Below we provide a bit of clarity and understanding to Treasury Secretary Timothy Geithner’s announcement of the Public-Private Investment Program (PPIP) for “legacy” assets.

Adding to its arsenal of weapons to combat the current economic downturn, the Treasury, in conjunction with the FDIC and the Federal Reserve announced on March 23, 2009, its new Public- Private Investment Program to spur investments into two categories of troubled and illiquid real estate assets (so called toxic assets), (i) existing mortgage loans (Legacy Loans) and (ii) existing asset backed securities backed by residential and commercial mortgage loans (Legacy Securities). The intent of the PPIP is to enable banks to rid themselves of those illiquid legacy assets, to create certainty on their balance sheets, and to raise capital, with the goal of increasing liquidity in the real estate market by inducing those banks into lending again to provide credit to homeowners and business. The PPIP will accomplish these goals by leveraging $75-$100 billion of equity capital from the Treasury with equity capital from private investors and FDIC-guaranteed loans or other government financing to generate $500 billion of purchasing power (with the potential to expand up to $1 trillion over time) to buy troubled real estate assets that are clogging the financial system.

The PPIP is split into two separate initiatives, one for Legacy Loans and one for Legacy Securities, both following three basic principles: (i) maximizing the impact of each taxpayer dollar by leveraging with private investors to increase purchasing power; (ii) sharing risk and reward with the private investors; and (iii) attracting private capital by allowing sellers and private market equity investors to establish the appropriate market pricing for the asset purchases through an auction process.

PPIP for Legacy Loans

The proposal for purchasing Legacy Loans entails a complex debt and equity structure using the FDIC and Treasury together with private investors to acquire Legacy Loans from banks. The participating banks will sell their Legacy Loans to Public-Private Investment Funds (PPIFs) in exchange for cash equity paid at closing and debt issued by the PPIFs that is guaranteed by the FDIC. The FDIC guaranteed debt could be held by the participating bank or sold into the secondary market.

The basic process is expected to be as follows. The details will be fleshed out in the near future through regulations to be adopted following notice and public comment.

(a) Eligible participating banks (any FDIC insured institution but not entities owned or controlled by a foreign bank or foreign holding company) will select the Legacy Loans to offer for sale, subject to meeting qualifying criteria to be set by the FDIC and Treasury1;

(b) The FDIC will then determine the amount of financing it will guaranty for the particular loan portfolio using third party valuation firms2 and a leverage not to exceed 6 to 13;

(c) Pre-qualified private investors (or private investor groups) will bid on the right to provide the equity financing for the portfolio purchase through an auction process, thus establishing the sale price for the portfolio. The selling bank will be entitled to reject the bids. The winning private investors will form a PPIF and will be required to provide 50 percent of the equity, with the Treasury providing the remaining 50 percent of the equity in a non-controlling position;

(d) The private investors and Treasury will share profit and loss equally based on their equity contributions to the PPIF;

(e) Governance procedures for the PPIF including asset management and servicing will be determined by the FDIC and Treasury subject to strict oversight from the FDIC; and

(f) The Treasury will have warrants in the PPIF consistent with the requirements of the Emergency Economic Stabilization Act of 2008 (EESA), the terms of which will be determined in the future.

Private investors may include financial institutions, individuals, insurance companies, mutual funds, publicly managed investment funds, and pension funds. Pre-formed investor groups may participate in the auctions but investors may not cooperate once an auction begins. A private investor cannot participate in any PPIF that purchases assets from a seller that is an affiliate of the investor or that provides 10 percent or more of the aggregate private capital in the PPIF.

PPIP for Legacy Securities

For Legacy Securities there are two separate programs intended to replace illiquid low-valued securities on the balance sheets of banks with more liquid assets.

First, the previously announced Term Asset-Backed Securities Loan Facility (TALF) is expected to be expanded to include financing for purchases of residential mortgage backed securities that were AAA rated when originally issued and commercial mortgage backed securities and other assetbacked securities that are AAA rated. The amount of the financing, term and interest rates for TALF financing of Legacy Securities will be determined in the future.

