Despite extensive and varied responses of the United States Treasury ("Treasury") and the Federal Reserve, economic stimulus packages passed by Congress and efforts by financial institutions and regulators around the world, the United States is in the midst of the worst financial crisis since the Great Depression. In its continuing and ongoing response to this crisis, on February 10, 2009, Treasury Secretary Timothy Geithner announced the Financial Stability Plan, consisting of a series of plans and programs designed to improve the stability and functioning of the financial system. Preliminary details for one of these programs, the Public-Private Investment Program ("PPIP"), were released on Monday, March 23.1 In addition, some limited clarification from the Federal Deposit Insurance Corporation ("FDIC") on some of the issues has also been made available.2
PPIP is a $500 billion to $1 trillion plan that joins the forces of public and private investment to facilitate the sale of certain illiquid assets by eligible U.S. financial institutions. PPIP is designed to draw new private capital into the market by providing government equity co-investment and attractive financing for the purchase of distressed assets from these institutions. The key feature of the program, similar to the Term Asset-Backed Securities Lending Facility ("TALF") program, is the non-recourse, non-mark-to-market financing provided to investors in the program.
This alert summarizes briefly the material provisions of PPIP, examining the provisions dealing with the creation of investment vehicles, the structures of the transactions, and the actual purchase, management and sale of assets included in the program, and discusses the potential implications of such provisions for PPIP and the capital markets. While many details of the program were not set forth in the initial announcement and important questions remain unanswered under PPIP that will need to be addressed in additional guidance, the fundamental features of the program have been established.
This alert will focus on answering two primary questions. First, what are the differences and similarities between the two PPIP programs: the "Legacy Loan" program and the "Legacy Securities" program? Second, who can take part in PPIP, and how? The Legacy Loan program will be coordinated by the FDIC, and is expected to assist financial institutions which are U.S. banks to divest themselves of distressed mortgage assets. The Legacy Securities program will be run by Treasury and is more broadly based, and is expected to facilitate the sale of mortgage-backed securities by a broader range of financial institutions. The primary purpose of the Legacy Loan program is to provide liquidity to the participating banks, rather than provide liquidity for the markets generally. The purpose of the Legacy Securities program is to provide liquidity to the general market for mortgage-backed securities, rather than to assist any financial institutions in particular.
There are opportunities for many different types of financial institutions to become heavily involved in PPIP, although there are limitations, and political risks which are difficult to analyze. There are opportunities here for financial institutions to divest themselves of distressed assets, for investors to obtain levered returns, and for fund managers, valuation service providers, trust service providers, due diligence providers, and others to become involved in the process.
I. Program Structure
PPIP is divided into two separate programs, one for mortgage loans (the "Legacy Loans" program) and one for mortgage-backed securities (the "Legacy Securities" program). Under each program, Public-Private Investment Funds ("PPIFs") will be created through which private investors and Treasury can invest in the relevant assets. Click here to view two diagrams showing the structure of the two PPIP Programs.
1. Legacy Loans
The first diagram shows the structure of the Legacy Loan program. Under this program, eligible private investors partner with Treasury to purchase, through the PPIF, eligible loans and other assets being auctioned by "insured depository institutions" ("Participating Banks") with the oversight of the FDIC. The PPIF will be established upon determination of the winning bid. Treasury may invest in up to 50% of the equity of the PPIF, although the FDIC has requested comments as to the appropriate percentage of government equity participation which will maximize returns for taxpayers while assuring integrity in the pricing by private investors. The PPIF may then obtain FDIC-guaranteed financing to complete the purchase of the eligible assets. The participating bank selling the assets will then transfer such assets into the PPIF in exchange for the cash equity investment or the cash equity investment coupled with FDIC-guaranteed debt issued by the PPIF, or the cash proceeds of the sale of such debt. FDIC financing is capped at a debt to equity ratio of 6 to 1, and will be based upon the quality of the assets and its own independent valuation. Under the Legacy Loan program, Treasury will be entitled to receive warrants in the PPIF to the extent of its equity investment. The terms of these warrants are unclear, although the terms will probably not be significantly adverse to investors.
