Today it looks like Secretary Paulson will relent.  An early report says that he is going to concede on the issue of CEO pay.  In the arrangement, financial institutions that seek the federal government to purchase their distressed assets must agree to an as yet undetermined set of restrictions on the pay of their CEO and their boards.

This follows on some general outrage about executive compensation.  One report shows that CEOs earn, on average, about 275 times what their rank and file employees make.  That’s a high number, much higher than in the era of industrialized economies with their labor unions.  It is much higher than before globalization.  With NAFTA, GAAT, and the rest, certain jobs and skillsets have been able to be utilized across greater spans.

All of that is to say that there is alot of reason for people to be upset about CEO pay.  Yet it seems like its the wrong remedy for this illness.  Again, the problem is the way that these mortgages have been underwritten and subsequently sold.  The problem is subprime lending.  The problem is within securitization into things like collateralized debt obligations, i/o strips, and the like.

CEO pay is a fine thing to add to a bill that redresses those wrongs.  But we are making a big mistake if that’s the thrust of the reforms that critics of TARP focus upon.

If you are watching the financial crisis, then an important detail will be to see how groups agree on the terms of the pricing of these assets.  There appear to be two main approaches:

The Net Present Value Model

In this scheme, the value of the future cash flows from a mortgage are discounted to produce an equivalent one-time exchange value.  Discounting depends upon an agreed “time value” for money.  Usually, with government investment, time is less valuable than with private investment.  In this instance, its a public buyout of private goods, so the prevailing value could be in doubt.  A public discount rate might by 8 percent, but a private rate could be as high as 12 percent.  Oddly, in this case, the public rate would produce a higher resale value!

Anyway, with the NPV calculation, these assets could be priced much higher than their market value.  That is because the flood of distressed mortgages that send the market values down is not felt in this model.

The Reverse Auction Model

The other option is to create a pricing scheme that forces the private firms to make their own judgments about the value of their distressed assets.  In a reverse auction, banks would indicate the lowest price that they are willing to accept.  The government would then buy loans from the bottom up.

The taxpayer does better in this system.  The banks are forced to make hard choices.  If they accept 30 cents on the dollar in a reverse auction, then they are giving up a lot of upside.  It goes with out saying that in this approach, only the most toxic assets will be bought by Treasury.  Then again, that makes the public investment the most cost effective choice.

The downside is that greed will encourage some banks to keep toxic assets on their balance sheets.  Then, the $700 billion may not be tapped, and the crisis could continue to linger.

Pay attention to which approach is utilized.  It will have a big impact on the outcome from the perspective of both taxpayers and banks.