Three months and three-hundred billion dollars of bank rescue efforts have gotten bogged down in a widespread and irrational fear among policymakers: the fear of trying to put a price on banks’ troubled assets. So profound is this fear that the Bush Treasury opted instead for the “suitcase approach,” where large sums of cash were delivered to banks (solvent and insolvent alike) with few strings attached. The government needs to restore the banking sector, while protecting the interests of taxpayers. There is no substitute for the P-word.Auctions, financial auctions, financial crisis

Lawrence M. Ausubel

Peter Cramton

English

Research Papers in Economics

--
Economists’ Voice  www.bepress.com/ev  February, 2009 © The Berkeley Electronic Press
No Substitute for the “P”-Word in 
Financial Rescue
LaWRENcE M. auSuBEL aNd PETER cRaMToN
T
hree  months  and  three-hundred 
billion dollars of bank rescue efforts 
have gotten bogged down in a wide-
spread  and  irrational  fear  among 
policymakers: the fear of trying to 
put a price on banks’ troubled assets. So pro-
found is this fear that the Bush Treasury opted 
instead for the “suitcase approach,” where large 
sums of cash were delivered to banks (solvent 
and insolvent alike) with few strings attached.
The  fear  of  pricing  could  be  seen  in  the 
early hours of TARP, as commentator after com-
mentator repeated the need for the Treasury to 
avoid setting a price so low that banks would 
fail or a price so high that the program would 
be viewed as a bailout. Even worse was the con-
cern that, after a price was established, banks 
would  be  obligated  to  mark-to-market  their 
remaining assets, which was somehow viewed 
as wiping out bank capital rather than simply 
better measuring that capital.
Fear of pricing is easy to document in the 
mainstream media. “The central reason TARP 
didn’t get off the ground is pricing,” said bank-
ing analyst Bert Ely. “It becomes politically con-
troversial. If the price is seen as too high then 
it’s  a  taxpayer  giveaway.  On  the  other  hand, 
if prices are seen as too low, banks won’t sell, 
saying they can’t take a hit.”
Senator  Charles  Schumer  (D.,  N.Y.)  was 
quoted in November as saying, “The more you 
look at auctions or asset purchases, the more 
you have the same problem: How do you set 
the price?”
why assets need to be priced
N
evertheless, a new consensus has begun 
to emerge in the last few weeks. Banks 
need to be divided into two groups: insolvent 
banks and solvent banks. Insolvent banks need 
to be taken over promptly by the government. 
(Some  people  call  this  “nationalization”;  we 
prefer to call it “protecting depositors.”) Sol-
vent banks need to have the toxic assets re-
moved from their balance sheets, perhaps by 
transferring them to a “bad bank,” so that the 
remaining “good bank” can resume functioning 
as a normal bank. 
It has not yet sunk in that this new consen-
sus requires doing exactly what the policymakers 
have feared all along—pricing the toxic securities. 
Lawrence M. Ausubel and Peter Cramton are Professors of 
Economics at the University of Maryland and experts in the 
theory and practice of auction design. Their auction proposal 
and experiments relating to troubled assets have received the 
attention of the Treasury and policy makers, and can be found 
at www.ausubel.com and www.cramton.umd.edu.--
Economists’ Voice  www.bepress.com/ev  February, 2009
In hopeful moments, they assume that, since 
you are taking over the insolvent bank, pricing 
the bank’s toxic assets is unnecessary.
But, of course, one cannot determine which 
banks are solvent and which are not without 
pricing the assets, either implicitly or explicitly. 
The only way to tell whether a bank is solvent 
is by putting a price on the bank’s assets and 
comparing this to the bank’s liabilities.
Moreover, the solvent banks are not going 
to be taken over. (That is where the word “na-
tionalize”  could  be  used  appropriately—and 
where  the  U.S.  Constitution  creates  suitable 
impediments.)  Some  banks  hold  relatively 
good mortgage-related securities, while others 
hold bad securities. If a “bad bank” or govern-
ment purchase program is to be implement-
ed, it will need to differentiate among these 
securities using prices.
use reverse auctions for pricing
A
uctions are the standard device for deter-