The role of the FDIC in the Legacy Loan program is fairly dominant. In addition to setting the criteria for the Participating Banks, it will obtain an independent valuation of the assets and approve the private investors who can invest in a PPIF. Even after a transaction closing, it will maintain a very strong oversight role in how the assets of the transaction are managed and liquidated. Although Treasury will be an equity investor in the program, it is unclear whether or not its involvement will be material.
As a result, although Participating Banks may want to participate in the Legacy Loan program, their ability to do so may be constrained. Those with large concentrations of high risk residential mortgage loans or commercial mortgage loans may be the most likely to participate. Investors in this program must be willing to comply with the requirements the FDIC sets for potential bidders, and must also accept FDIC involvement in the management in the assets. Interested financial markets participants, including asset valuation experts, likely will be those who have substantial experience with the FDIC, particularly with respect to the purchase of assets in FDIC auctions from failed institutions. However, the Legacy Loans program may provide an opportunity for investors who are not normally included in these types of transactions.
2. Legacy Securities
The second diagram shows the structure of the PPIP for Legacy Securities. Under this program, eligible private investors partner with Treasury to purchase eligible securities. This program is similar to the Legacy Loan program with respect to the equity investment but the financing to purchase eligible securities may come from either Treasury or from the Federal Reserve Bank of New York through the TALF program, or from both. Treasury financing is currently limited to 50% of the PPIF's total equity capital, but it will consider requests of up to 100%. As TALF did not permit mortgage-backed securities to be pledged as collateral, the PPIP can be viewed in part as an expansion of TALF to a new asset class but subject to the PPIP structure. Under the Legacy Securities program, Treasury will be entitled to receive warrants in the PPIF to the extent of its equity investment and any financing. The terms of these warrants are also unclear.
Unlike the Legacy Loan program, after the selection of the fund managers, the Legacy Securities program does not have as much governmental involvement. The role of the government and the Federal Reserve through direct Treasury financing and through TALF is more as a passive limited partner and financier, who is relying on the fund manager primarily to determine the investment outcome. Sellers into the Legacy Securities program may be subject to intense statistical analysis of the cash flows of their mortgage-backed securities more than an evaluation of the underlying collateral. Despite the proposed size of the Legacy Securities program, the market for mortgage-backed securities may not become completely liquid as a result of the program, but pricing transparency should be obtained. Investors in this program would need to have a high level of confidence in the fund manager. However, because of the amount of leverage being provided, the potential here is great for returns on investment.
II. Eligible Assets
1. Legacy Loans
Loans and other assets to be acquired under the Legacy Loan program are "loans and troubled assets from depository institutions under criteria established by the FDIC." The FDIC has made verbal statements that this will initially focus on high risk residential mortgage loans and commercial loans, but has requested comment as to which asset categories should be eligible for sale through the Legacy Loan program, what priorities the FDIC should consider in deciding which pools to set for the program and what would be the optimal size and characteristics of a pool for the program. High risk residential mortgage loans under consideration by the FDIC may include non-performing loans and open-ended loans such as HELOCs. The FDIC will select the assets for sale collectively with the Participating Bank and its other regulators. The exact requirements will be subject to notice and comment rulemaking.3 Participating Banks will need to engage in discussions with the FDIC and their regulators about what kind of assets would be best to sell. Banks will have their own internal valuations of the assets and may want to sell those for which their expectations for selling those loans in the market are not substantially different. However, the regulators may want Participating Banks to sell the most illiquid assets first to remove them from their balance sheet. There may be considerable tension here, particularly to the extent any sale requires the Participating Bank to reduce the carrying value of any of its assets which remain on balance sheet.
Advising Participating Banks with respect to which assets to sell will require considerable input from accountants and third-party advisors who have a sense of the market for the assets. While the FDIC will obtain its own independent valuation, the Participating Bank might consider obtaining an additional valuation especially where the valuation obtained by the FDIC differs from their internal expectations.
2. Legacy Securities
Securities to be acquired under the Legacy Securities program "will initially be commercial mortgage backed securities and residential mortgage backed securities issued prior to 2009 that were originally rated AAA or an equivalent rating by two or more nationally recognized statistical rating agencies without ratings enhancement and that are secured directly by the actual mortgage loans, leases, or other assets but not other securities (other than certain swap positions as determined by the Treasury)." However, Treasury may expand the eligible assets which may be Legacy Securities to include these other assets.
