As the government’s proposed $700 billion bailout plan winds its way through Congress this week, the issue of how to price banks’ mortgage-related assets — and potential taxpayer exposure — has caused concern among economists. Dean Hubbard, writing with Hal Scott of Harvard Law School and Luigi Zingales at the University of Chicago Graduate School of Business, raises the issue of price-setting in a Wall Street Journal column, “Let’s Get The Bank Rescue Right” published Sept. 24.

The [Treasury’s] proposal needs to articulate the price-setting process. Although a reverse auction has been suggested, with asset holders “bidding” to sell their mortgage-related securities to the Treasury, such an approach raises significant problems. Most significant is the risk posed by asymmetric information regarding the value of these securities. Because the holders of complex and incomparable mortgage-related securities have more information regarding their worth than does Treasury, Treasury is at a huge disadvantage and will likely overpay. … How can we design a transparent asset purchase process that avoids arbitrariness and potential favoritism? Any such process will have to be designed from scratch, because there is no U.S. precedent for such a targeted purchase of bad assets.

Professor Charles Calomiris also addressed the complications of setting a fair price for bad loans, suggesting that purchasing banks’ equity, rather than their mortgage-related assets, would limit taxpayer exposure. Writing in the Financial Times on Sept. 19, Calomiris said:

Government injections of preferred stock into banks, advocated by New York’s Sen. Charles Schumer and inspired by the Reconstruction Finance Corporation’s policies in the 1930s, are a better choice. Pricing sub-prime instruments for purchase would be very challenging, and fraught with potentially unfair and hard-to-defend judgments. If the price were too low, that could hurt selling institutions; if it were too high, that could harm taxpayers. Who would determine how much should be purchased from whom in order to achieve the desired systemic risk reduction consequences at least cost to taxpayers? How would the purchasing entity dispose of its assets?

Preferred stock assistance would leave asset valuation and liquidation decisions to the private sector, but would provide needed recapitalization assistance to banks in an incentive-compatible manner to facilitate banks’ abilities to maintain and grow assets. If executed properly, it would limit taxpayers’ loss exposure, and leave the tough decisions of managing assets, and deciding on how to allocate capital assistance from the taxpayers, to the market.

Preferred stock assistance would work best if it were required to be matched by common stock issues underwritten by the private sector, which would ensure the proper targeting of assistance, and force private parties rather than taxpayers to bear first-tier losses. Banks in need of capital would apply for Matched Preferred Stock (MPS) assistance. Initially, say for three years, there would be no dividend paid to the government on MPS. That subsidy would increase the net worth of the recipient and facilitate raising additional capital via common stock.