The U.S. Department of Treasury announced on March 23 more details of its plan to buy toxic assets from US financial institutions. The Public-Private Investment Program ("PPIP") envisions the creation of a number of Public-Private Investment Funds ("PPIFs") through which Treasury and private investors will partner to purchase so-called "legacy assets". "Legacy assets" are real estate loans, whether residential or commercial ("legacy loans"), and securities backed by loan portfolios ("legacy securities"). These assets are still sitting on the balance sheets of US financial institutions, elevating losses, and in many cases, threatening the solvency of the institutions.
Through PPIP the US Government plans to provide equity co-investment funding for establishing the PPIFs and attractive financing through FDIC guarantees for the purchase of the legacy assets by the PPIFs. PPIFs for legacy securities will have a ten year life and private investors may not withdraw for three years. PPIP seeks to leverage some of the remaining TARP funds ($75-$100 billion) to generate at least $500 billion in asset purchases for the Program. This might increase to as much as $1 trillion.
Though many of the details still remain to be determined, such as pricing and haircuts for the loans and the formation and operation of the PPIFs, to name a few, the fact that there is a PPIP is welcome news for all financial market participants, and generally speaking, the reaction to the proffered terms to date has been favorable. That is good news, as one of the cornerstones of PPIP is engaging private capital to help solve the nation's financial crisis.
Set forth below is a summary of the details of PPIP as announced thus far. The exact structure and requirements of PPIP may be modified. The Legacy Loans Program is subject to rulemaking and public comments, starting today and ending on April 10. In the case of the legacy securities, revisions will probably be done through guidance issuances and FAQs.
The Legacy Loans Program
Approximately half of the legacy asset money is earmarked for the purchase of legacy loans, although there is flexibility to allocate resources within PPIP, as necessary. US banks and thrifts of all sizes may participate in the Legacy Loan Program but not those owned or controlled by a foreign bank or company. Participating banks, their primary regulators, the FDIC and Treasury will start the process by identifying the loans to be sold. The FDIC will employ contractors to analyze the pools of loans and determine the amount of funding it is willing to guarantee. The FDIC will guarantee debt to finance the purchase price of the assets in an amount not to exceed a 6-to-1 debt to equity ratio. An eligible pool with committed financing will then be auctioned by the FDIC based on "pre-established criteria" to qualified bidders, which could include individual investors, pension plans, insurance companies and other long-term investors.
Investors willing to contribute up to 50% of the equity for a PPIF will bid for the equity stake and the related FDIC guarantee amount, which will determine the price offered to the selling bank for the loans. The bank would then decide whether to accept the offer price. The private investor will manage the assets until final liquidation, subject to strict FDIC oversight. It is contemplated that, in most cases, servicing will be provided by the selling financial institution.
Example: A bank has a pool of residential mortgages with $100 million face value and the pool is auctioned at $84 million to a private bidder. The bidder would then create a PPIF to purchase the asset pool. The FDIC would provide a guarantee for $72 million of the financing, leaving $12 million of equity. The FDIC guaranteed debt would be collateralized by the pool and the FDIC would receive a fee for the guarantee. Treasury would then provide one-half of the equity funding on a side-by-side basis with the investor, in this example $6 million, and the investor would also put up $6 million. The private investor would manage the asset pool and the timing of any sales using asset managers approved by, and subject to, FDIC oversight.
The Legacy Securities Program
There are two parts to the proposal to buy troubled securities. First, the Treasury Department will provide debt financing to buy legacy securities through the Federal Reserve under the existing Term Asset-Backed Securities Loan Fund ("TALF"). Under the second part, Treasury will match private investments in PPIFs established to purchase legacy securities.
Expansion of TALF into PPIFs to Buy Legacy Securities
TALF loans will be made available to investors to fund purchases of legacy securities. Eligible Securities for this part of the PPIP are expected to include certain non-agency residential mortgage-backed securities that were originally rated AAA and outstanding commercial mortgage-backed securities and asset-backed securities that are rated AAA.
Under TALF, Eligible Borrowers are able to obtain loans through a Primary Dealer. The first loans were made available under TALF this week for the purchase of new issuances of securities. Much remains to be filled in as to how TALF is supposed to work for legacy securities. Such things as borrower eligibility criteria, pricing, haircuts, lending rates, minimum loan sizes and loan durations have not yet been determined.