Second, the Treasury will form PPIFs to purchase commercial mortgage backed and residential mortgage backed securities issued prior to 2009 that were AAA rated when originally issued (Eligible Assets). The Eligible Assets may only be purchased from institutions from which the Secretary of the Treasury may purchase assets pursuant to Section 101(a)(1) of the EESA. The AAA or equivalent ratings must be achieved without any ratings enhancement, and the securities must be secured directly by the actual mortgage loans, leases, or other assets and not by other securities.

In contrast to the PPIFs under the Legacy Loan program, the Legacy Securities PPIFs will be managed by private investment fund managers (Managers) who must be prequalified, as described below. The Managers will have primary responsibility for asset selection, pricing, liquidation, trading, and disposition. After they are prequalified, Managers will have a short period of time to raise at least $500 million in funds to co-invest with the Treasury on a 50/50 equity basis in a PPIF. In addition to the equity capital provided by the Treasury and private investors, PPIFs will be able to obtain government debt financing, either in the form of non-recourse loans from the Treasury in an amount of 50 percent to 100 percent of the amount of equity in the PPIF or through the TALF legacy securities funding program, if the securities are eligible for TALF funding. PPIFs also can obtain private debt financing. For example, if the Manager raises $1 billion, the Treasury will provide $1 billion in equity and $1 billion (and in some cases $2 billion) in debt for a total debt and equity capitalization of $3-4 billion.

Profit and losses of the PPIF will be shared pro-rata between the private investors and Treasury based upon equity contributed, with Treasury obtaining warrants in accordance with EESA.

The Manager will manage the PPIF with significant oversight by the Treasury and other protections, including the right by the Treasury to stop funding at any time, special waste, fraud and abuse protections, and strict reporting and record keeping.

The life of the PPIF should be less than 10 years.

A PPIF may only purchase Eligible Assets from sellers that are not affiliates of the Manager, the Manager of any other legacy security PPIF, or any other Manager, or any investor that provides 10 percent or more of the aggregate private capital in the PPIF.

The initial requests by Managers for pre-qualification are due April 10, 2009, and Treasury expects to inform the applicants of preliminary qualification around May 1, 2009. Treasury expects to select approximately five Managers that qualify, but may consider expanding that number depending upon the qualifications of the applicants; applications are available at http://www.financialstability.gov. To qualify the Managers must demonstrate, in addition to other requirements, that: (a) they can raise at least $500 million of private equity; (b) they have a demonstrated track record with Eligible Assets; (c) they have at least $10 billion of Eligible Assets currently under management based upon current market values (no guidance was immediately provided for the criteria for that value determination); (d) they have the operational ability to manage the PPIF in accordance with the goals of the Treasury; and (e) they are headquartered in the United States. Small, veteran-, minority-, and women- owned asset managers are encouraged to partner with other qualified asset managers to meet the approval criteria.

General Considerations

The success of these two initiatives will depend on whether the process will enable private investors to establish market prices for these troubled real estate assets originated prior to the economic recession and whether banks will be willing to sell assets at the prices established through the auction process. Because private investors haven’t been willing to establish a market for these troubled real estate assets out of fear that purchasing them is too risky, the infusion of equity capital, financing, and guarantees by the government is expected to alleviate some of the risk burden, and it is expected that the limited capital that private investors still have in jeopardy will cause such investors to bid competitively, resulting in some semblance of a market.

In addition, due to the recent outrage over executive compensation and bonuses, Treasury has preemptively stated that the parties involved in the PPIP will not be subject to executive compensation restrictions that are imposed on recipients of government support from the Troubled Asset Relief Program (TARP) or other government programs under the EESA, unless such parties have otherwise accepted bailout funds from TARP or other government programs under the EESA.

Of course, while Treasury has finally clarified its intended direction concerning these asset purchase programs, the combination of Federal agencies involved – the Federal Reserve, FDIC, and Treasury – still have a lot of details to decide, and in some cases still need to implement formal rulemaking. There is also significant question as to whether bank will participate if the valuations are not sufficient, and ultimately end up reducing capital. Similarly, questions remain whether private investors are willing to co-invest with the government and potentially be subject to the political whims and theater that might result if there is significant profit, or loss. Of course, as the PPIP and TALF programs continue to be implemented, we expect to see additional modifications to the terms, conditions, procedures, and documentation.