How to make toxic asset auctions work.

What is to be done? Here are two suggestions. First, it helps to make the items as valuable as possible. Many of the defaults are arising because homeowners are being forced to pay interest rates that no one ever thought they'd pay. Remember the auction securities market, where liquidity dried up and rates jumped sky-high? The same thing has happened to mortgages. The lenders never expected to get 12 percent. This was just the penalty rate that would lead people to refinance in three years. Except now they can't refinance. So our first solution is for the government to change the contracts and cap all rates at 7 percent. The lower interest rate could even increase the value of the mortgages because it prevents inefficient defaults.

Second, use an alternative to auctions. Banks have already written down the value of these securities on their books. Instead of buying the securities at face value (par) or at some bargain price, why not simply lend the banks an amount equal to the current (Sept. 30) book value? These loans would be secured by the banks' mortgage pool and, ultimately, by the equity of the firms. This limits the government's upside potential for making money on the deal but provides a quick and fair way to give the banks access to capital with good downside protection. As taxpayers, we'd rather lend with good security then buy something in an auction in which we don't know what we're getting.

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