Should the government bailout the financial institutions or should they let them fail? While this issue is debated, those with a strong strategic sourcing background may see a significant opportunity.

While there is risk with the Government taking over these assets, this risk is minimized if they are purchased at the current true market price. Broken down into a simple market picture, what we really have here is a number of suppliers (the financial institutions wanting to sell their illiquid assets) and a single buyer (the US Government). What’s the best way to handle a multi-supplier, single buyer negotiation, making sure that true market pricing is achieved? A Reverse Auction of course.

In an interview on CNBC, Warren Buffet talked about the importance of getting the market price…

“If they [the US Government] do it right, and I think they will do it reasonably right, they won’t do it perfectly right, I think they’ll make a lot of money. Because if they don’t — they shouldn’t buy these debt instruments at what the institutions paid. They shouldn’t buy them at what they’re carrying, what the carrying value is, necessarily. They should buy them at the kind of prices that are available in the market. People who are buying these instruments in the market are expecting to make 15 to 20 percent on those instruments. If the government makes anything over its cost of borrowing, this deal will come out with a profit. And I would bet it will come out with a profit, actually.”

I spoke with my old colleague, FreeMarkets Co-Founder Sam Kinney, about the situation. As an expert in finding true market price through reverse auctions, Sam had some great ideas for how the process should work:

“The way the Treasury should proceed is to host a long series of reverse auctions to purchase specific non-performing assets that are troubling bank balance sheets. Whenever you have a single-buyer, multi-seller marketplace, the right market technology is a reverse auction. That’s exactly what the Treasury faces. In a series of ‘lots’, the Treasury would offer to purchase these assets at the lowest price offered by any market participant. The participants might be limited to US national banks, but could include any holder of the specified assets. However, the assets the Treasury offers to purchase should be those dominantly held by US national banks. I don’t believe there’s a need to take equity stakes in market participants under the security purchase program. Paying a low market price has the effect of creating upside opportunity for the Treasury.”

That’s right. The Treasury could actually be making a wise investment that yields a significant return. But don’t underestimate the stabilizing aspect this approach could have on the markets or the speed at which the returns could begin to come in…

“As the Treasury buys these assets, they would contribute the purchased assets into a series of closed-end trusts. Having assembled assets into a trust, the Treasury should immediately turn around and offer for sale interests in these trusts back into private markets. Once stability is re-established in the market, there should be investor interest in these trusts, whose asset value has been effectively ‘haircut’ by the Treasury reverse auction. Many private investors reaped great reward during the S&L bailout by purchasing assets from the Resolution Trust Corporation. This time, we should be smarter about (a) letting the Treasury ride the aggressive workout of the private sector, and (b) making the private sector pay more for the opportunity to work out these assets. Each trust should also hold an auction for a workout servicer (the “servicing partner”), who would be required to put up a cash stake in the trust of between 2-5% of the underlying trust ownership. The servicer should get warrants on the trust as an incentive for aggressive workout activities. I would hope that the workout servicer role with an upside incentive would attract the smartest money in the world. By selling interests in the trust, the Treasury gets to reclaim funds sooner than might be available if assets were held to maturity. The Treasury should remain the ‘managing partner’ of each trust. The trusts must represent ‘equity’–no guarantee of return by the Federal Government.”

But, where do we start? How do we establish the fair market value of the “lots”? It’s not easy, but Sam offered up a scenario he believes would work:

“The biggest challenge is in ’setting the lots’ for purchase in a way that you get effective price competition among the holders. It is probably important, for example, to have lots that represent a small fraction of the total assets that would fit the specification, and purchase multiple lots over multiple weekly auctions. This would let early desperate sellers dump assets at low prices, but let prices creep back up as you squeeze the most desperate sellers out of the market. The SEC, Fed, and FASB should suspend daily mark-to-market accounting. A better alternative would be to allow banks to quarantine assets as ‘discontinued’ and force a significant one-time write down, but allow ‘long term’ assets to be revalued quarterly or semi-annually, and to let market value increases offset market value decreases. Banks could create their own “bad bank” program and let the bad bank participate in the auctions.”

By handling this purchase strategically and correctly, the US Government stands to make a tidy profit on the Bailout, to the benefit of all taxpayers. Like any good sourcing program, a strategic process needs to be put in place and rigorously followed. Getting the “lotting ” right up front will be extremely important in developing the competition necessary and making sure that everyone understands the rules up front will be paramount. (Does any of this sound familiar?)

Maybe we should earmark a few funds to get a good CPO?

Ed Bockman is a Director in Ariba’s Spend Management Services group.