An Overview of the Public Private Investment Program, Part 1

I have reviewed analyses of the PPIP in blogs and news outlets across the web and have perused the comments section in as well. I am impressed by the bright, cogent analysis but need to warn my blog readers that those early analyses may not be based upon the facts as described in the actual plan but upon speculation as to what the plan may contain. I have had my team review the plan and we will reveal what it means to the analysis that we have released as well as what I foresee for the future.

The historically ridiculous (as in one of the greatest rallies ever, based upon a plan that practically no one who participated in the rally has actually read cover to cover) is evidence of technical and momentum orientated traders and not a change in the fundamentals. I'm not saying that the fundamentals have not changed, but we need a chance to find out. I can say that price discovery needs to occur on a natural level for a sustainable bull market. To my knowledge, that has not happened and it is not a feature of the PPIP. I will explore the plan and its parameters in detail and report back ASAP!

About the Program

The US sponsored Public-Private Investment Program intends to target legacy assets - legacy loans (real estate loans held "directly" on the books of banks) and legacy securities ("securities backed by loan portfolios").

The Aim of Program: A huge decline in prices of legacy assets have strained the capital of financial institutions limiting their ability to lend and have increased cost of credit. The stated goal of the Public-Private Investment Program is to strengthen capital base of financial institutions and enhance their ability to lend, ensure efficient price discovery of legacy assets by involving private players and minimizing the risk to taxpayers while providing opportunity to private players to earn sufficient returns.

Legacy Loan Program

The program intends to attract private capital to purchase eligible legacy loans from participating banks through the provision of FDIC debt guarantees and Treasury equity co-investment.

Financing: The private participants (individual investors, pension plans, insurance companies and other long-term investors) alongside Treasury will provide equity financing. The Treasury intends to provide 50% of the equity capital for each fund, but private managers will retain control of asset management subject to FDIC oversight (this is an interesting point). FDIC will provide a guarantee for debt financing issued by the Public-Private Investment Funds to fund asset purchases.

Process:

• Banks would decide which assets (ex. a pool of loans) - they would like to sell.
• The FDIC will then conduct an analysis to determine the amount of funding it is willing to guarantee, limiting the leverage to 6:1 (much of the analysis that I have read assumed a foregone conclusion of 6:1 leverage).
• The FDIC will conduct an auction for these pools of loans. The highest bidder will have access to the Public-Private Investment Program to fund 50% of the equity requirement of their purchase.
• If the seller accepts the purchase price, the buyer would receive financing by issuing debt guaranteed by the FDIC. The FDIC-guaranteed debt would be collateralized by the purchased assets and the FDIC would receive a fee in return for its guarantee.
• The Treasury would then provide 50% of the equity funding.
• The private investor would then manage the servicing of the asset pool and the timing of its disposition on an ongoing basis - using asset managers approved and subject to oversight by the FDIC.
• Private sector investors would stand to lose their entire equity investment in a downside scenario.

Legacy Securities Program (securities tied to residential & commercial real estate and consumer credit).

The goal of this program is to restart the market for legacy securities, allowing banks and other financial institutions to free up capital and stimulate credit flow. Price discovery will also reduce the uncertainty surrounding pricing of these legacy securities held by other financial institutions. My opinion is that this is not true price discovery, primarily due to the non-recourse nature of leverage implemented, which will engender considerably more wreckless risk taking due to the warping of the naturally occurring risk/reward curve!

Financing:

The Legacy Securities Program consists of two related parts to draw private capital.

• Providing debt financing from the Federal Reserve under the Term Asset-Backed Securities Loan Facility ((TALF)). Non-recourse loans will be made available to investors to fund purchases of legacy securitization assets. Eligible assets are expected to include certain non-agency RMBS that were "originally" rated AAA (read as distressed and most likely sloppily underwritten) and outstanding CMBS and ABS that "are" rated AAA. Duration of loans, lending rates and minimum loan size are yet to be determined.
• Match private capital being raised for dedicated funds targeting legacy securities. Treasury will approve up to five asset managers with a demonstrated track record of purchasing legacy assets who would be provided a time frame to raise capital and matching capital would be contributed by the Treasury. Asset managers could also subscribe for senior debt for the Public-Private Investment Fund from the Treasury Department in the amount of 50% (100% in certain cases) of total equity capital of the fund. Thus Manager could manage as far as $4 of assets for every dollar raised (max out at 4:1 leverage).

Our take on the plan

Private investors under Legacy Loan Program have huge downside risk: The position of private investors is similar to an equity tranche in a CDO. These private investors could enjoy huge upside returns on back of massive leverage as high as 13:1, (6:1 is the leverage for fund of which Treasury would contribute 50% of capital) but however they would be the 1^st to bear the loss in the event of further losses. These further losses are imminent, in my (and our) view (see the real estate review in the following post).

