An Overview of the Public-Private Investment Program, Part 2

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Impact on Lending

The program's aim to ensure that banks kick start lending is most likely overly optimistic. The program's core premise that the banks are reluctant to lend due to a overhang of legacy assets is based on a false assumption. The many reasons banks are unwilling to lend - not withstanding a dearth of capital - include fast deteriorating economic conditions, poor credit quality of borrowers, increased risk aversion, and the tumbling prices of underlying assets. Banks will continue to remain cautious unless, and until, the real economy stabilizes or risk acting against the best interest of their shareholders (and their bonus programs), defeating the very (stated) purpose of the program. Any program which focuses only on securities without focusing on fundamentals that affect the underlying assets (economic fundamentals) would fall short of its intended purpose. Common sense from my perspective, but I've always been sort of different so maybe I see things...differently.

Lack of liquidity

The second basic premise of the plan's success lingers upon adequate participation from private investors. Even based on the assumption of maximum leverage granted by the FDIC to everybody for everything that can possibly be purchased by anybody in the program (6:1), private investors would have to come up with $68 bn of funds (in this investor scary environment) to achieve the $500 bn target of legacy assets and $136 bn to purchase the full stated $1,000 bn of legacy assets promised to be leveraged into by the government. If the Fed's valuation committee is just slightly more conservative in its valuation estimates and uses lower (but more realistic, at least on average) leverage (ex. 4:1) granted to everybody for everything that can possibly be purchased by anybody in the program, then private investors would need to raise $188 bn to achieve the target goal of $500 bn and $375 bn to achieve target of $1,000 bn. Lest we show our short term memory propensity, do not forget that there are $2 trillion+ of these assets out there, not $1,000bn! So even with the government program maxed out to the fullest, we are still touching only 50% of the asset pool, as the underlyings to these assets are still in rapid descent.

click to enlarge

Let me put this into perspective for you. The entire hedge fund industry is currently only about $1.5 trillion in assets under management (with many of those assets still fleeing as the lockups expire and the exit gates that were thrown up last year to prevent a run on the fund start to open). Garnering such an enormous amount of capital from private investors would require a significant amount of time and persuasion that could significantly delay the process and further depress the asset prices and the economy along with it. That is assuming it can be done at all - after looking at and digesting the numbers above, it appears to be increasingly unlikely. Despite all of these very real facts, the broad market participated in the biggest rally ever, in the history of exchange traded stocks in the US. What's next, see the graph here: Bear Market Rallies Shake Out Weak Hands!

Risk and Reward in the PPIP!

Now, to be fair to Geithner, et. al., he (they) never declared the PPIP to be a be all and end all. What he did state was that this was a method of facilitating price discovery. It was to be bundled with a variety of other tactics, from quantitative easing to forcing capital down the throats of banks that fail government mandated stress tests. Well, looking at everything as a package, it does tend to make sense. The caveat is that although I definitely see the logic in the whole plan, the market seems to have misconstrued what I see as somehow being positive for extant bank common and preferred shareholders - NOT! It may very well end up being a positive for the banking system, but I wouldn't even buy a bank stock with YOUR money!. Now, on to the biggest potential problem with the plan...

Possible loopholes

The plan specifically provides for the exclusion of SIVs (off balance sheet Structured Investment Vehicles of banks) from investing in the bank's legacy assets through PPIP by excluding affiliates of banks participating in distressed assets .So technically a bank cannot set up an SIV with a more than 10% stake and overbid for those assets.

However there is no such mechanism as such to prevent private investors to engage in collusion and overbid for securities, risking tax payers' money since both the parties stand to gain in such an event (out of this three party affair).

"Private Investors may not participate in any PPIF that purchases assets from sellers that are affiliates of such investors or that represent 10% or more of the aggregate private capital in the PPIF."

In the model above (which you can download for free for your own use: PPIP full model, with collusion and implied leverage 2009-03-26 01:00:41 202.00 Kb) we have assumed that Bank A and Bank B both participate in the PPIP program. Current fair value of Bank A's asset are at 60 cents on the dollar while Bank B's assets are at 80 cents on the dollar. However during the auction Bank A's and Bank B's assets are sold at 80 and 90 cents on the dollar, respectively. Bank A purchases Bank A's asset with equity investment of $6.4 while Bank B purchases Bank A's asset with equity investment of $5.4. At the end of period the actual value for these assets of Bank A and Bank B (originator) were 40 cents and 60 cents on the dollar, respectively.

Although both the banks lost 100% of their respective equity under the PPIP they were considerably better off (and I do mean considerably) selling each other their legacy assets, (effectively, selling them to the Treasury) with tax payers taking the ultimate hit. This should be safeguarded against. No need to worry, unless bank management takes out this blogger in the near future, I and my team will have our eyes out for such shenanigans. I can't guarantee I will catch it, but I wouldn't bet against me, either!

The Implied 14x Leverage Effect

Jeff S. posted the following comment on BoomBustBlog:

Am I mistaken in that the "Treasury Equity" is being funded by the remaining TARP balance? If so, is this not a deceptive title in that this "Equity" is really no different than the additional PPIP funds, and therefore, should be classified as "Debt?" And if so, does this not make the leverage ratio 14:1 (84/6) and not the stated 6:1?

Me thinks we are being lied to again. But I could be wrong.

Please advise...

In response:

There are 2 parts of the plan - the Legacy Loan Program and the Legacy Securities Program.

The Legacy Loan Program would purchase legacy loans through the Fed Guaranty (limited to leverage of 6:1) and the balance would be contributed equally between Treasury and Private Investor.

As a result under the assumption of maximum leverage (6:1 D/E) the effective Debt/Equity for the participant is 13:1, or leverage of 14.0x. We have highlighted the same in the structure, although probably not in the most lucid way, and we believe that the Fed has provided sufficient information on the same without the intent of misleading the investment community.

Comments

[Between The Numbers]

One does not even have to be the bank itself for this to work, just a bank equity shareholder! As per the data above, a small equity investment gives the investor the ability to move significantly more money to where he would like it. I'd even be willing to pay over the book value for an asset, as every marginal $1 paid for an asset flows directly to the bank while the vehicle equity holder need only put up 7.6 cents. More losses (complete loss) in the equity tranche are *good* for the PPIF investor playing both sides, as that means the bank was overpaid by that much more and my bank equity holding goes up by that much.

I could also see bank debt-holders looking at a 75% haircut doing the same thing (and now made whole), or even an issuer of CDS on the bank debt staring a $0.25 settlement value situation ($0.75 liability)!

Also, it seems the other comments may be missing the point of this giveaway. Yes, it is a sweet deal for an investor to get levered, non-recourse financing, and there exists a chance to make a killing on the right assets. However, as Reggie pointed out:
seekingalpha.com/artic...
It isn't as great an upside as one would think, and the banks will be unwilling (unable) to sell at the prices that would leave lots of upside for investors because it would force them to take immediate large losses. Banks that sell even a small piece of their assets book-valued at $0.75 for, say, $0.40, face an immediate book loss of $0.35 on all of the other assets if marked-to-market.

No, this plan is primarily about figuring out a way to overpay for weak assets and have that non-recourse loan kick in as a back-door re-capitalization giveaway to banks. Maybe Timmy G. isn't the fool we are making him out to be, as this is actually a quite subtle and creative plan to move huge sums from the Treasury to the bank without fomenting the lynch-mob that would form were he to just give the cash directly.

2009 Mar 26 02:33 PM