September 30, 2008
The Gibson, Dunn & Crutcher Financial Markets Crisis Group continues to closely monitor statements from the Executive Branch and Congressional leaders concerning the structure of proposed Treasury auctions to buy up collateralized debt from investors and banks holding illiquid securities
Last week, Treasury Secretary Henry Paulson testified before the House Committee on Financial Services that the Treasury Department would employ market mechanisms" to value mortgage securities. Paulson identified key goals of the auctions as "price discovery" and "transparency."
The Secretary mentioned instituting reverse auctions as a means of pinpointing market prices and allowing smaller financial institutions to enter the process. In a reverse auction, the government would accept bids from multiple sellers to offload debt, and the sellers would compete by successively lowering their bids until only one participant remained. The government has past experience in operating reverse auctions for mineral rights, Treasury securities and wireless spectrum.
The Treasury Department may also utilize the descending auction model. In a descending auction, the government would start the auction for a particular quantity of security at a relatively high price. The price would then be gradually lowered until supply equals demand – at the price where the aggregate of security holders wish to sell the stated auction quantity. The descending auction would help accomplish Paulson’s "price discovery" goal, hopefully leading the secondary market to use newly acquired pricing information and re-liquidate the assets among private investors.
In last week’s Senate Banking Committee hearing, Federal Reserve Chairman Ben Bernanke responded to questions about the information gap that exists between the mortgage debt holders and the government over the value of the securities. Senator Robert Menendez worried whether the government would end up over-paying for debt that does not have an easily discernible value to outside investors. Bernanke opined that opening up the auctions to a greater number of institutions would increase competition and allow for market forces to determine prices with greater accuracy. Ideally, these market forces would eventually settle prices well above the "fire-sale" point, but slightly below "hold-to-maturity" book prices.
In order to structure an efficient buyout, the government could set up separate auctions for an announced quantity of different classes of securities. The Treasury may decide to auction the most widely held mortgage-backed securities first in order to create an overall pricing scheme for later, more specialized sales of collateralized-debt obligations. Declining to give details, Secretary Paulson has merely stated that the initial auctions would probably be for "smaller" amounts.
The rescue legislation authorizes the Treasury Department to enter into contracts for services, including for experienced private asset managers to aid the government in valuing securities – as the Fed did when it hired BlackRock to manage Bear Stearns’ asset portfolio earlier this year. The current draft of the rescue legislation includes a provision that would establish procedures for choosing the asset managers. The draft grants the Secretary broad authority to solicit proposals, manage potential conflicts of interest, and restrict information sharing by managers contracted to aid the government’s asset valuation. The provision further allows the Treasury Department to hire the Federal Deposit Insurance Corporation as an asset management entity, similar to the agency’s role in the Savings & Loan bailout. However, Paulson has publicly supported the retention of private portfolio managers.
As of today, the structure and timing of the proposed Treasury auctions remain uncertain. It appears unlikely that the details of the auction mechanisms will emerge in the legislative process, as Bernanke and Paulson believe that these logistics should be developed by specialized experts hired at the Department’s discretion.
We understand that, while the Treasury Department has been focused on getting a bill to the President’s desk, it is also starting to think about how to run the asset purchase program, provided the bill becomes law. Under the current bill, Treasury is required to publish program guidelines – including purchase mechanisms, pricing methods, procedures for selecting asset managers, and criteria for determining what assets to purchase — no later than 45 days after enactment. Needless to say, if the bill becomes law, we are facing an eventful 45 days.
The Financial Markets Crisis Group will continue to keep our clients updated on the latest events in Washington. Additional updates relating to the financial markets crisis are available on Gibson Dunn’s website.
 Patrick Temple-West and Andrew Ackerman, Paulson, Bernanke Focus on Taxpayer, The Bond Buyer, Sept. 25, 2008.
 Justin Lahart, Economists Look at Ways to Structure Auctions, Wall Street Journal, Sept. 25, 2008.
 Vikas Bajaj, Plan’s Mystery: What’s All This Stuff Worth?, New York Times, Sept. 25, 2008.
 Rebecca Christie and Jody Chenn, Paulson, Bernanke Put Bank Ahead of Best Deal, Bloomberg, Sept. 24, 2008.
 Albert Bozzo, How Will the Bailout Work? Nobody Actually Knows, CNBC.com, Sept. 25, 2008.
 Pete Kasperowicz, Bernanke Says US Government Would Buy Securities in Undefined Reverse Auction, Thomson Financial News, Sept. 23, 2008.
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