The very fact that a bank is willing to sell its legacy assets at a discount underscores the potential risk inherent in those securities. We believe prudent institutional investors would be reluctant to be in an equity tranche position in such high risk securities.Then again, I have overestimated the prowess and prudence of institutional investors in the past.

Potential demand for distressed assets in a zero sum game: The success of the plan to a great extent depends upon risk appetite of plan participants towards distressed securities. Despite the fact that there are huge upside potential for these legacy assets, private investors would have no methodology to determine what prices to bid for these securities since aggressive pricing to buy assets could significantly reduce returns and even result in losses since the underlying assets of these are plunging rapidly. On the contrary conservative price bidding could force massive wave of write-downs for other banks and financial institutions. This seems like zero-sum game where gains of financial institutions at private investors expense and vice-versa.

Willingness of banks to participate in the program and undertake mark-to-mark write downs

There is no incentive for banks to participate in the program unless and until they require immediate capital. Banks which have already taken huge write-downs (ex. the ex-investment banks) would be better off holding these assets until maturity. On other hand banks which have been conservative on their asset write-downs (ex., the Doo Doo 32) would be reluctant to sell their legacy assets under the plan because that would significantly increase the mark-downs.

Risk of overpayment for legacy assets

Guidelines: An independent valuation firm will provide valuation advice to inform the Legacy Loans Program in its bidder selection. Also as mentioned earlier PPIF leverage would be limited to 6:1 based upon analyses performed by the FDIC with input from a Third Party Valuation Firm

We believe that since the first loss is being borne by private investors there would be no incentive to overbid. The price determination is by auction process so market forces could enforce a better price stability than determined by Treasury alone.

Huge downside loss do not justify the potential risk: If one were to simply run the numbers in a simple spreadsheet, you will see that although there is the potential for significant upside, the risk is not trivial.

Sample Investment under the Legacy Loans Program

Face value of pool of mortgages	100.0
Price determined by auction	84.0		<--Be aware that the lower this number, the greater the capital hit to the selling bank!
Debt-Equity ratio	6.0
Debt FDIC Guaranty	72.0
Equity by private investor	6.0
Equity by treasury	6.0
Interest on FDIC Debt	4.0%
Discount Face Value by X%	2.2%

	$	Gain (loss)	Interest on FDIC debt	Gain to equity investor	Gain / loss to Private investor*	% return
Actual Value
Face value	$100.00	$16.00	$2.88	$13.12	$6.56	109.3 %
97.8% discount on FV	$97.80	$13.80	$2.88	$10.92	$5.46	91.0 %
95.6% discount on FV	$95.65	$11.65	$2.88	$8.77	$4.38	73.1 %
93.5% discount on FV	$93.54	$9.54	$2.88	$6.66	$3.33	55.5 %
91.5% discount on FV	$91.49	$7.49	$2.88	$4.61	$2.30	38.4 %
89.5% discount on FV	$89.47	$5.47	$2.88	$2.59	$1.30	21.6 %
87.5% discount on FV	$87.51	$3.51	$2.88	$0.63	$0.31	5.2 %
85.6% discount on FV	$85.58	$1.58	$2.88	($1.30)	($1.30)	(21.7)%
83.7% discount on FV	$83.70	($0.30)	$2.88	($3.18)	($3.18)	(53.0)%
81.9% discount on FV	$81.86	($2.14)	$2.88	($5.02)	($5.02)	(83.7)%
80.1% discount on FV	$80.06	($3.94)	$2.88	($6.82)	($6.00)	(100.0)%

*Assuming gains are shared on proportionate basis to investment

As seen in the table above the downside risk does not justify the risk undertaken by the prudent investor. The risk/reward profile here happens to be very similar to the equity tranches of the CDOs that blew up last year. We have seen many of those equity tranche investors take 100% losses. After taking an empirical look at the program, I now see why the non-recourse sweetener and excessive leverage had to be added, but the fact still remains that the existence of this highly favorable financing distorts price discovery. If it is an unfavorable risk/reward ratio with near free money that you don't have to pay back, just imagine what the natural pricing would look like without these extra-market incentives!!! For those who want to play with their own assumptions, simply register for a free membership at BoomBustBlog and download the model that created the table above - Quick and Clean Public Private Partnership Risk/Return Model 2009-03-24 09:57:27 57.50 Kb.

