I have written quite extensively, starting in August 2007, with much of it appearing in this blog, about how the central bank can make a market in illiquid securities for which there is no market price or any other verifiable benchmark available, without providing a subsidy to the private sellers of these securities. It’s not hard, and does not require the central bank to know anything more than anyone else about the fair value of the security. Indeed, it does not require the central bank to know anything at all – which is probably just as well.
In response to comments from Martin Wolf on an earlier blog of mine I will here just give a brief summary of these earlier scribblings on how central banks can organise auctions for loans against against illiquid collateral for which there isn’t a market price, without rewarding reckless lending and borrowing and thus encouraging a repeat of past excesses in the provision of credit.
Well-designed auctions will act as reservation price-revealing mechanisms for the central bank. The simplest auction is a reverse Dutch auction with the central bank as the only buyer. The central bank has to have a list of securities eligible for access to the auction. I would recommend the central bank only include simple structured investment products on the list, to provide incentives for private financial innovators to keep their wilder horses under control. It could also restrict access to the auction to sellers that are subject to a regulatory regime approved by the central bank. Unregulated financial institutions would have to try their luck with those regulated institutions that were successful obtaining liquidity from the auctions.
The central bank would have to decide for each auction an upper bound on the amount it is willing to purchase at the auction. It could do so by setting an upper bound either on the market value or on the notional or face value of the securities it is willing to purchases. Assume for the sake of argument it sets an upper limit of £10bn for the face value of the securities it is willing to buy. The central bank starts by offering to buy any amount up to £10bn at the lowest possible price, say, 1 penny for each pound sterling of face value. Assume £2bn worth of face value is sold at 1 penny. Next it offers to pay 2 pennies for each pound sterling worth of face value for up to £8bn worth of securities. If the cumulative sales at 1 penny and 2 pennies don’t add of to £10bn, there will at least be a third round, say, at three pennies for each pound sterling of face value. The auction continues until the pre-set upper limit, £10bn is reached, or until the price reaches 1 pound sterling for 1 pound sterling worth of face value.
In such a reverse Dutch auction, those desperately short of liquidity will offer to sell first, at very low prices. The less panicked would-be sellers hold out for higher prices, but risk missing out altogether.
The central bank would take the securities it had bought at the auction onto its balance sheet. If the markets for the securities bought at the auction by the central bank were to normalise later, the central bank could opt to sell the securities at that time. There is, however, no need to do so. The central bank can simply hold all the securities it buys at the auction until maturity. That way it never has to form a view on what they really are worth. There are advantages to never being liquidity constrained – the happy condition of the central bank.
The central bank would, of course, take credit risk onto its balance sheet if it buys private securities at the auction. The reverse Dutch auction with a monopolistic buyer is, however, so hard on the sellers, that the central bank could expect to make a profit out of the activity. Should it be hit by an unexpected wave of defaults on these securities, it would have to be recapitalised (bailed out) by the Treasury. This, of course, is also the situation the Bank of England faces today with its exposure to Northern Rock through the Liquidity Support Facility.
To encourage those private financial institutions that do not wish to mark to market their illiquid assets to participate in the auction, it could be made a legal or regulatory requirement that all securities for which auctions are organised, even those not offered for sale, be marked-to-market at the prices established in these auctions (in the case of the reverse Dutch auction, you could use the average price, say, for this).
The Fed, in its Term Auction Facility, could extend the range of eligible collateral further. There is no reason why illiquid junk could not be auctioned and bought by the Fed using the mechanism outlined here. There are many other kinds of auctions with desirable properties, that don’t require the auctioneer (or the monopolistic buyer), to know much if anything about the fundamental value of the securities that are being auctioned. Economists like Paul Milgrom in the US, or Paul Klemperer and Ken Binmore in the UK, should be able to get a suitable set of auctions up and running in no time.
So, no, the central bank does not have to establish what a competitive market price would be. It does not have to buy at a price above ‘the market price’. My reverse Dutch auction will generically not have a single market price. Securities will be bought at different prices, starting at the lowest. In its purest form, this would be a perfect price discrimination mechanism that creams off all the surplus over the seller’s reservation price for the monopolistic buyer. It would be tough on the sellers, but it would be efficient. There would not be even the faintest whiff of moral hazard in the air.
What it takes to make these auctions successful is not a central bank that knows more than the private sector about the fundamental value of the securities that are being auctioned. There need never to have been a market for the security in question – they could be (standardized) OTC instruments. The central bank could be a bear of very little brain. All it needs is deep pockets and the ability and willingness to take the long view. Those do not seem of to be unreasonable demands to place on the central bank.