On July 31, the Federal Deposit Insurance Corporation (FDIC) announced that it has taken the next step in the development of the Legacy Loans Program (LLP). The LLP is part of the Public-Private Investment Program intended to assist financial institutions in removing troubled assets from their balance sheets. The LLP is meant to help financial institutions sell troubled residential and commercial mortgage loans, while the Legacy Securities Program, recently launched by the U.S. Treasury Department, focuses on securities backed by those loans.  

The FDIC is testing the LLP’s funding mechanism through the sale of residential mortgage loans owned by a bank in FDIC receivership. If the test is successful, the FDIC will offer the LLP to open banks as needed.  

The test transaction will involve a transfer of a portfolio of residential mortgage loans on a servicing released basis to a limited liability company (LLC) in exchange for an ownership interest in the LLC. The LLC also will sell an equity interest to an accredited investor, who will be responsible for managing the portfolio of mortgage loans. Loan servicing must conform to either the Home Affordable Modification Program guidelines or FDIC's loan modification program.  

Accredited investors will be offered an equity interest in the LLC under either (i) an all cash basis, with an equity split of 80% (FDIC) and 20% (accredited investor); or (ii) a sale with leverage, under which the equity split will be 50% (FDIC) and 50% (accredited investor).  

A leveraged transaction will be financed through an amortizing note guaranteed by the FDIC offered by the bank in receivership to the LLC. Financing will be offered with leverage of either 4-to-1 or 6-to-1, depending upon certain elections made in the bid submitted by the private investor. If the bid incorporates the 6-to-1 leverage alternative, then performance of the underlying assets will be subject to certain performance thresholds including delinquency status, loss severities and principal repayments. If any one of the performance thresholds is triggered over the life of the note, then all of the principal cash flows that would have been distributed to the equity investors would be applied instead to the reduction of the note until the balance is zero. The performance thresholds will not apply if the bid is based on the lower leverage option.  

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