Saturday, September 26, 2009

Toxic asset auction design

One of the biggest challenges that Central Bankers and policy makers faced in their efforts to administer the TARP and similar toxic asset purchase schemes during the sub-prime mortgage crisis was the problem of valuing these assets and desinging an efficient price discovery mechanism. Now, Oxford Professor Paul Klemeper (of the European telecom spectrum auction fame) has proposed a new auction design, called "product-mix auction" (more details in pdf here), that can be used for toxic asset purchases and central bank liquidity auctions in a credit crunch.

Simultaneous multiple-round auctions are infeasible in financial market auctions because of the transaction costs and incentive distortions they are likely to impose. He therefore proposes a "simple-to-use, sealed-bid, auction that allows bidders to bid on multiple differentiated assets simultaneously, bid-takers to choose supply functions across assets", and one that makes it harder for bidders to collude or exercise market power in any unfair manner. He desribes his auction design thus,

"Each bidder can make one or more bids, and each bid contains a set of mutually exclusive offers. Each offer specifies a price (or, in the Bank of England’s auction, an interest rate) for a quantity of a specific "variety". The auctioneer looks at all the bids and then selects a price for each "variety". From each set of offers in each bid, the auctioneer accepts the one that gives the bidder the greatest surplus evaluated at the selected prices or no offer if all the offers would give the bidder negative surplus. All accepted offers for a variety pay the same (uniform) price for that variety.

The idea is that the menu of mutually exclusive bids allows each bidder to approximate a demand function, so bidders can, in effect, decide how much of each variety to buy after seeing the prices chosen. Meanwhile the auctioneer can look at demand before choosing the prices. (Allowing the auctioneer to choose the prices ex post creates no problem here because it allocates to each bidder precisely what that bidder would have chosen given those prices in the environments for which the auction is proposed.) Importantly, offers for each variety provide a competitive discipline on the offers for the other varieties, because they are all being auctioned simultaneously."

To clarify, "each bidder can make any number of bids and each bid specifies a single quantity and an offer of a per-unit price for each variety. The offers in each bid are mutually exclusive. The auctioneer looks at all the bids and chooses a minimum "cut-off" price for each variety, consistent with both market demand and its own supply curve. The auctioneer accepts all offers that exceed the minimum price for the corresponding variety, except that it accepts at most one offer from each bid. If all the price-offers in any bid exceed the minimum price for the corresponding variety, the auctioneer accepts the offer that maximizes the bidder’s surplus, as measured by the offer’s distance above the minimum price. All accepted offers pay the minimum price for the corresponding variety – that is, there is 'uniform pricing' for each variety."

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