Making Sense of the PPIP

Mar.29.09 | About: SPDR S&P (SPY)

Tim Geithner unveiled a good amount of detail on the much-awaited financial sector resuscitation package over the last week. Apart from addressing the core issue of unfreezing the credit market and hence imrpoving liquidity, the Treasury also clearly articulated the broad guidelines of new financial sector regulation.

Let's try to make sense of the PPIP - the plan basically envisages the government putting its skin-in-the-game to push/incentivize private sector participants (read money managers) to take that elusive step forward - buy distressed assets and securities. The government's share of risk is through a mix of FDIC guarantees, direct Fed loans and Equity participation. To make sense of the program, let's look at the Legacy Assets and Legacy Securities program separately.

Legacy Assets PPIP program - This envisages private parties (meeting certain eligibility criteria) to bid for defined pools of troubled assets as made available by banks. Once the best bidder is decided for each pool, the government would match equity contribution. But the bigger piece of the puzzle here is the FDIC guarantee - FDIC would employ consultants to value each pool and provide debt guarantees up to 85% of the total bid value of the pool. The actual guarantee percentage for each pool (85% or lesser) would eventually determine total credit risk assumed by the government.

Assume a USD 100 million RMBS pool with a bid value of USD 80 million (to account for potential losses in the portfolio), if the FDIC provides a debt guarantee up to 85% of bid value, it basically means the government is taking a risk of USD 6.0 mn in Equity + additional losses if the actual realizable value of the asset pool is lesser than 68 million. This is fine in case the overall PPIP plan does turn back the market to normalcy; but it's a significant risk to the Treasury's balance sheet otherwise...another 12 million (15%) value drop on the portfolio is not beyond practicality! In a nut shell, there is enough risk sharing from the government to bring in private investment - but on the same note, an ineffective execution can expose the treasury balance sheet significantly. Considering the vary nature of the base asset (loans as against negotiable securities), initial participation is bound to be tepid, unless the securities PPIP program picks up speed and loosens the secondary market.

Legacy Securities PPIP program - The basic premise of the plan is similar to the assets program described above, but the modus operandi is a bit different. It starts with the treasury inviting bids from large assets managers (again, defined eligibility criteria) to select up to 5 asset managers to run the program. These managers would form distressed securities funds with disclosure on fund amount, investor mix, asset selection strategy, asset management strategy, fees etc. The treasury would commit an equal share of equity and on top of that, provide a matching share or in some cases (based on analysis of target investment pool, strategy etc) even twice the matching share in the form of senior debt. Assuming the maximum share of senior debt from the treasury/FDIC, this basically means there's an open risk beyond a value depletion of 25% on the base assesses value of the securities pool. Given the fact that several large global funds have already raised significant money targeted at distressed securities, this plan should drive active participation and free up liquidity in the market.

From the above, it's clear that this is a well-thought out plan from the Treasury, but it's no magic wand. As in any other solution, it does assume rational markets (and market participants) and hence does imply significant balance sheet risks to the treasury - up to 800+ billion, a large number considering the 9 trillion + balance sheet size. But, given the already-distressed value of the base assets and latent investor appetite for such assets, I would bet my money on the plan gradually unleashing liquidity over the next few quarters. The dark horse here is the impact that freshly unveiled regulatory changes (read registration, increased disclosures and hence constariend investment strategies) will have on the existence and volumes associated with critical participants like hedge funds, venture capital funds and private equity funds.

Stock position: None.