As currently defined, assets under the Legacy Securities program are more restricted than the assets permitted under the Legacy Loan program. By excluding securities that were not originally rated AAA, such as mezzanine and subordinate securities, Treasury is clearly not intending to benefit the main investors in those non-AAA-rated securities, which included CDOs and hedge funds. CDOs themselves, even of RMBS and CMBS, and even if originally AAA-rated, are excluded from the definition as well. By including the language "without ratings enhancement," Treasury may be saying that securities which received the benefit of financial guaranty insurance are not eligible.
As a result, sellers who are insurance companies, pension funds or other financial institutions who invested in originally AAA-rated mortgage-backed securities will have the largest inventory of securities eligible for sale under the Legacy Securities program. Those who invested in CDOs, resecuritizations, or subordinate securities will not benefit from this program. Investors should evaluate their portfolios to determine which assets are available for sale under the program. The return on these types of senior securities, even if downgraded, may be dependent more on interest rates and prepayment speeds than on losses on the underlying collateral.
III. Eligible PPIP Participants
A. Eligible Sellers
1. Legacy Loans
Under the Legacy Loan program, the eligible assets may only come from Participating Banks "under criteria established by the FDIC". These criteria have not yet been determined, but the Participating Bank would not necessarily be troubled. It is clear that the FDIC will work with the bank and its other regulators, if any, to determine which assets should be included in an auction. It is not clear whether a depository institution can elect to be a Participating Bank on its own. Smaller Participating Banks may be able to pool assets for sale in larger structures.
2. Legacy Securities
For Legacy Securities, the requirements for eligible sellers are much broader. "Eligible Assets must be purchased solely from financial institutions from which the Secretary of the Treasury may purchase assets pursuant to Section 101 (a)(1) of the Emergency Economic Stabilization Act of 2008 ("EESA")". Generally, these are institutions that (a) are established and regulated under the laws of the United States or a State and (b) have significant operations in the United States. In addition to depository institutions, insurance companies and broker-dealers, these institutions may include regulated funds and pension plans. Investors in AAA-rated securities generally were institutional investors, such as insurance companies, and most of them would qualify under this definition. An eligible financial institution may be owned by a non-U.S. entity other than a foreign government. However, certain private hedge/equity funds, REITs, conduits and other non-regulated institutions may be excluded because they fall outside the definition.
Given the broader reach of the financial institution definition, many institutions can become involved and should review their ownership of eligible legacy securities which they can make available for offer and sale. PPIP does seem to be directing the Legacy Securities program to those investors who acquired AAA-rated investments without believing that their investment had a substantial risk of loss to obtain improved prices in the market and remove those securities from their balance sheet. In addition, the Legacy Securities program will create liquidity and a program for sale of these securities, which may be undervalued.
B. Eligible Investors
1. Legacy Loans
Any investor group involved in the Legacy Loan program must be pre-approved by the FDIC. Investor groups are required to act as bidders for loans to be auctioned from one or more specific Participating Banks. Investors in the Legacy Loan program included in an investor group are expected to include an array of different types of investors. A mechanism may be required to insure that subsequent investors in a PPIF meet the approval criteria.
Private Investors in the PPIF will likely be required to be "qualified purchasers" so that the PPIF is exempt from registration pursuant to Section 3(c)(7) under the Investment Company Act of 1940 (the "1940 Act"). Direct investment by retail investors does not appear possible without a change in current law or the creation of a closed-end fund trading on an exchange. Hedge funds, including feeder funds held by tax-exempt institutions or foreigners, should be able to invest as "qualified purchasers" under the 1940 Act. Treasury anticipates that private vehicles will be structured so that benefit plan investors, within the meaning of Section 3(42) of the Employee Retirement Income Security Act of 1974, as amended ("ERISA"), will be eligible to participate as indirect investors in PPIP. While Treasury is not specific, the private vehicle structures might involve a limitation on the aggregate investment of benefit plan investors, reliance on an existing prohibited transaction class exemption, or new structures based on changes to the plan assets regulation or new prohibited transaction exemptions developed by the Department of Labor for the PPIP.
