hands. As reported in Last night's Newsnight, what we have inevitably now been promised is the usual politicking, cats fighting in a sack, from politicians whose only objective is to win the prize of the Presidency; and to hell with the rest of us. Who, in their right mind, these days trusts any such politician. They are, indeed, the last people we would, or should, entrust our economic futures to; and billions around the world know that.

    The icing on the cake was added by the worst President in US history screaming ‘We are doomed…we are doomed”! We probably now are, and the population of the US almost certainly is.

    The only saving grace is that the safety measures invented by Keynes are still embedded in our own government systems; though no longer in those of the US – FDR is long forgotten there.

    Thus, for instance, Keynes stressed the importance of automatic stabilisers; in particular, social payments to the unemployed – including free health services and related sickness benefits as well as direct unemployment benefits. These would ensure first that the individuals would not suffer too much; but they also meant that the economy did not totally lose the purchasing power of these people.

    Above all, though, large parts of the economy were brought under public control; in the form of expanded services and nationalisation, but also as the subjects of regulation.

    Thus, in Europe as a whole, socialism is now to be found at the heart of government. It has often been said that socialism saved capitalism from Marxism, but it may now be that socialism will now save us – but possibly not the US – from capitalism. The socialist web which, rather than Tory feudalism, now holds our society together may be more robust than that which obtained in the 1930s. Let us hope so.

  • Comment number 9.

    very good piece by soros in the ft today


    - obama's proposed amendments to paulson's deal (help for troubled mortgage borrowers / bipartisan oversight of the rescue plan / equity role for the taxpayer in the banks being helped / penalties for management) are all justified

    - the buyback will be fraught by an information gap (banks know how cr ap their assets are, whereas the tsy does not), which means the tsy is likely to get stuffed with all the most toxic cr ap (same point i made in post 5 about quality control)

    - he recommends the tsy spends the 700bn buying equity in the banks instead, as this will do much more to deleverage them, and will leave the cr ap assets with the people who know what they are really worth

    - legislation needed to strengthen homeowners in default to renegotiate their mortgages instead of being pushed straight into foreclosure (something banks might actually welcome as everyone recognises it is the rush by cash-strapped banks to foreclose that is one of the main factors deepening the housing/banking crisis)

    imo soros has called this crisis right all the way through (e.g. he was adamant when the market had its post-bear stearns relief bounce 6 months ago that there was going to be another more intense crisis to come).

    i do think his criticisms of paulson in the same article are unfair though. in a bbc interview early last week he pointedly side-stepped a question about whether letting lehman go under was a mistake, basically saying we will know with hindsight. now he has that hindsight, he questions paulson's judgment.

  • Comment number 10.

    btw i think buiter's plan in your link makes no sense at all.

    he basically says that existing lenders to banks should have their loans forcibly converted into equity.

    problem 1: if the government proposed doing this, it would take some time to implement. in the meantime banks would completely lose the ability to borrow, as nobody would want to make loans that will be turned into worthless equity

    problem 2: who are the lenders that you forcibly convert? deposit takers (presumably not, unless you want to start a run on the bank)? the fed/boe, which are the biggest lenders to these institutions (no)? presumably we are only talking about longer term loans (i.e. not overbank interbank loans), but where do you draw the line? 12 month maturity?

    problem 3: the effect on individual banks will be very assymmetric, as it will depend on their existing capital structure (e.g. % of deposits). in any case, aren't the banks that are really in trouble the ones that have been relying on too much short-term financing? these problem banks are now reliant on the fed/boe provide overnight loans. but buiter's proposal would penalise most those banks that have sensible long-term financing, and least those banks that are on the monetary authorities' liquidity drip.

  • Comment number 11.

    the dodds plan looks very good. but it says absolutely nothing about how the price at which assets are purchased will be determined (which is probably a good thing imo).

  • Comment number 12.

    Fascinating read! I'm afraid that my grasp of economics is very simple and so I am not qualified to administer a kicking to anyone! But my logic says that both options are fundamentally flawed in that all the risk is borne out by the taxpayer in the reverse auction plan (banks can exploit this for their own motives) and all the risk is borne by the banks in the fire sale plan (banks could go to the wall bringing the whole system down with them).

    However, I have come up with another theory which shares the risk between the taxpayer and the banks and reduces the downsides to both plans aired in this article. Hopefully, this will persuade Paul to award me a blue peter badge!!

    Why not make a link between how far a bank is prepared to mark down its toxic assets to the equity it is prepared to give away to guarantee its existence? For example, if Bank A is confident enough to suggest that it can survive having marked down these assets to only 36c in the dollar, then the govt should guarantee these toxic assets for say 36% equity of the bank. If Bank B isnt so confident and can only mark down to say 90c in the dollar, then the govt should take up to 90% of the equity for a full guarantee. I would have thought that a system along these lines would reduce the downsides to both parties.

    Maybe I'm missing the point completely, but I will gladly stand corrected!

  • Comment number 13.

    I have just realised that I have made the same mistake as the rest of the commentators; I have been largely talking about the economy, where the crisis is in the financial markets – and the two are not the same. In 1929 they largely were; with assets mainly raised through the markets. By 1980, however, the large corporations in Europe raised their own capital internally – without recourse to the markets. To a large extent they still do; so they are no longer so dependent on the markets and may be relatively less affected than any crash on Wall Street.

    The exception to this in the UK was that Margaret Thatcher’s ‘Big Bang’ deregulation eventually led the banks from their role as just dealers – albeit in the largest casino of all – to be players. The result, where they put their own assets at risk, is now that they account, in their own right, for a quarter of the UK economy. The final extreme of UK deregulation has been the emergence of the private equity funds, which are the ultimate junk bonds but which own some major names in industry – which may be at risk as their capital melts away. Accordingly, in terms of its core economy the UK is more exposed to the financial crisis than the rest of Europe; but, with only 25% at risk, far less so than the US.


More from this blog...

Latest contributors

BBC © 2014 The BBC is not responsible for the content of external sites. Read more.

This page is best viewed in an up-to-date web browser with style sheets (CSS) enabled. While you will be able to view the content of this page in your current browser, you will not be able to get the full visual experience. Please consider upgrading your browser software or enabling style sheets (CSS) if you are able to do so.