The Geithner Plan, Part 2
In my last post I argued that the auctions Sec. Geithner is (by all accounts) about to propose as part of his plan to solve the problems with the banking industry might not work at all; that if they did work, they would do so by giving buyers an incentive to overpay, with both their dollars and ours, for troubled assets; and that the plan therefore represented an enormous gamble, with our money, on the proposition that those assets are presently undervalued.
In what follows, I want to describe a different and more troubling way in which these auctions might tempt people to overpay. This is a problem I have not seen discussed elsewhere, and I have wavered about whether or not I should write about it: it might be that the reason it hasn’t been discussed elsewhere is that I just don’t have any idea what I’m talking about, and this really won’t be a problem. I decided to go ahead and write it up, but bear in mind: I’m a philosophy professor, not an economist. That said:
A lot of the “toxic assets” are very hard to value. They are not traded all that often, and there are not a lot of comparable sales to use as a guide. This means that the prices arrived at in an auction might serve several different functions. One function is obvious: when a buyer and seller agree on a price for some asset, that asset will change hands at that price.
In addition, though, for any asset of a kind that is (a) both rarely traded or otherwise hard to assign a price to, and (b) in some way comparable to other assets, the price that emerges from an auction might also be used as data for setting values for other, similar assets. If the auction price is low, regulators might force the owners of comparable assets to write those assets down. Thus, the owners of comparable assets would seem to have an interest in those prices being as high as possible.
If the private parties to the auction had to put up 100% of the money, then we wouldn’t have to worry as much about those owners’ trying to bid up the prices of the assets in order not to have to write down comparable assets: it would probably cost them too much and be too risky. But the less money they have to put on the line, the more likely it becomes that the amount they need to risk to drive prices up is less than the amount they would stand to lose if they had to write their comparable assets down.
We are about to ask private parties to put down very little money to participate in this auction. Worse, in some cases we will guarantee against losses, which would seem to remove the risk from bidding too high. This seems like an invitation to banks that are worried about the prices that might be discovered in such an auction to bid higher than they would if they had no concerns about the value of comparable assets. Possibly quite a lot higher.
The most obvious way to deal with this is to create rules about who can participate in the auctions. Clearly the original owners of the assets should not be allowed to bid on them. But it seems to me that for the reasons just outlined, no one who owns comparable assets should be allowed to bid on them either. Those people have a conflict of interest: as owners of comparable assets, they have an interest in having those assets seem to be more valuable than they actually are.
It would be fairly easy to exclude these two kinds of firms, and people employed by them, from participating in the auctions. But consider a third group: firms that do not own any such assets, but that do a lot of business with firms that do, and that stand to lose a lot if any of those other firms go under. Those firms also have an interest in overpricing those assets. They would probably be pretty hard to exclude. But if they overpay for these assets, we are all on the hook.
Moreover, excluding people from firms who own comparable assets, let alone people from firms with substantial exposure to those who do, would exclude a lot of the people who would, offhand, seem most interested in participating in such an auction, and most knowledgeable about the assets being auctioned off. I, for instance, have no conflict of the kind I’ve just described, but that’s because I have no experience whatsoever in this kind of investment. For that reason, I’d be a terrible person for the government to invite to participate in these auctions. It’s worth asking just how many unconflicted firms with the expertise to make this kind of investment and do well at it there are.
As I said at the outset: I’m sure you all normally bear in mind the possibility that I might be wrong, but I’m especially likely to be wrong about this point. I’d love to hear any views about whether, and how, I am. If I’m right, though, this is one more reason why we should expect the prices set by the auctions to be too high. And if they are too high, that means we, the taxpayers, are paying too much.