Monday, October 06, 2008

The "How To" Questions of Reverse Auctions

The Treasury plan is to buy mortgage backed securities (MBS), instead of purely whole loans (the mortgages themselves). They have the authority to buy the underlying mortgages, but I am not sure there is $750 billion of those available. Most of the mortgages went into pools, on which the MBS are defined over. And then some of the MBS went into secondary pools, on which collateralized debt obligations (CDOs) were created. What a mess.

So how will Treasury buy the MBS? It is easy to just say, well, by reverse auction. Current owners of the MBS submit offers to sell (price and quantity specified). The government accumulates the bids, from lowest price to highest price, and keeps track of cumulative volume offered. When that dollar volume hits what the government has agreed to buy in that auction, the price associated with the last accepted offer (or first not accepted offer)becomes the price that all offers are paid. That would be a nondiscriminatory auction. An alternative would be a discriminatory auction, whereby all accepted offers get the price they offered their MBS at. For several reasons I won't elaborate on here, I think the nondiscriminatory auction is the way to go.

But this begs the question of: what is being offered? Not all MBS are the same! If we were buying, say, shares of GM from different holders, there would be no problem, one share of GM being equivalent to another.

So the big issue is how to define the characteristics of MBS that will be accepted in any given auction. There is even the simple matter of different coupon rates, so that you cannot even say that $100 of face value is the same across different MBS even if credit issues are equivalent. But credit issues are the real big one.

I still think that the way to go will be to define ranges of credit characteristics that will enable a MBS to qualify for an auction. Prime candidates for the qualifying characteristics: Date of mortgage issuance, original rating of MBS, degree of subordination in pool (ie what tranche), prepayment history of pool, current default rates, etc. Just the kinds of things that the rating agencies would use to give a rating -- hey, maybe that will be some more work for our friends the rating agencies!

My colleague Bob Aliber has a neat idea, which I think has some merit. He suggests having sellers put all their MBS into a new pool, and define new securities with equal claims to the cash flows from that pool. Then the sellers offer these new securities to the government.

Note that this is essentially creating new CDOs out of the MBS. Neat. Put all the MBS into a pool, and define just one class of collateralized mortgage obligation on that pool. This is in fact essentially what CDOs did, and you can now see why maybe they made original sense -- to pool a bunch of disparate risks together. (Of course, the original CDOs then created multiple tranches on those secondary pools, which in Aliber's plan would not happen.) What this plan also may help to solve is the risk of getting just the absolute worst "lemons" from the sellers. If they have to pool everything together, they can't cherry pick and keep the best.

My thinking has been that Treasury will buy the MBS using pooling techniques of some kind, and then will pool all the MBS and create new securities, ie, CDOs, on that new pool and sell off those claims.

We shall see. It does look like Paulson is moving fast. Given the market turmoil today, that would be good.

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