Legacy Securities Purchased Using PPIF
Under this part of the legacy securities program, PPIFs will be established by private sector fund managers to purchase Eligible Securities. Eligible Securities will initially be comprised of commercial mortgage-backed securities and residential mortgage backed securities issued prior to 2009 which were originally rated AAA or an equivalent rating. The Eligible Securities may only be purchased from "financial institutions" (as defined under the Emergency Economic Stabilization Act of 2008 ("EESA") banks, savings banks, credit unions, broker-dealers and insurance companies). The fund manager has full discretion as to the Eligible Securities the fund purchases, subject to restrictions on purchasing Eligible Securities from Affiliates. It can however purchase Eligible Securities from a private investor that has committed at least 10% of the aggregate private capital raised by such Fund Manager.
Under PPIP, private investment managers will apply for pre-qualification as fund manager of a PPIF that will invest in CMBS and RMBS originally issued prior to 2009. The Federal Reserve intends to choose at least five qualifying fund managers to manage the portfolios of Eligible Securities. Fund managers will be chosen based upon the following criteria:
- Capacity to raise at least $500 million of private capital,
- A minimum of $10 billion (market value) of Eligible Assets currently under management,
- Fund manager has to be headquartered in the US,
- Five-year performance track record investing in Eligible Assets, and
- Demonstrate operational capacity to manage the PPIFs consistent with Treasury's long term objective and strategy.
Applications are due by April 10, 2009. (A link to the application is included in the Treasury Department links above.) Along with the application, applicants must submit their plan to raise the necessary capital, including the time required to raise the funds.
Managers whose proposals have been approved will have a period of time to raise private capital and will receive matching Treasury funds under the Program, which will be invested on a one-for-one fully side by side basis with a private equity investor; provided, that, except as otherwise agreed by Treasury, Treasury's equity capital may only be drawn down at the same time and in the same proportion as private capital is drawn down. Further, asset managers will have the ability, if their investment fund structures meet certain guidelines, to subscribe for senior debt for the PPIF from Treasury in an amount up to 50% of total equity capital of the fund; however ,Treasury debt financing will not be available to any Fund Manager where private investors in the PPIF have voluntary withdrawal rights. Senior debt for the fund in the amount of 100% of its total equity capital will be considered by Treasury subject to further restrictions. Debt financing will be funded concurrently with draw downs of equity commitments.
Managers will have to file monthly reports relating to the Eligible Securities, submit to annual audits and make their books and records available for inspection. It is contemplated that a third party valuator will be involved in setting the price for the Eligible Securities. However, there is little additional information regarding the pricing and sale process for Eligible Securities.
Proceeds from the sale of assets received by a PPIF will be divided between Treasury and the PPIF based on equity contributions except that Treasury will take warrants as required by the EESA to protect the interests of the taxpayers. The terms and amounts of such warrants will be determined in part based on the amount of Treasury debt financing taken.
Example: A fund manager submits a proposal to Treasury and seeks to be pre-qualified to raise private capital in a joint investment with Treasury on a one-for-one match basis. If the fund manager raises $100 million, Treasury provides a $100 million equity co-investment and will also provide up to $100 million in non recourse loans to the PPIF, with the possibility of an additional $100 million loan. Presently, Treasury has the right to cease funding of committed but undrawn Treasury equity capital and debt financing in its sole discretion. Further, the Fund may also take advantage of the expanded TALF program.
- This announcement by the Treasury Department starts to provide details that the market felt was missing when Treasury announced the Financial Stability Plan on February 10, 2009.
- PPIP is designed to move toxic assets off the books of financial institutions using primarily government money to create the entity and purchase the assets. It is a variation on the good bank-bad bank structure that was successfully used by Mellon in late 1988 to shed its toxic assets.
- The decision as to what assets to sell appears to involve not just the bank and its primary banking regulator but the FDIC and the Treasury Department. The agencies' role in this process will be important.
- A key consideration for the bank sellers of Legacy Loans and Legacy Securities will be whether they can absorb the asset write-downs and, if so, their resulting financial condition.
- The stress test will be a very critical consideration for bank sellers and for Treasury. It could determine what should be sold, how much of a writedown a bank can take and whether it will require a government infusion of capital.
- Under PPIP, gains on the sale of appreciated toxic assts should be shared among the private investor, on the one hand, and Treasury and the US taxpayer, on the other.
- Potential private investors in PPIP will likely be initially leery of participating due to the overhang of Congressional reactions if PPIP is deemed too rewarding.
- A true read on the success of PPIP will not be determined over the short run.
- If banks remove the toxic assets from their balance sheets that will free them to concentrate on growing their business and becoming more forward-looking.