mining prices in the face of uncertainty. To 
go forward with a restoration of the banking 
system, we need such a process to establish true 
market prices for the troubled assets. We should 
not be looking for a political compromise on 
prices, but for a bona fide assessment of the 
true value of assets.
Elements of a successful auction include: 
using  a  transparent  process  that  establishes 
meaningful prices; purchasing only some (and 
not all) of each troubled security; adhering to 
well-specified rules that treat all sellers equally; 
and following an approach that attracts private 
capital to assist in the government’s efforts.
We proposed in a working paper and an 
Economists’ Voice article one design for a trou-
bled asset reverse auction early in the TARP 
process and, together with colleagues, we ran 
experiments testing the design in a University 
of Maryland economics laboratory in October 
and November. Both the theoretical and experi-
mental results suggest that the proposed design 
would work well at setting prices for troubled 
assets. The test also demonstrated the feasibil-
ity of implementing auctions quickly for the 
roughly 8,000 troubled securities using state-
of-the-art auction techniques.
Other market design experts such as Paul 
Milgrom and Paul Klemperer also formulated 
promising proposals in the fall.
The pricing task is difficult and cannot be 
accomplished perfectly. In particular, some of 
the  mortgage-related  securities  have  highly 
concentrated ownerships that make the func-
tioning  of  simple  auction  mechanisms  prob-
lematic. But this is not an excuse to abdicate 
on the task and thereby allow our economy to 
fall further into the abyss.
In November, the government abandoned 
any pretense of seeking to identify prices of 
troubled assets, in favor of what we have called 
the “suitcase approach”—handing banks large 
sums of cash to keep them from failing. This 
opaque approach is now recognized as a fail-
ure. Solvent banks remained hobbled, as no 
progress was made on reducing the uncertainty 
in the value of their assets.
The government needs to restore the bank-
ing sector, while protecting the interests of tax-
payers. There is no substitute for the P-word.
Letters commenting on this piece or others may 
be  submitted  at  http://www.bepress.com/cgi/
submit.cgi?context=ev.
references and further reading
Ausubel,  Lawrence  M.  and  Peter  Cramton 
(2008)  “A  Troubled  Asset  Reverse  Auction,” --
Economists’ Voice  www.bepress.com/ev  February, 2009
Working Paper, University of Maryland. Octo-
ber  5.  Available  at:  http://www.powerauction.
com/docs/troubled-asset-reverse-auction.pdf.
Ausubel,  Lawrence  M.  and  Peter  Cramton 
(2008)  “Auction  Design  Critical  for  Rescue 
Plan,” Economists’ Voice, 5(5): Art. 5. Available 
at: http://www.bepress.com/ev/vol5/iss5/art5.
Ausubel,  Lawrence  M.,  Peter  Cramton,  Emel 
Filiz-Ozbay,  Nathaniel  Higgins,  Erkut  Ozbay, 
and Andrew Stocking (2008) “Common-Value 
Auctions with Liquidity Needs: An Experimen-
tal Test of a Troubled Assets Reverse Auction,” 
Working Paper, University of Maryland. Octo-
ber 26. Available at: http://www.econ.umd.edu/
~ozbay/liquidity.pdf.
Bozzo, Albert, (2009) “’Bad Bank’ Regains Fa-
vor as Solution for Toxic Debt,” CNBC. January 
23.  Available  at:  http://www.nbcwashington.
com/news/business/_Bad_Bank__Regains_
Favor_As_Solution_for_Toxic_Debt.html. 
(Quoting Bert Ely.)
Klemperer,  Paul  (2008)  “A  New  Auction  for 
Substitutes: Central Bank Liquidity Auctions, the 
US TARP, and Variable Product-Mix Auctions,” 
Working  Paper,  Oxford  University.  Available 
at:  http://www.nuff.ox.ac.uk/users/klemperer/
substsauc_NonConfidentialVersion.pdf.
Milgrom,  Paul  (2008)  “Assignment  Messages 
and Exchanges,” Working Paper, Stanford Uni-
versity.  December.  Available  at:  http://siepr.
stanford.edu/papers/pdf/08-14.pdf.
Solomon, Deborah, (2008) “Treasury Consid-
ers Private Role in TARP,” Wall Street Journal. 
November  12,  A4.  Available  at:  http://online.
wsj.com/article/SB122646068478519997.html. 
(Quoting Charles Schumer.)

No Substitute for the 'P'-Word in Financial Rescue

http://www.cramton.umd.edu/papers2005-2009/ausubel-cramton-fear-of-pricing.pdf

No Substitute for the 'P'-Word in Financial Rescue

Abstract

Similar works

Full text

Available Versions

Research Papers in Economics