The administration is arguing that the private sector's risk aversion will ensure accurate pricing. As Geithner said at this morning's pen and pad briefing, "we're going to use the financial incentives of investors to help set the price." The problem is that what we normally think of as "the financial incentives of investors" includes aversion to loss. If this auction does not include aversion to loss, or radically blunts it, it is impossible to imagine how we end up with accurate pricing. Wall Street, after all, is not objectively valuing the assets. They are assessing the likelihood that their profits on the assets will outweigh their losses. If the Treasury's plan artificially changes that calculation, then it artificially changes the prices, too. James Kwak runs a scenario -- and in this scenario, "Bebchuk's example" is similar to Geithner's plan -- that explains what happens to a banker's risk calculation when someone else is covering the losses.
Let's say that I'm a fund manager, and without government money I'm willing to pay 30 cents for some asset. That means that when I run my valuation models, there is some chance I will be able to sell it for more than 30 cents, and some chance that I will have to sell it for less, and those distributions balance each other. Government money doesn't change that distribution of outcomes; it just changes the share of the gains or losses that I incur. In Bebchuk's example, out of those 30 cents, only 1.5 cents (5%) are mine, so I don't have to worry about the risk of the price falling below 28.5 cents. But I still get all of the upside. You can see how that shifts my expected outcome in my favor. Because my losses are capped at 5% of my purchase price, I might be willing to pay 40 cents instead of 30 cents: even though my chances of making money are small (the distribution of eventual sale prices hasn't changed), my losses are capped at 2 cents (5% of 40 cents), so I don't need a lot of upside to compensate for my limited downside.In short, the larger the proportion of government funding, the higher my willingness-to-pay.
Brad DeLong, I think, would argue that the private sector's risk aversion is currently magnified beyond all reason, and so a plan that artificially corrects for some of that risk aversion is likely to approximate something closer to the actual price of the assets than a plan that does not correct for that risk aversion. But this is not the market at work. It is the Treasury Department at work. The government is basically guessing at the price of these assets and laundering their guess through private investors who are in turn demanding a huge payoff to participate.