Potential Impact on Banks and Insurers

• Plan could lead to considerable write-downs of assets particularly for those banks and financial institutions who have been conservative in their write-downs in case the securities price determined is considerably less than current valuations. This is most likely where Geithner is planing to plug in the stress testing and the forced capital injection program from the TARP. I believe that many of the insurers, asset managers and regional banks covered in BoomBustBlog have a ways to go in writing down their assets (see topics: Insurers and Insurance, Commercial Banks, and Financial Services).
• According to estimates, banks are currently holding at least $2 trillion in troubled assets, mostly residential and commercial mortgages. If successful the plan could considerably help banks to transfer their toxic assets and free up their capital. The plan currently plans to buy $500 billion of assets with potential to increase to $1 trillion.

I will follow up on this tomorrow, with further analysis and opinion, and will continue with an update on real estate value trends (undoubtedly and extremely negative). For all who do not realize, downward real estate price trends will considerably distress, further, the most of the assets at the base of the PPIP program.

>>> Go to part 2

Comments

[PROXIMO:]

Thanks for the overview, Reggie. Looking forward to your further take on the PPIP.

Mar 25 11:03 AM

[User 143167:]

I think the one point you may neglect is how to distribute the loan proceeds. The cash flow structure in the legacy assets(with prepayments and higher yields) are much different than that in the FDIC debts(plain vanilla debt). So if the private investor can distribute the interest and prepayment to their favor. Private investors can get their money back earlier than the debt holders. Therefore, it is NOT a CDO at all if equity tranch could absorb the yield spread and prepayments first.

Mar 25 11:24 AM

[CJJ:]

Reggie,
Thanks for such an in depth restatement of the plan. That being said your thesis that if things get worse they'll get worse is not very useful.

I know you have no optimism(at least you base yours on numbers and not blind assumptions) but it seems quite a waste of time to do so much research that amounts to "if things get worse they'll get worse".

Happy number crunching.

Mar 25 02:58 PM

[Reggie Midd...:]

@# User 143167
I see your point, but this was a quick, off the cuff analysis and not an in depth research project.

@# PROXIMO
Your Welcome!

@# CJJ
You're right. I do not have optimism. That is for philosophers and hobbyists. I am a full time professional investor, and feelings such as optimism and/or pessimism can put me in the poor house! I have what you may term as "realism".

I am not one to give out unsolicited advice, but I will for this one time. If you have optimism or pessimism, I do hope you don't invest your own monies. Investing should be a dispassionate endeavor. With that being said, you're welcome as well.

For all of those who haven't read the article in Forbes, check it out. I liked it: www.forbes.com/2009/03...

Mar 25 04:19 PM

[THofler:]

Willingness of banks to participate:

S. Bair has implied that the stress test results will be used to motivate bankers to put assets up for sale in the PPIP. This process might get very interesting!

Mar 25 08:02 PM

[Between The...:]

Let's suppose that we accept that the PPIP has some flaws, yet we put it to work anyway. The assets are revealed (which loans, which tranche, performances to date, etc) in a transparent way and investors can bid with the knowledge. The banks will assuredly put up the MBS or CMBS that they think they can get the most money for *in comparison to their current book value*. They likely don't dare try to sell the most toxic of securities, as the bids likely to come in on those are going to be very low and it will give regulators the smoking gun needed to force a change in behavior. So the end result may actually be a weakening of the banks that have been too conservative on writing down loan securities, as they will sell some of their remaining decent assets and will hold onto all of the most questionable ones. It will buy them time, but won't stop the fact that what is left is just a ticking time bomb of loan-resets, unemployment related defaults, and toxic waste tranches of underwater mortgages.

Mar 25 08:53 PM

[Between The...:]

Prepayment risk was much larger when people had equity in their homes and could refinance. No point to pre-pay if one is way underwater and ready to mail the keys into the bank.

Secondly, the investor has the right to manage the servicing of the asset pool, but almost all of the securitized products are chopped up horizontally, meaning all investors with a stake would have to sign off on loan modification like rate or principal changes. This would mean conflict between those holding the senior slices of the MBS with those holding the risky "toxic waste" pieces. A loan mod that would keep the cash flowing for the benefit of the junior tranche would be in conflict with just opting for foreclosure, which would make the senior tranches whole immediately and destroy the equity of the junior tranches.

Mar 25 09:27 PM

[Soldalma:]

Reggie, I disagree with you on this one.

First, this is not a zero-sum game: the Treasury is giving a free put. Participants will try to "monetize" that put by hedging themselves, selling correlated indexes. I know some people who are already setting themselves up to do so. This means massive index selling will counteract the demand for the toxic assets, and the net effect will be minimal.

Second, your table is based on a price of 84. Try the same exercise with 40 instead of 84 and the risk-reward becomes ridiculously good.

Keep the good work. I am a big fan of your posts.

Mar 26 10:44 AM