Gaming The Financial System

Oleg Baranov is a 27-year-old Russian earning his Ph.D. in economics at the University of Maryland. But for the last month he's been more actor than academic. His unenviable role: playing the part of an American bank with a balance sheet riddled with toxic mortgage-backed securities. Rounding out the cast are 15 of Baranov's classmates, all of whom are also pretending to be similarly troubled financial institutions. For the past month, they've been spending several very real hours each week hunched in front of computers, competing against each other to sell make-believe assets to a make-believe U.S. Treasury Department, played by Maryland economics professors Peter Cramton and Larry Ausubel.

What's the point of this little academic role playing game? The professors wanted to prove that a relatively obscure financial transaction known as a reverse auction might just be the best way to implement the $700 billion rescue plan Congress passed Oct. 3. Shortly after the bailout was approved, Congress was supposed to be using reverse auctions to buy up toxic assets from troubled banks to help stabilize the financial system, boost confidence and ease the credit crunch. That didn't happen, partly because pricing problematic mortgage-backed securities was thought to be too difficult. Instead, Treasury Secretary Henry Paulson is now favoring a plan to inject capital directly into struggling banks and companies. Whether or not that plan of attack will work or is a good use of taxpayer money is debatable.

So what will work? A reverse auction shouldn't be ruled out, say Ausubel and Cramton. Unlike regular auctions, in which buyers outbid each other to win goods or services, the sellers in a reverse auction lower their prices in order to win new business. The benefits are twofold, say the Stanford-trained professors. "First, it establishes a price for these assets by providing a secondary market for them," says Cramton. "And second, it gives banks so much needed liquidity."

To prove their point, they made their auction experiment as real as possible by giving each student a portfolio of assets similar to the mortgage-backed securities that are weighing down the books of hundreds of banks and financial institutions. Subjecting their students to a series of intense three-hour sessions, they plied them with Red Bull and granola bars to keep them focused. And for an extra bit of reality, they had their students play with real money: $20,000 each. The students (a.k.a. "banks") that established the best prices and ended up with the most money received cash awards. After four lengthy sessions, Baranov came away as the top earner with a little more than $1,500. "It was pretty intense," he says. "It helped me understand the problem, and I earned some money too, so it's good all around."

Ausubel and Cramton have been touting that kind of win-win situation during regular conversations with Treasury officials, with whom they've shared their results. They hope to convince officials that not only does a reverse auction work, but, in the event the Treasury conducts one, to run it off their patented software platform. Ausubel and Cramton own two auction-services companies, Power Auctions and Market Design, each of which handle the back end of auctions for companies and foreign governments. They've already helped the French government sell electricity off its grid and Danish energy companies auction off natural gas.

After crunching the final results, Ausubel and Cramton feel their experiment did exactly what they hoped it would: prove that a reverse auction would result in the best use of taxpayer dollars spent through the bailout. They never paid more than a dollar for a dollar's worth of assets they bought from students—an even deal at worst. But in many cases, they were able to buy about a $1.20 of assets for every dollar they spent. Applied to the real world, this means that taxpayers won't be overpaying for what Treasury buys; in fact, they may get a bargain. "It wound up being a great deal for the taxpayer," says Cramton. "Not only did we get value for the money we spent, but we were able to establish a price for these assets."