Help wanted…

Something I do not understand about the TARP: suppose the Treasury buys the troubled assets for what the market thinks they’re worth. How this is to be achieved is still not clear though the Chairman Bernanke mentioned a reverse auction in his testimony to Congress on Wednesday.

But assuming some price discovery is possible, then we acquire them for the market’s best guess as to what they are really worth. The price reflects all the available information about future development in economy and the housing market in particular. In other words, at these prices, the best estimate of their net present value is zero; we will be paying as much for them as the markets expects we will get back. In other words, everyone’s best guess as to their worth means that the taxpayer should expect to neither make nor loose money on the deal.

However, if we pay the market price, the banks still have under-capitalized balance sheets; this, as far as I understand it, is what is preventing other banks from lending them money. So buying the assets at the market price makes no difference to the lack of credit, the problem that is making the impact so much more wide-spread than a problem for just the banks; their balance sheet are still too weak.

If, however, the plan was to buy the assets at their book value, which would certainly shore up the banks’ balance sheets and fix the liquidity problem, the taxpayer is almost guaranteed to loose. Paying anything above the market price for the ‘toxic assets’ represent an expected subsidy to the banks and an expected loss to the taxpayer.

So my question is this: is the above logic wrong? If not how do we avoid getting stuck will the bill if the bail-out works? (Two questions actually).