On the Paulson US Treasury Reverse Auction Process

Assuming the mooted auction does go ahead here are some thoughts as to possible designs.

The US Govt has a lot of experience in forward auctions selling treasury bonds as described here: http://www.newyorkfed.org/aboutthefed/fedpoint/fed41.html. If you have the time, Kenneth Garbade’s history of the treasury auctions is well worth a read – he emphasises the responses to failure as well as the successes in building a solid programme of auctions: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=596966.

For readers who are used to reverse English auctions the US Treasury format is very different from what you might expect. It is a single-round auction. As a bidder you put in one bid up until the deadline. This bid can state a price you wish to pay and how much you will buy at that price, or it can state a quantity you wish to buy at whatever the average price is. The Treasury then allocates the available bonds across the bidders based on who is offering the highest prices.

I expect that the US Treasury would want to use something similar in the proposed reverse auction. But things are not going to be as simple as that. There is some good debate amongst people who know auctions:

On one level the actual design of the auction is of secondary importance. Simple agreement on a bailout plan will be sufficient to soothe many nerves.

But once they start the reverse auctions will be the subjects of intense media and market scrutiny, at least in the early stages. So reverse auctions at the outset will need to be kept very simple. For this reason any real-time complex optimisation will need to be ruled out. At least to start with.

NERA point out in their paper (link above) a good issue: In a procurement reverse auction the buyer would likely only buy from one (or perhaps two or three, but certainly not all) of the bidders in the auction. So the bidders have to compete against each other to push the price down. Under the Paulson plan, if the government is committing to buying all the securities from all the banks (until the money runs out) then what is the incentive for any bidder to place a low bid? They know that the government will bail them out. To avoid this the auction process could include a number of bidders but commit the Treasury to buying securities from a small number of the bidders, or to buy a fraction of the auctioned value, such that all bidders have an incentive to bid.

There is also the question of one-round or multiple-round bidding. The US Govt currently sells Treasury bonds with one round of bidding so I’m sure they will be tempted to use a similar design for the bailout. But given the uncertainty around the value of the assets in question now I would expect the transparency of multiple-round bidding will be better. Paul Klemperer has some great horror stories of single-round bidding events. Search for “Banespa” and “New Zealand” in the document. The Banespa case was a first-price sealed bid auction, the New Zealand case was a second-price sealed bid auction (Vickrey auction). Both led to great embarrassment.

So could an auction work in this US bailout? It’s certainly well known across government and private sectors that auctions are the best way to ascertain a market price when the true market price is not known. I have seen some very successful reverse auctions for pension funds, for example. So perhaps using reverse auctions for mortgage-backed assets is not such a crazy idea after all.

On balance I think a long, regular series of auctions based on a multiple-round descending clock auction design with the government only buying a fraction of the securities on offer in each auction would be a good way to start the process. Then as the purchases become more commonplace, the desperate sellers offload their assets and prices creep up the government could look to add in optimisation technology.

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3 thoughts on “On the Paulson US Treasury Reverse Auction Process

  1. Mike Oswalt

    Knowledge of the current financial crisis is well outside my domain of expertise. I’m wondering, however, what they are actually going to be auctioning. Part of the problem (I think) has to do with the use of CDOs (collateralized debt obligation). While these CDO’s may contain mortgage-backed securities, they are essentially a corporate entity constructed to hold assets as collateral and to sell packages of cash flows to investors. It is the cash flow that is being traded not the underlying assets. These investments are layered according to risk in credit tranches and the lower tranches have dried up (no one willing to trade or buy).
    If they were merely auctioning mortgaged-backed securities and the values of the securities was directly tied to the value of the physical assets (the homes), it may be OK for the US Gov’t to buy these assets. If, on the other hand, they are auctioning CDOs and other synthetic variants, the auction method is not of as much consequence as the literal value of what is being auctioned.
    I think you are correct in the assessment that “The US Govt has a lot of experience in forward auctions selling treasury bonds”. That experience will benefit them in determining the better method to sell (or buy) whatever it is that will be on the block.

  2. Alan-

    Thanks for the citation. It has been interesting watching the policy debate on the Hill. My thoughts were really just a few hasty comments in reaction to the first mention of using reverse auctions from Secretary Paulson’s Senate testimony last week.

    Regarding one round versus multi-round, my instinct tells me that so little is known about where true market pricing lies on some of these securities that some sort of multi-round interactive auction would be preferred. I think single round auctions are great time savers when loads of other market information exists to help the field converge on a decent price from the outset.

    I agree also that simple is better here.

    Regards.

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