The Legacy Loans Program (the “Program”) announced on March 23 presents potential investors with complicated questions about participation. Many of these questions are unanswerable without greater detail, primarily from the Federal Deposit Insurance Corporation (FDIC). On March 26, the FDIC issued a request for comments (“FDIC Request”) on the Program as part of a rulemaking that, if successful, will enable investors to make informed decisions about participation.  

The comment period is short: the deadline for comments is less than two weeks away—April 10. This advisory highlights several issues that may warrant comment for selling or purchasing institutions. We also will be discussing many of these issues at a teleseminar on April 2 at 2:00 p.m. (Details are available at http://www.  

The Program

At the most fundamental level, the Program attempts to realize a major goal of the Emergency Economic Stabilization Act (EESA) that was enacted nearly six months ago: to encourage the purchase of troubled assets from banks, so as to increase liquidity and enable banks to increase their lending capacity. To that end, section 101 of EESA created the Troubled Asset Recovery Program (TARP), which was put to use initially as a mechanism for Treasury to invest additional capital in banking organizations.  

At the time, Treasury put aside any asset purchase program on the view that such an initiative involved such substantial implementation issues that no meaningful program could emerge for several months. Among the implementation issues were a suitable price discovery mechanism that avoided price-setting by the federal government and an appropriate balance between private risk-taking and government participation. The Program attempts to address these and other reservations about asset purchases, but, as we explain below, it may not provide a fully market-based solution.  

In brief, the Program will allow banks and thrifts (“Participating Banks”) that wish to sell certain pools of assets to put them up for auction.1 Bidders (“Private Investors”) will then submit sealed bids. The Program hopes to encourage bids—and, particularly, competitive bids—with two incentives. First, each purchase will be made through a Public-Private Investment Fund (PPIF or “Fund”) in which Treasury will provide approximately 50 percent of the capital, and the Private Investor will provide the remainder. (The Private Investor will control the Partnership.) Second, the FDIC will guarantee a non-recourse loan from the Participating Bank to the Partnership at a leverage ratio of up to 6:1. In a case where the Treasury investment is 50 percent, and where the FDIC has provided the maximum leverage, a Private Investor would invest between seven and eight percent of the purchase price. The Participating Bank is not required to accept the winning bid.  

Issues for Comment

The potential risks and rewards of the Program for both Participating Banks and Private Investors are difficult to identify and must await the completion of the FDIC’s rulemaking process. Complex components of the Program that may warrant considered comments to the FDIC include the following:  

  • Seller Eligibility. A Participating Bank may put assets up for sale only if the FDIC has approved the bank as a seller. The FDIC has not identified the prerequisites and has requested comment. A broad issue, and one not expressly stated in the FDIC Request, is whether the Program is intended as a way for unsettled banks to stabilize their financial condition or whether it will be limited to banks that already are healthy. In general, a bank does not receive a significant capital gain simply through the sale of assets.2 Moreover, the prices of most assets sold through the Program are likely to be less than the prices at which these assets have been held on a Participating Bank’s books, and, as a result, few unstable banks may be able to bear the necessary write-down. If the Program is intended to reach less healthy banks, then some additional government support may be necessary.  
  • Investor Eligibility. All investors must be pre-qualified by the FDIC, and the FDIC has requested comment on what these standards should be.3 Almost regardless of comments, we anticipate that the standards will include relatively common requirements, such as adequate net worth and experience with the assets put up for auction (initially, real estate loans).  

A complex eligibility issue is whether or to what extent earlier involvement with assets to be sold or with the Participating Bank should disqualify individuals from joining or working with investors. On the one hand, the FDIC presumably would not allow bank managers to arbitrage the Program by encouraging or assisting their banks in selling assets and then purchasing the same assets with the benefit of government funding. Nor would the FDIC be likely to allow a former bank executive to bid on the same assets that he or she had originated or overseen at the Participating Bank. On the other hand, Private Investors likely would benefit from the real estate lending experience of former bank executives. The FDIC will have to strike a careful balance here.  

  • Types of Assets. Based on the remarks of FDIC officials in the days after the announcement of the Program on March 23, the Program will focus on residential and commercial mortgage loans—whole loans and not securities backed by these loans. The Program is not, by its terms, limited to real estate loans. An important question, and one raised by the FDIC, is whether other asset classes should be available for sale through the auction process. For such other assets, potential Private Investors or Participating Banks with an interest in such assets should be sure to submit comments to the FDIC.
  • Assets Available. Which assets will be sold out of which banks nominally will be a collective decision of Participating Banks, the federal bank regulators and the FDIC. In practice, we expect the decisions of most banks to be made for them by their regulators.4 While this decision-making process may be dispositive as to eligibility, the concept of asset eligibility presents two other issues that the FDIC is likely to address.  

