How to make toxic asset auctions work.

Auctions are a wonderful tool. They are often the best way to sell a hard-to-value item, whether it be a vintage Pez dispenser on eBay or spectra for cell-phone licenses, as in the FCC's multibillion-dollar auction. The problem is that auctions work much better for selling stuff than buying it. It is hard to see how the government can use an auction effectively to buy distressed debt.

In a normal auction, there is one seller and lots of buyers. The buyers bid against one another using a common currency-namely, cash. The person who bids the most is the winner. Auctions can also be run the other way around. A procurement auction is one such example. A city that needs a road built gets contractors to bid against one another. In this case, the bids go down, rather than up, and the person willing to bid the lowest is the one who gets the job.

You can see the problem. The buyer is offering to pay the same thing to all the bidders-namely, cash-but the bidders may be providing items of different quality. Buyers try to solve this problem by providing detailed specifications of what they want, such as engineering plans, material specifications, and the like. Still, the low bidder is often the low-quality provider, and the buyer ends up losing by going with the lowest bid.

This problem seems insurmountable when it comes to buying mortgage pools via an auction. The government can't just say that it will spend $50 billion and see who will give it the most securities for that price. That would lead to banks competing to see who could come up with the most worthless securities to turn over.

Consider the analogy of a firm that tried to hire a CEO by running an auction and giving the spot to the person who is willing to do the job for the lowest pay. To paraphrase Groucho Marx, anyone who wins that auction isn't someone you'd want to hire.

To make the auction work, all the bidders have to be offering securities that are equivalent. But to know whether the securities are really equivalent means looking carefully inside the sausage, and we don't have time or skills to do that. We could try to put things in classes, such as by vintage, servicer, geography, and risk tranche. But that would lead to literally hundreds of different pools. How would the government allocate its funds across those pools? And the mortgages in each of those pools would still be heterogeneous, which means the winning bidder would be the one with the worst-quality items.