“You are assuming that, acting as market maker of last resort, central banks know intrinsically how much the securities-in-question should be priced. If this were the case, it would be better off for the CB to publish their model as to prevent crises of the sort in the first place. Personally, I don’t think there is any reason to believe that central banks are in any better position to price securities than the private sector.”
I would hope that (to be better prepared for the next financial crisis) the central bank would indeed acquire expertise that would give it a better crack at determining the fundamental value of illiquid securities than it has any hope of achieving currently. Fortunately, the central bank need not know the fundamental value of the illiquid securities in order to make a market. I am sure that many experts on auctions (such as Professors Ken Binmore, Paul Milgrom or Paul Klemperer)will be able to improve on this shorthand proposal, but I would think a Dutch auction could be a fine way to go. In a Dutch auction, the the central bank would announce that it would be willing to buy up to, say, $10bn (at face value) worth of CDOs backed by impaired subprime mortgages. It would start the auction offering a buying price of, say, one cent on the dollar. CDOs offered at that price would be accepted, up to the total amount of the auction ($10bn face value). If the total amount offered at 1 cent on the dollar exceeds $10bn face value, there would be pro-rata sharing among those making offers to sell. If less that $10bn face value is offered at one cent on the dollar, the remainder gets offered at, say, 2 cents on the dollar, all the way up to 100 cents on the dollar. Such a Dutch auction is a price discovery mechanism. The central bank does not need to know the true value, it simply needs to have a mechanism for discovering the reservation prices of the private holders of the illiquid securities. The central bank has all it needs: deep pockets and the absence of a profit motive.
© Willem H. Buiter 2007