By Ronald P. O’Hanley and Charles. J. Jacklin

Critics of the government’s financial rescue plan are rightly concerned about taxpayers getting stuck with a $700 billion tab that benefits Wall Street bankers.  No plan can be successful if it unduly enriches any of the participants at the expense of the taxpayer.

But does this rescue plan really need to be a ‘bailout’ in order to be successful?   Not if it is structured properly and strikes the right balance between protecting taxpayers and encouraging participation by the financial industry.  Remember how we got here: an increase in credit risk, a decrease in liquidity, and increased ambiguity of valuation.  The Treasury plan will not eliminate credit risk, and taxpayers should not bail out companies that made bad decisions.  However, Treasury can increase liquidity by increasing demand and can reduce ambiguity by providing transparency. The best way to do so is to put in place a reverse auction that can help lift the entire market.

Traditional auctions have one seller and many buyers competing on price.  But in this situation, there is likely, at least at first, to be only one buyer (the U.S. Treasury) and many potential sellers (all the banks holding these toxic securities).  Through such a reverse auction, these sellers would propose to the Treasury – and ultimately any other buyers willing to come into the market as co-investors – the lowest price they would accept for their eligible securities. This will help protect taxpayers from overpaying for these securities.

Several other fundamental principles of effective auctions can help ensure that Secretary Paulson’s plan achieves its ultimate objectives:

• The More Buyers, the Better: In addition to the Treasury, pension funds, sovereign wealth funds, foundations, endowments, investment managers, distressed funds, private equity funds and others should be allowed to participate in the buying process. These players are on the sidelines in the current moribund market, but they are more likely to dive in once a series of reverse auctions helps establish liquidity and transparency.

• The More Auctions, the Better: Investors may be reluctant to participate in a new process they do not yet fully understand.  So, a single, market-wide auction is not the answer.  The Treasury should hold multiple auctions – which will help establish liquidity and transparency and ultimately increase the potential impact of the plan among an increased pool of buyers.

• Allow Smaller Bidders to Participate By Pooling Funds: Qualified high-net-worth individuals and smaller institutional investors may also wish to participate in the auction.  The Treasury should consider providing seed capital to create pools of assets from which smaller investors could purchase pro-rata shares, and thus further broaden the pool of buyers.

• Disclose Total Treasury ‘Buy-in’ Prior to the Initial Auction:  The Treasury needs to be clear upfront about the total size of its purchases and how it plans to allot them over time.  This will allow sellers and buyers to gauge the ultimate price of the securities, encourage participation up front, and serve to lift prices, even in the first auction.

• Begin With the Larger, Widely-Held Issues: This will make it easier for potential buyers to analyse fewer, larger issues – and thus encourage greater participation in the earlier auctions.

• Provide Transparency: The lack of information in the marketplace is one of the fundamental problems that led to the problems with these toxic securities.  Simply having a large and willing buyer won’t help restore the market unless it also restores a price-setting mechanism.  All transaction prices should be disclosed and easily accessible to get this market functioning effectively again.

The original Resolution Trust Corporation was a positive force during the savings and loan crisis in the early 1990s in part because it succeeded in creating a mechanism for determining asset prices in a frozen market.  It used auctions to define a market bottom, and from there to facilitate rising asset values, and bids.   TARP is intrinsically more complex.  Yet the primary goal is the same: stabilizing the financial system during a period of unprecedented stress.  The fate of the global financial market depends not just on Washington agreeing to a plan, but implementing one with the right design that will actually achieve the desired goal.

Ronald P. O’Hanley is Vice Chairman, The Bank of New York Mellon
Charles. J. Jacklin, PhD, President and CEO, Mellon Capital Management

Tags: US politics

September 26, 2008 5:09pm in Credit squeeze | Comment