First, the term sheet for the Program states that assets to be put up for sale must meet criteria to be specified by the FDIC, and comment has been requested on this issue. Chairman Bair has said that the Program can facilitate the sale of approximately $500 billion in assets, but that banks hold approximately $1 trillion of such assets. Necessarily, then, the FDIC will have to set priorities. One approach, in order to achieve the intended purpose of increasing liquidity in the credit markets, would be to focus on assets that historically have traded easily but that now, given the overall state of the banking industry, cannot close the bid-ask spread. If this were to be a criterion, the FDIC would have to rely heavily on outside sources, possibly its third-party valuation firm. Alternatively, if the Program also is intended to stabilize the banking industry, then higher risk, lower quality loans should be promoted through the Program.  

Second, the FDIC notice invites comment on whether more than one bank or thrift may contribute real estate loans to a single pool put up for auction. For smaller institutions, pooling may be necessary in order to attract investor interest, and the FDIC appears clearly to be in favor of multi-bank asset pooling. Private investors may wish to weigh in on the appropriate size of an asset pool.  

  • Financing and the FDIC Loan Guarantee. All asset purchases will be funded by a non-recourse loan from the seller to the purchasing PPIF. This loan will be guaranteed by the FDIC up to the appropriate leverage, a decision that will be made by the FDIC. Two important issues about the loan and the guarantee will need clarification in the FDIC’s rulemaking process.  

First, there are no specifics on the terms of the loans, including rates or maturities. Indeed, it is not clear whether such terms are at the discretion of the Participating Bank or at that of the FDIC. Additionally, the materials do not discuss whether a selling bank could make (or an investor offer to accept) a loan that exceeds the amount of the FDIC’s guarantee. For a variety of reasons, we expect such loans would be rare at best, but it may be a matter worth exploring.  

Second, the FDIC has not identified any of the factors that will inform its decision on the appropriate level of leverage. Participating Banks and potential Private Investors should consider whether the variation in leverage decisions will amplify differences in bid prices. One would assume that the FDIC will be willing to guarantee a higher-leverage loan for higher quality assets. The decision on the leverage ratio may send an important price signal, and whether this will cause bid prices on high quality assets to rise and those on low quality assets to fall remains to be seen. One potential answer is to set a single leverage ratio. In any event, the process by which the FDIC decides the right amount of leverage should be as transparent as possible.  

  • Treasury Investment. This issue may be contentious. As the outlines of the Program have emerged, Treasury’s investment has been described as 50 percent of a Fund. As the FDIC Request makes clear, however, Treasury may invest less than 50 percent and may do so in a form other than cash. The fact that Treasury’s investment in a Fund may vary from the apparent norm is not fatal to the Program. However, if the investment is less than 50 percent, it may cause Private Investors to adjust their prices downward to a point where they would expect to receive the same return on investment as if Treasury had made the “full” 50 percent investment.  

If a lower Treasury investment results in a lower price, then there will be a reduced gain for Participating Banks and an erosion of the intended goal of the Program to improve liquidity. As with the FDIC’s leverage ratio decision on guaranteed debt, the level of Treasury investment may send a price signal. A fixed investment percentage may avoid that signal. In any case, Treasury’s decision making here should be transparent.  

One final point on the Treasury investment is worth noting. By statute, Treasury will receive a warrant in each Fund; since the Program refers to the Funds as partnerships, presumably the Funds will take this form, but the design of a warrant in a partnership (or a limited liability company) will be a daunting task.  

  • Due Diligence. On a reading of the materials released on March 24, the scope of due diligence will need clarification. The scale of the Program may limit due diligence to FDIC-prepared materials. Private Investors will have one critical piece of information: the leverage ratio on the debt that the FDIC will guarantee. It is not clear whether Private Investors will have access to another piece of information: the valuation of each asset pool that a third party valuation firm will prepare for the FDIC (although some estimate may be inferable from the FDIC’s leverage decision). Of course, more information is better than less, and Private Investors attuned to this issue should submit a comment to the FDIC.

The availability of the third-party valuation raises competing considerations for the FDIC. From a public policy perspective, the use of information developed by the third-party valuation firm may be controversial. From a strict economic theory perspective, the fact that one party (whether or not a bidder) has placed a value on an asset pool should not affect the bidder’s own pricing of a bid, since—in theory—both have access to the same information. If the valuation firm has access to other information, then that firm’s valuation is important because it rests on a stronger set of data. If this is so, then, in order to optimize the efficiency of the bidding process, this valuation should be made available to all bidders.

From a lay perspective, however, there is an instinctive expectation that the bid prices will aggregate closely around the valuation by the third-party firm. If so—and since bidders are likely to compete with each other on many auctions, there may be a game theory-based argument for staying close to the valuation price— bid prices may be much closer than would otherwise be the case. This possibility may militate against a public release of the valuation by the third-party firm.

  • Fund Investment Structure. Each Fund presumably will take the form of a limited partnership (or, possibly, a limited liability company), but the FDIC should clarify any expectations it may have about the legal form of the Fund and the law under which it is organized.
  • Capital costs. Banks and bank holding companies presumably could qualify as Private Investors, but their bids (unlike those of non-bank competitors) must take into account the capital charge on the acquired assets. Because prices should be relatively low, the total amounts of the charges should be relatively low as well. The risk weights of purchased assets nevertheless should be confirmed; for example, subprime assets have carried different risk weights depending on the regulator’s assessment of the bank or thrift holding these assets.