The Public-Private Investment Program: An Assessment

Douglas J. Elliott

The Obama administration announced today a more detailed plan for moving “toxic assets” off of the balance sheets of the banks. The Public-Private Investment Program (PPIP) will combine money from private investment funds with public funds to buy toxic assets from the banks. The government will provide the great bulk of the funding, but the private investors will bring critical expertise that is intended to ensure that the right prices are paid for these complex assets, in addition to providing some of the funding. The administration considers this private participation so critical that it is enticing them in with cheap financing and a floor under their potential losses.

It is critical to deal with the toxic assets (or “legacy assets,” as they have been rebranded). U.S. banks own roughly $1-2 trillion of these assets, depending how they are defined. This has raised substantial fears about the banks, since the assets are of very uncertain value. The banks could have hundreds of billions of dollars less capital if the toxic assets are worth the low end of the range of potential values, sinking some of the banks. Moving the uncertainty, and the potential for additional losses, off of the balance sheets of the banks is indeed a high priority, although it would not fix the credit crisis on its own. (Please see “Designing the Public-Private Partnership” and “The Administration’s New Financial Rescue Plan”, for more background.)

Will the PPIP succeed? Unfortunately, we will not know until we see the program in actual operation. There are substantial reasons to be concerned that the program will fizzle or prove to be too expensive for the taxpayer, but there are also some grounds for hope. The key determinants of its success or failure are:

Will the banks sell at the prices the investors are willing to pay? The current market for toxic assets is virtually non-existent because the investors and the banks disagree sharply on price. The value of the toxic assets is so uncertain that there are reasonable grounds for arguing that the average asset is worth anywhere from 30-60 cents on each dollar of face value. That is, everyone agrees they have lost at least 40% of their value, but it could be as much as 70%. The PPIP provides substantial economic incentives for investors to bid higher and the regulators will presumably push banks to sell. However, the valuation gap may simply be too large to bridge on reasonable terms for the taxpayer.

The administration’s counter to this concern is that the lack of a market today results from liquidity problems and a lack of transparency, both of which would be fixed by the government’s intervention. Hedge funds and other potential investors find it difficult and very expensive to borrow to fund purchases of distressed assets. They also cannot easily discern a true market price, given the very low volumes of actual transactions. Government financing will eliminate the liquidity problem and the hope is that once a few transactions occur, they will snowball. Transparent market prices for a few securities will help investors and the banks to estimate the fair market price of additional securities, which will then help establish the price range for yet more securities.

Will the program cost the taxpayers too much? The government is providing large economic incentives that should persuade investors to participate and to willingly pay substantially higher prices than they otherwise would. The value of cheap multi-year government financing is quite significant, as is the government’s promise to put a floor under losses at 10 or 20% of what the investor puts up. It is possible that these incentives will cause investors to overpay for the assets, with most of the eventual losses flowing to the taxpayer because of the downside protection offered the investors. For example, it could be rational for investors to offer 40 cents on the dollar, calculating that they would benefit sharply if the price went to 50 cents while the government would absorb most of the losses if the value fell to 30 cents on the dollar.

There is also a substantial opportunity cost to channeling cheap funding to the investors. Perhaps other uses of that funding would have aided the economy more. For example, there are some who argue that the government would be better off buying the assets directly, contending that the economic subsidies are worth more than the expertise the investors are bringing. It will be difficult to judge this until we have considerably more detail about the program and even then it may be unclear.

Will investors participate? The answer here is almost certainly “yes.” The government seems to have designed a program with enough economic incentives to lure investors in, despite sharply increased concern recently that the government might retroactively change the terms of the deal. Hedge funds worry that Congress will mandate changes to their governance or impose an “excess profits” tax if the contracts prove particularly valuable. However, these concerns are likely to be overcome by the potential profits and the downside protections. Press reports indicate two of the giants of the fixed income business, Blackrock and Pimco, intend to participate and there will doubtless be many others.

Summary of the proposal
The approach has evolved considerably from the high-level plan announced on February 10, reflecting changing financial and political circumstances. The revisions generally appear positive, although a number of key details will not be known until later. There will now be three programs with different but overlapping approaches. Most of the funding will come from the Federal Reserve (Fed) and the FDIC rather than from Treasury. This funding choice is driven more by the need to hoard Treasury’s remaining authorized funding from the Troubled Asset Relief Program (TARP) than by substantial policy considerations. The Fed has virtually unlimited ability to lend on a secured basis and the FDIC is in a better position than Treasury to gain Congressional approval for new funding. The FDIC’s favorable position stems from the theoretical ability to recover any losses through future deposit premiums and from the political ramifications of past actions by Treasury and the FDIC. The PPIP is targeting purchases of $500 billion to $1 trillion of assets, using $75-100 billion of TARP funding from Treasury.

There are three components to the plan:

Expanding the Term Asset-backed Securities Lending Facility (TALF) to cover toxic assets. Under this program the Federal Reserve loans private investors most of the funds they need to purchase securities backed by loans of various kinds. This program is very new; the first trades have not even closed yet. The original intention was to cover only highly creditworthy, new securitizations of loans to consumers and small businesses. Now the TALF will also cover old securitizations whose market values have declined sharply due to expected losses. How this works will be heavily dependent on details about the assets to be included, collateralization levels and the interest rates to be charged by the Fed.

A new set of public-private partnerships to buy securitized toxic assets. The government will support a series of new Public-Private Investment Funds (PPIFs) that will purchase toxic assets in their classic securitized form. There will likely be five funds initially, but this could be expanded. The Treasury and private investors will co-invest in the equity of the funds on a 50/50 basis. Treasury has further agreed to lend an amount equal to at least half of the equity and potentially as much as 100% of the size of the equity investment. (The interest rate has not yet been specified. This will be very important to the economics.) Importantly, the fund will have the ability to participate in the TALF program when it is expanded to cover toxic assets, which would open up substantially more leverage opportunities, using the Fed’s non-recourse loan structure. Toxic asset purchases are likely to be much more attractive once the TALF financing becomes available.

FDIC-sponsored sales of loans. The FDIC will give banks the chance to offer for sale packages of loans of a similar nature to those underlying the toxic asset securitizations. The FDIC will auction these packages of loans off and will provide up to 6:1 leverage to the winning bidders, with the financing provided as FDIC-guaranteed debt. Treasury would expect to co-invest on a 50/50 basis with the winning bidder.

This paper will address the following questions.

  • What are toxic assets and why do we care?
  • How big is the problem?
  • What approaches are available to deal with toxic assets?
  • Why did the administration choose the approach that it did?

Read the full paper » (pdf)