PPIP: The Creation of a U.S. Sovereign Wealth Fund

by: The Curious Investor

It seems that the market’s 500 point positive reaction to the US Treasury’s Public Private Invesment Program was a resounding vote of confidence. Then again, given the many headfakes the market has given us over the last year (anyone remember October’s 900 point day?), the market doesn’t seem the greatest judge of fiscal policy effectiveness. So, what exactly is this new plan and why is it going to save the day?

The Proposition
The exact numbers seem to be conflicting. Some claim that the government will take an 85% equity stake. Others, a 50% equity stake. What we do know is that the entire plan is to create upwards of $1 trillion in availability to buy so-called “toxic” assets off of bank books. Two hundred billion in equity capital will be contributed and the FDIC will provide a non-recourse loan to lever this capital up to 5x.

Can we trust Wall Street with Main Street’s money?
The government will solicit private market asset managers to direct the investing, but it will require them to put up equity capital somewhere in excess of 15%. This means that the asset managers will be entitled to >15% of any profits made on this $1 trillion portfolio. Just to be absolutely clear, the managers would only be entitled to 15% of profits because of the very large loan the FDIC is giving these investment programs. This debt ensures that the plurality of initial capital must be paid back before equity holders are able to extract any returns from their involvement in this program.

As you can imagine, despite not having an assurance of return, the upside is potentially enormous for both our government and the private investors involved.

Can Wall Street trust the Feds?
Unfortunately, the recent threat of action against banks who “took” (some were coerced into it) TARP money has probably left private financiers wary of getting in to bed with the Feds. You can bet there will be some serious protections written into the agreements governing these new partnerships. Unfortunately, as we have seen, the current leadership on Capitol Hill probably doesn’t care too much about contracts.

Will this solve our banking problems?
Worldwide credit write downs have recently broken $1 trillion. $2.5 trillion dollars in mortgage backed securities were issued in the US between 2005 and 2007. This does not count various derivatives and other products issued off of these products or the vast sums of mortgaged backed securities issued before 2005. Some economists like Roubini believe that credit writedowns in the U.S. alone could reach $3.6 trillion when all is said and done.

According to the basic logic, current write down levels leave about $2.5 trillion to be accounted for in the future. The theory behind this fund and other policy moves by the Fed and Treasury is that a $1 trillion fund to take assets off of bank books would directly help to prop up our financial system and possibly help to re-inflate valuations. Quantitative easing, low interest rates, and other actions by the Fed should likely be able to account for the rest of the risk these assets pose to our financial system.

The problem with this fund, however, is that it relies on a belief that the assets that will be purchased have value so long as liquid markets return and a baseline in housing and consumer demand can be reached. That is, is there a rational investment case for “toxic” assets at or above current book values currently listed? Can the government buy these securities without inappropriately risking taxpayer money while at the same time maintaining bank solvency?

Truth be told, this plan was tried when the TARP was first announced and Hank Paulson determined that finding such a reasonable market clearing price was nearly impossible. Our current administration seems to believe that by recruiting private investors, we will be more effective in creating a market and fundamental valuations for bank assets.

For what it’s worth, Paul Krugman does not think this is the case. He believes we’re all about to find out that there just isn’t enough value in “toxic” assets for many of our nation’s banks to operate as going concerns. If this is true, we would hope that the government’s private public investment program will judiciously conserve its capital. Krugman, of course, remains unconvinced that the PPIP will be so conservative.

Here’s to betting against a Nobel Prize winner.