Direct investment in the PPIF by non-US investors and tax exempts may cause some tax concerns. While foreign investors are generally permitted to own mortgage loans, the ownership of REO and any workout activities may pose trade or business concerns. If the PPIF uses debt financing there will be concerns regarding "unincorporated business taxable income" (UBTI) for tax exempt investors. Interest payments on mortgage loans will not have the benefit of the portfolio interest exemption because mortgage loans are not in registered form. Placing the loans in a grantor trust will satisfy the registered form requirement. Non-US Investors and Tax Exempt Investors may choose to invest through a blocker US corporation to minimize the tax consequences of the Foreign Real Property Tax Act ("FIRPTA").
As a result, investors in the Legacy Loan program will need to overcome a number of hurdles to become involved. Many investors want to work out pools of distressed residential mortgage loans or commercial mortgage loans, and this may be an opportunity for them to participate if they can meet all of the requirements. Investors in this program must consider, however, that despite investing considerable time and energy in evaluating a portfolio and bidding on a pool of assets, the minimum bid may not be met, or the Participating Bank may reject a winning bid, in which case no transaction would occur.
2. Legacy Securities
Investors in the Legacy Securities program do not need to be approved, but will otherwise be subject to the restrictions expressed above with respect to the 1940 Act and ERISA when investing in the private vehicle that invests in the PPIF. Since the Legacy Securities program is likely to contain, primarily or exclusively, eligible assets which were REMIC regular interests or debt securities for which a "will be" debt opinion was obtained at issuance, the ability of foreign investors to invest should be of less concern than investments in the Legacy Loan program. In addition, investors in this program will not have to wait for the results of an auction to see if they are "approved" for their investment. As a result, the Legacy Securities program may be an easier program to participate in for those investors who want to be involved in PPIP.
IV. Asset Acquisition and Management
A. Asset Acquisition
1. Legacy Loans
The Legacy Loan program requires a Participating Bank to auction the portfolio to proposed PPIFs. Due diligence will be part of the program, and representations and warranties will be made about the assets, although it is unknown specifically what representations and warranties will be made. The FDIC will play a large role in the process. Because the FDIC auctions mortgage loans individually or in pools as a standard practice in connection with its takeover of insured depository institutions, the mechanism for sales of loans under the Legacy Loan program may be similar. The FDIC will request a valuation from a service provider in connection with the sale, which will provide an opportunity for participants in that market, and it may be expected that a due diligence firm is engaged to review the assets on a loan-level basis.
2. Legacy Securities
Control over the acquisition of securities under the Legacy Securities program will be in the hands of the PPIF fund manager, who will be able to acquire assets from any financial institution as defined under EESA. However, given the glut of distressed securities available for purchase in the market, a purchase of those at a steep discount may have a limited impact on the liquidity of the market. Sellers in a market with an enormous number of sellers may find that only those financial institutions which are forced to sell or are capable of absorbing large losses will sell, which may adversely affect markets on securities held by financial institutions. However, the attractive financing and government co-investment may result in prices for these securities that are higher than would otherwise be the case. Regardless, it is unclear whether or not sales of securities under the Legacy Securities program will affect mark-to-market evaluation of these securities for financial institutions.
B. Asset Management
1. Legacy Loans
Under the Legacy Loan program, the loans will be managed by an asset manager and will have primary servicing provided by a servicer. The FDIC has verbally expressed a preference that the primary servicing be retained by the Participating Bank selling the assets, but has requested comment on how the servicing might be sold and transferred. In addition, the FDIC has made it clear that residential mortgage loans included in the program will be subject to a modification program4 and will otherwise be subject to parameters set forth by the FDIC and by Treasury. Private investors have expressed concern that there may be no alternative workout strategies permitted except those required by such guidelines, and such limitations could limit the price investors might offer. If an investor in a PPIF were an affiliate of the asset manager, the asset manager could potentially act as a "master servicer/loss mitigation advisor" and approve all of the decisions made by the primary servicer, subject to "strict FDIC oversight."5 The FDIC has requested further comment on the role of the government in the selection and oversight of any asset manager.
Foreign investors and tax exempts could face trade or business issues resulting from the modification of mortgage loans purchased under the Legacy Loan program. While many private equity funds have approached both Treasury and the Office of Chief Counsel, there has been no guidance issued on whether, if a fund acquires distressed mortgages with the intention to work them out through modification, it will give rise to trade or business issues in the United States. The more involvement the Fund manager has in the servicing decisions, the more difficult the analysis of trade or business becomes.
