On March 23, 2009, U.S. Treasury Secretary Timothy Geithner announced details of the highly-anticipated Public-Private Investment Program for the federal government to partner with private investors to purchase “toxic assets”—now called “legacy assets”—comprised of mortgages and certain types of securities that are mostly backed by mortgages. (This latest announcement follows up on Treasury’s prior Financial Stability Plan announcement of February 10, 2009.) Treasury initially intends to use $75 billion to $100 billion from the Troubled Asset Relief Program (TARP, P.L. 110–343) for part of this effort to remove toxic assets from bank books, rejuvenate credit markets, and restore securitization markets.

While the new program has the potential to offer huge profit opportunities for investors, it comes with costs and issues of unknown scope, including government oversight, reporting requirements, and other restrictions inherent in participating in government programs.

Eligible private investors under the new plan are expected to include financial institutions, individuals, insurance companies, mutual funds, publicly managed investment funds, pension funds, U.S.-headquartered foreign investors, private equity funds, and hedge funds. Private investors will be charged with contributing both capital and pricing expertise. The federal government will put up half of the equity capital and effectively all of the debt financing on a non-recourse basis.

At least for now, the plan focuses primarily on the residential and commercial mortgage sectors, including both whole mortgage loans and securitizations backed by mortgage loan portfolios. Accordingly, there are two parts to the plan: a Legacy Loans Program for whole mortgage loans, and a Legacy Securities Program for certain types of securities mostly backed by mortgages.

Legacy Loans Program

The Legacy Loans Program focuses on toxic loans (and other assets under criteria to be established by the FDIC) held by participating seller banks, and it is expected that approximately half of the TARP resources for cleansing toxic assets will be used here. Separate Public-Private Investment Funds (PPIFs) will be established to purchase whole loans or loan pools. The FDIC will run auctions to set prices, with the highest bidder investing equity capital along with Treasury in the resulting Legacy Loan PPIF for each given loan or loan pool. The FDIC will provide a guarantee for debt financing to be issued by each PPIF to fund asset purchases. This debt will be placed initially with each seller bank for holding or selling in turn. Leverage will vary from pool to pool, depending on input provided to the FDIC from third-party valuation firms, but it will not exceed a 6 to 1 debt-to-equity ratio. The private investors in each PPIF will manage the assets until liquidation, with “strict” and “rigorous” FDIC oversight. The exact nature of this oversight, along with the exact requirements and structure of the Legacy Loans Program, will be subject to notice and comment rulemaking, and the FDIC is currently requesting public comment submissions until April 10, 2009.

Legacy Securities Program

The Legacy Securities Program consists of two related parts—expanding the Term Asset-Backed Securities Loan Facility (TALF) to legacy securities purchases, and partnering with private investors in legacy securities PPIFs.

For TALF expansion, eligible assets now will include certain non-agency residential mortgage-backed securities (RMBS) that were originally (but presumably no longer) rated AAA and commercial mortgage-backed securities (CMBS) and asset-backed securities (ABS) that still are rated AAA. Borrowers will need to meet eligibility criteria. Terms that need to be determined after discussions with market participants will include the haircuts (which will reflect the riskiness of the underlying collateral), lending rates, minimum loan sizes, and specific loan durations (which will reflect the duration of the underlying assets).

Under the second part of the Legacy Securities Program, Treasury will create several Legacy Securities PPIFs to target initially the purchase of non-agency RMBS and CMBS that were rated AAA at origination prior to 2009. Despite the many flavors of mortgage-backed securities (MBS) in the market (some comprised, in turn, of other securities), the eligible securities here must be secured directly by actual mortgage loans, leases, or other assets and not by other securities (other than swap positions, as determined by Treasury).

Private investment managers will have the opportunity to apply to be fund managers (FMs) for the Legacy Securities PPIFs, and, for now, Treasury expects to approve approximately five FMs. (Early reports indicate that firms planning to apply to Treasury for FM positions include BlackRock and PIMCO.) Approved FMs will raise private capital to target a designated asset class. Treasury will act as a co-investor matching dollar-for-dollar the equity investments from private investors. FMs will control the process of asset selection, pricing, and disposition. While the aim is for Legacy Securities PPIFs to employ a long-term buy-and-hold strategy, Treasury will consider other strategies involving limited trading. The FMs will be subject to conflict rules and will be required to present monthly reports to Treasury. Prices of eligible assets will be tracked using third-party sources and annual audited valuations.

In addition to Treasury equity investments in Legacy Securities PPIFs, Treasury debt also will be available to increase the purchasing power of these funds, and depending on the amount of Treasury debt provided in a given fund, further debt under the TALF program would also be available for Legacy Securities PPIFs.

Opportunities and Issues for Investors

A fundamental question involving toxic assets has been market valuation—have potential buyers been valuing these assets so low because they are indeed unlikely to produce sufficient income, or have these assets as a group been unfairly besmirched because potential buyers have become highly risk-averse? The government takes the latter view, and offers investors non-recourse debt financing and the opportunity to investigate specific assets within PPIFs to answer the questions for themselves on a case-by-case basis. By providing credit to those willing to buy toxic assets, the government hopes to boost market prices and induce the banks now holding them to sell.

Investors will have to do extensive research and due diligence to determine what exactly is being offered for sale in each case and to what extent those assets are likely to produce continuing cash flow. For example, potential investors in Legacy Loan PPIFs may want to determine the extent to which federal programs for mortgagors requiring generous loan modifications or preventing foreclosures might apply to legacy loans being offered.

Investors also may be concerned with unknown details of the Public-Private Investment Program as a whole and whether participating in it will subject them to unforeseen restrictions, such as those impacting recipients of TARP equity infusions. On an encouraging note, Treasury has made clear that executive compensation restrictions will not apply to passive private investors by virtue of participating in the Public-Private Investment Program, and the government has signaled a willingness to accommodate other concerns that may otherwise deter participation. Nonetheless, interested investors will want to know more about the potentially burdensome qualification, oversight, and reporting requirements, which have not been entirely spelled out yet. While Treasury’s latest announcement provided more detail than its initial announcement in February, a lot of questions remain unanswered. As the program unfolds, however, answers will come, and regardless of the challenges, there will be great opportunities for savvy investors.