A Reverse Auction for Toxic Assets

Abstract

The proposed 2008 TARP auction was intended to facilitate rapid purchases by the U.S. department of Treasury of a wide array of mortgage-backed securities in order to remove these "toxic assets" from the portfolios of financially stressed banks. The Treasury had selected a Reference Price design whereby bids to sell different securities would be normalized or "scored" by reference prices that reflect estimates of relative values. Although the auction was suspended just prior to the 2008 Presidential election, we continued with a series of laboratory experiments aimed at evaluating the performance of Reference Price auctions relative to several benchmark conditions. The experimental results indicate that a simple Reference Price auction can be an effective mechanism for avoiding serious effects of adverse selection and strategic bid manipulation, even when reference prices are not set accurately. An econometric analysis of bidding patterns and auction outcomes reveals how underlying behavior produces efficiency differences in this common-value framework.

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