2. Legacy Securities
Under PPIP, fund managers for the Legacy Securities program are required to submit applications for the program by April 10th, and a final selection is supposed to be made by May 1st. The requirements for assets under management and experience are substantial, limiting involvement to only the largest managers of distressed assets in these areas. Approximately five managers will be selected. Each will be required to describe the types of investors it plans to have. These managers may consider looking for creative ways to involve retail investors, although there may be limitations. Each applicant should also consider partnering with small, veteran-, minority- and women-owned firms in their application.
Under the Legacy Securities program, the fund manager will be much less restricted than an asset manager will be for Legacy Loans. The fund manager will have the ability to select assets from any financial institution, and may bid for and purchase securities directly, rather than going through an auction process. AAA-rated securities issued in connection with securitizations generally were not given significant control rights over servicing decisions. Unless the securities have been significantly downgraded and are currently in a first loss position, the fund manager may not need to evaluate credit risk as much as cash flows. Note that rating agencies cover first dollar of loss, so a security that was originally rated AAA and has been downgraded to CCC may take minimal losses.
V. Legislative Concerns and Political Risk
Legislative concerns and political risk should be a consideration for any capital markets participant thinking of becoming involved with PPIP. The political climate for the PPIP and other Treasury/Federal Reserve programs remains highly charged, with substantial criticism and skepticism by a number of Members on both sides of the aisle apparent in recent hearings. As the House and Senate budget process commences this week and next, a central issue will be whether Congress seeks to include budget resources for additional funding of EESA programs, including PPIP, TALF, and TARP. In addition, furor over retention and other bonuses paid to personnel employed by financial entities that received TARP funds has resulted in substantial Congressional backlash -- as legislation has already been introduced and passed by the House of Representatives by a significant margin that would impose a retroactive tax on those bonuses.
Whether this Congressional oversight will ultimately result in changes to the compensation system, or other changes to the "rules of the game" with respect to the PPIP is an open question, and may create further uncertainty among participants in the PPIP or other Treasury/Federal Reserve/FDIC programs related to toxic assets. Secretary Geithner and President Obama have expressly requested that Congress enact legislation that would authorize Treasury to more directly intervene (either by direct control or through a mandated restructuring) in financial and non-financial institutions that pose systemic risk in times of economic stress. Secretary Geithner returned to Capitol Hill yesterday to outline the Administration's broader strategy for systemic risk regulation, including a request for substantial new disclosure requirements for hedge funds and participants in the derivatives market, tighter capital requirements, and a greater role for the Federal Reserve in overseeing systemic risk. Legislation on such regulatory reform initiatives has already been introduced by Senator Susan Collins (R-ME), and House Financial Services Chairman Barney Frank (D-MA) has indicated that regulatory reform will be a centerpiece of the Congressional agenda following the April recess.
The ability of Congress to act definitively on issues related to the financial markets is compounded by a crowded legislative agenda that is already expected to include health care reform and climate legislation, and a Congressional calendar that is already beginning to diminish. Whether the focus on the "crisis of the moment" translates into concrete legislative action on regulatory reform, systemic risk, insurance issues, or changes to the EESA suite of programs is uncertain in light of these and other political dynamics.
Recently proposed legislation passed by the House of Representatives by a significant margin imposing a retroactive punitive tax on bonuses paid to personnel at institutions receiving TARP funds may affect the willingness of participants to participate in PPIP. Congress' willingness to "change the rules" may serve as a warning to anyone participating in these types of programs, as well as their willingness to respond to public indignation about compensation matters. Amid these environmental factors, the involvement by the U.S. Treasury as a co-investor in the PPIP may well serve to reduce concerns over Congressional overreach, as any substantial gains recognized by investors in the program will be shared by the U.S. taxpayer. It may also reduce political risk if a substantial portion of the investment is provided by retail investors, assuming that the program performs well.
We are optimistic that the PPIP will be successful, mostly because of the intense and often-stated desire of financial institutions to remove these assets from their balance sheets so they can focus on lending again. We are confident that the financial community will bring its collective knowledge, experience and, of course, capital, to bear on rebuilding the capital markets and providing (rational) financing for individuals and businesses around the world.