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Understanding the PPIP

davidellis-flow1-07sOn March 23, 2009, the Treasury Department released details of the Public-Private Investment Program (PPIP), which is one of the programs under the TARP aimed at restoring financial stability.

The details of the program were complicated enough to elicit a standalone post.

The Problem. According to the Treasury, one of the problems plaguing the financial system is that of legacy assets – real estate loans held directly by the banks (“legacy loans”) and securities, or tradable financial instruments, backed by loan portfolios (“legacy securities”).  The true value of these assets has been brought to question. As a result, there is uncertainty surrounding the balance sheets of the institutions holding these assets.  Markets don’t like uncertainty as is evident from their performance, especially that of bank stocks, over the last 12 months.

Proposed Solution. The program’s intent is to repair the balance sheets of these institutions by moving the legacy assets off the hands of banking institutions and into the hands of investors.  Cleaner balance sheets could make it easier for banks to raise capital and increase their willingness to lend.

Principles of the Proposal. Treasury will use $75 – $100 billion in TARP money to become co-investors with the private sector, with backing provided by the FDIC and the Federal Reserve.  The “investment partnership” will, thus, be able to purchase $500 billion to $1 trillion of toxic mortgage assets (both residential and commercial) from banking institutions that currently carry them.

There are two separate approaches, one for legacy loans and the other for legacy securities.  Initially, Treasury will share its $75 – $100 billion equity stake equally between the two programs with the option of shifting the allocation towards the option with the greater promise of success with market participants.

  1. Legacy Loans Program: Suppose a bank has a pool of mortgages with $100 face value that it wants off its hands.  It approaches the FDIC, which determines whether it wants to leverage the pool at a 6-to1 debt-to-equity ratio.  If it decides to go ahead, the pool is auctioned by the FDIC.  Several private sector investors are hoped will bid.  The private sector bidder with the highest bid would be the winner and would form a Public-Private Investment Fund to purchase the pool of mortgages.  Let’s say the highest bid is $84.  Of this purchase price, the FDIC would guarantee $6 of every $7 in investment, or in this example, $72.  This is debt financing.  The remaining $12 is equity financing, which is shared equally by the private investor ($6) and the Treasury ($6).  The private investor would then manage the servicing of the pool of purchased assets.  The private investor and the Treasury would each be able to purchase $14 worth of assets for every $1 of their own money (14-to-1 leverage).
  2. Legacy Securities Program: Treasury will approve up to five fund managers for this program.  A fund manager, for example, submits a proposal and is pre-qualified to raise private capital.  The Treasury plans on being a joint-venture partner.  Let’s say a fund manager is able to raise $100 of private capital for the fund.  The Treasury will co-invest $100 in equity financing along side the private investor and will provide an additional loan of $100 (debt financing) to the “partnership” fund.  Additional requests for loans up to $100 will also be considered by the Treasury.  As a result, the fund manager has $300 – $400 in total capital for purchase of securities.  The fund manager has full discretion in investment decisions.  This program will be incorporated into the previously announced Term Asset-Backed Securities Loan Facility (TALF) whose original goal was to provide debt financing (non-recourse loans) to buyers of newly created consumer and small business loans.

The PPIP program has thus far met with lukewarm reception from the private sector, which is noteworthy given the necessity of their participation.  On a conference call to analysts and investors last Thursday, Jamie Dimon, the CEO of JP Morgan and, currently, the go-to guy for the US government on financial mergers/takeovers, said that they will not take part in the PPIP.  “We’re certainly not going to borrow from the federal government because we’ve learned our lesson about that,” said the Chief Executive.  Wells Fargo and US Bancorp are noncommittal.

It remains to be seen whether the Public-Private Investment Program will succeed in getting credit flowing again or further reveal corporate fear of business decisions driven a government that’s looking solely in the rearview mirror.

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