A proposed method for Treasury to buy toxic assets comes with caveats.

Ben Bernanke and Henry Paulson want the U.S. Treasury to buy up a bunch of troublesome assets, such as mortgage-backed securities, in order to forestall the financial crisis. The proposal poses an interesting challenge for the Treasury: What should they pay for these "toxic" assets? There are many different types of mortgage-backed securities, and for a variety of reasons nobody really knows what the toxic assets are worth.

The Treasury could just throw out bids for various securities, but it risks paying way more than it needs to. In his Congressional testimony, Ben Bernanke mentioned that a "reverse auction" might be the best way to address risk-pricing and concerns about overpayment.

So what's a reverse auction? Think about a regular auction first. Suppose Christie's auctions a T206 Honus Wagner baseball card to a group rich sports nerds. This is the auction most of us are used to: one seller, many buyers. The bidding can proceed a few different ways. In an English auction, the auctioneer starts things out at a relatively low price. If you're willing to pay the going price, you signal your bid to the auctioneer. The asking price continues to rise until one bidder remains. In a Dutch auction, the auctioneer starts off at a high price and lowers the asking price until someone bites. Either way, the highest bidder gets the goods.

Unlike the Christie's auction, a reverse auction involves competitive bidding among many sellers with the intention of driving prices down for one prospective buyer. Reverse auctions gained popularity during the 1990s and continue to have a significant online presence. Guru.com, for example, uses reverse auctions to connect business firms with freelancers. Need an army of phone jockeys to ceaselessly badger potential customers? The freelance auction sites provide the competitive quotes from an array of telemarketers and you choose the best one.

So in this case, the Paulson plan involves one buyer (the Treasury) and many sellers (the troubled financial institutions). In a reverse auction, the financial institutions would bid in an effort to sell their mortgage-backed securities and other troubled assets to the Treasury. The institution with the lowest asking price for a particular asset would win the auction. Having all sellers of a certain type of security compete to offer the lowest asking price will ensure that the Treasury doesn't end up paying way more for the assets than the institutions were willing to sell them for.

The reverse auction is not, however, a bulletproof solution. If sellers find a way to signal their pricing intentions to one another, they can prop up the bids, keeping prices artificially high. The financial institutions have a strong incentive to collude. The lower the price the Treasury pays for a certain type of security, the heavier the loss for financial institutions holding those assets. Higher prices would allow the institutions to take smaller write-downs on the securities they end up holding on to.