Track the Stimulus

The Treasury announced the creation of a mechanism to create Public-Private Investment Partnerships (PPIP) whose mission will be to acquire the legacy assets - loans and securities  (i.e. toxic assets) that the banks now hold.  Ultimately, the PPIPs are expected to buy up-to a trillion dollars of legacy assets, with an initial goal of $500 billion. 

The public-private investment parnerships are the mechanism that the Obama administration will use to do what the original Troubled Asset Relief Plan (TARP) was supposed to do; that is buy the toxic assets sitting on banks' and other institutions balance sheets so that a market for those instrumentsm which right now only fetch distress prices, could be created.  Under the Bush administration, the TARP never made any purchases of toxic/legacy assets and rather use the funds provided by Congress to inject liquidity directly into banks through the purchase of debt-like equity instruments (preferreds and convertible preferreds).  The former Treasury secretary abbandoned the idea to purchase toxic assets because of the difficulty on valuing those assets and the risk that the taxpayer will see very large losses on its investments. The PPIP program is designed so that by having these private market partnerships buy the assets and by putting private capital at risk (together with the government) and provide half of the capital.  Of course, valuation has been the crux of all the problems with "legacy assets" - the private markets have so far been unable to do this efficiently as banks believe they are worth more than potential buyers are willing to pay which in some cases is zero.  The new plan hopes to solve the problem by providing incentives to market participants to participate by providing the liquidity they need. .  The premise for the PPIP is relatively simple:

1. Banks have a large quantity of assets that have depreciated rapidly as a result of the collapse of the housing market;
2. Those losses are accentuated by the fact that private investors are not willing to purchase mortgage related assets at other than very distressed values (e.g. anecdotal evidence of recent transactions indicates that AAA credits that are current and performing are being negotiated at less than 60 cents on the dollar);
3. Reflecting those losses on the banks' profit and loss statements and balance sheets has resulted in a steep reduction of tangible capital/equity;
4. Lax regulation allowed for banks and other institutions to have leverage ratios of 10x or more (30-40x for investment banks), meaning that for a reduction of 10% in the value of the assets that a bank carried results in the bank becoming insolvent - for some investment banks the loss needed to be as small as 3%;
   
5. Many banks are dangerously close to having too little capital to continue operating under current capital maintenance rules established by financial regulators;
6. Private investors fearful of the continued near-term deterioration in the value assessed to the assets owned by the banks are unwilling to provide the needed capital to those financial institutions - those that did earlier in 2008 saw their investments evaporate;
7. The government is then the only institutions capable of providing capital to the banking system thus becoming the investor of last recourse;
8. There are at least 3 ways the government can help (or takeover):
• Provide capital financing - through the Capital Assistance Program
• Buy the toxic (aka legacy) assets from the banks - through the Public-Private Investment Partnerships
  
• Takeover the bank and dispose of the assets through the FDIC or other regulator (e.g. Fed)
9. The PPIPs are funded 50%-50% by private and government capital, and will have access to cheap financing from the FDIC and Fed.  By sharing the risk and reward with the private sector, the Treasury expects that the PPIPs will be better able to value legacy/toxic assets, and thus create a market for those securities;
10. As banks and other financial institutions sell their toxic/legacy assets and a working market exists for them, they will again be able to raise private capital since the threat of unknown losses caused by these assets would have either been eliminated or greatly reduced.
    

The PPIP Details

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The public-private investment partnerships plan calls for the government and private inspectors to co-invest in the purchase of $500 billion of legacy assets that can grow to $1 trillion.  Several PPIPs will be set-up where the Treasury will participate with 50% of the equity ($1 invested for every $1 invested by the private investor).  The governmnet will invest up to $100 billion - the funds will come from the TARP.  The government will also provide loan guarantees, and non-recourse loans through the FDIC and the Fed's TALF program. 

Legacy assets are divided into two categories: legacy loans and legacy securities.

For legacy loans, the plan calls for:

1. Banks that want to dispose of legacy loans in their books ask the FDIC to review the loans and examine whether they are eligible for a 6:1 leverage ratio that the FDIC will guarantee.  If this is the case,
2. The bank will run an auction where private investors will bid for the assets;
3. The highest bidder will then have to put forward 50% of the required equity, and the Treasury will put forward the other 50% for a total of 14.3% of the total value of the loans;
4. The remaining 85.7% will come from debt raised using FDIC guarantees.

What this means is that a private investor participating with $1 billion in equity could purchase close to $14 billion in assets - the treasury provides an additional $1 billion in equity and the remaining amount $12 billion will be financed through FDIC guaranteed debt.  A return of 10% on the assets will provide a return to the investor of close to 70%.

The treatment of legacy securities is different:

1. The government will select a group of investment managers that will raise funds to invest into legacy securities (e.g. mortgage backed securities and others). 
   
2. The Treasury will then provide a matching amount of equity funds. 
   
3. The resulting public-private fund will be able to raise debt worth 50% of the equity, and in some cases up to 100%.  So, if the selected manager raises $100 million, Treasury will add another $100 million, and it will be able to raise another $100 million in debt, and in some cases $200 million in debt. 
   
4. The total amount of investment fire powder will then be between $300-$400 million. 
   
5. In addition, legacy securities will benefit from the TALF - details are yet to be worked out, but the idea is for the Fed to provide debt financing for the purchase of these assets in the form of non-recourse loans that are collateralized by the securities being purchased.

The plan documents are available under the following links: