The Public-Private Investment Program: Legacy Loans
| March 31, 2009
| Finance & Restructuring Group
The Secretary of the Treasury Timothy Geithner announced the creation of the Public-Private Investment Program, a long-awaited component of the broader Financial Stability Plan previously announced by President Obama’s administration. The PPIP consists of two distinct parts, the Legacy Securities Program and the Legacy Loans Program. This Notice will focus specifically on the Legacy Loans Program and provides first a short summary of the mechanics of the Loans Program. Following that summary, this Notice touches on some important questions about the Loans Program that remain currently unanswered. The terms and details of the Loans Program will be more fully spelled out in upcoming weeks, so the information in this Notice is of a preliminary nature
Since the Obama administration’s announcement of the Financial Stability Plan last month, speculation over the approach that Treasury would take in attempting to break through congestion in the financial system had run rampant and deeply unsettled the public markets. The PPIP as announced strikes a balance between calls for a “resolution trust” entity, under which the government would have shouldered the full burden of pricing and acquiring distressed assets held by financial institutions, and hopes for a purely private solution. When finally released, the PPIP was greeted with enthusiasm in the public markets and appeared to spark a rally in the equity markets.
The PPIP is designed to use both federal and private capital, working together, to price and purchase distressed “legacy” loans and securities (often referred to, less diplomatically, as toxic assets) currently held on the balance sheets of US banks and other financial institutions. Secondary trading markets for many of these assets have largely ceased operating since the traumatic events of last fall, creating great uncertainty over the true value of the assets and the solvency of our financial system. The animating principle of the PPIP is the controversial view, expressed by Secretary Geithner and many in the banking industry, that the intrinsic value of the legacy assets is substantially higher than the “mark to market” values required under applicable accounting rules. The PPIP instantly became a central part of the government’s multi-faceted efforts to unclog the balance sheets of financial institutions, restart secondary trading markets and ultimately increase the flow of credit to consumers and businesses. Treasury indicated that it will use $75 to $100 billion in TARP Capital to fund the public side of the PPIP. The government estimates that, coupled with private capital, the PPIP will generate $500 billion (and potentially $1 trillion over time) in purchasing power for legacy assets. It appears that Treasury intends to allocate its funds equally between the Legacy Loans Program and the Legacy Securities Program.
How the Loans Program Will Work
In short, the Loans Program will facilitate the purchase of troubled loans from banks through an auction process with a combination of private capital, matching equity investment from the Department of Treasury and non-recourse debt issued by “public-private investment funds” and guaranteed by the Federal Deposit Insurance Corporation. Treasury released details of the Loans Program in the form of a white paper, fact sheet, summary of terms and answers to frequently asked questions.
The FDIC will play a critical role. It will oversee multiple PPIFs that will be created to purchase pools of loans from insured depositary institutions and then to own and manage the pools. Only US banks and savings institutions will be eligible to participate as sellers under the Loans Program; banks or savings associations owned or controlled by a foreign bank or company are excluded. Participating banks are to work with their regulators to identify pools of loans they wish to sell. The FDIC, with the assistance of third-party contractors, will then determine whether the indentified loans qualify as an “Eligible Asset Pool” and the amount of funding the FDIC is willing to guarantee to facilitate a sale of that pool. The debt to equity ratio will not exceed 6-to-1 for any PPIF.
The Eligible Asset Pool, with committed financing by the FDIC, will then be auctioned. Private investors will bid for the opportunity to provide 50% of the equity for a PPIF and to manage the PPIF’s assets, with Treasury providing the remainder of the equity. Critically, the bids by private investors will set the market price for each Eligible Asset Pool, thereby relieving government agencies of that responsibility. The winning bid for the equity stake, along with the pre-determined amount of FDIC guaranteed funding, will establish an offer price to the selling bank. The selling bank will then have to decide if it is willing to sell the pool for the offered price. If it agrees to sell, the consideration paid will either be in cash or, more likely, a combination of cash and debt issued by the PPIF to the seller, supported by the FDIC’s guarantee. The FDIC’s guarantee of the PPIF’s debt will be secured by the purchased loan assets.
The “buy side” of the Loans Program seems to present attractive opportunities to interested investors. Specifically, the FDIC-guaranteed financing is non-recourse and potentially will allow investors to leverage equity capital at up to a 6-to-1 ratio, although questions remain about the interest rates, maturities and other terms of the loans. Presumably, those specific terms will have to be negotiated on a case-by-case basis among the selling bank, the FDIC, Treasury and the private investor as part of the bid process. The Treasury itself anticipates that a wide array of investors will participate in the Loans Program, and stated that the Loans Program “will particularly encourage the participation of individuals, mutual funds, pension plans, insurance companies and other long-term investors.” The timing for the first auction has not yet been established, although there was some suggestion that it could occur within eight to ten weeks of Treasury’s roll-out of the PPIP.
Last week’s information from Treasury and the FDIC on the Loans Program, and the PPIP generally, provided many important details to investors. But, as would be expected in programs of this magnitude, a number of questions will have to be answered before investors likely will be willing to commit to participation. A few of these questions are highlighted below.
Limits on Compensation or Profits?
In the wake of the noisy AIG bonus and tax controversy, investors are understandably concerned about partnering with the government in a profit-seeking venture. Potential investors in the Loans Program, facing the substantial inherent risks associated with acquiring distressed assets, will reasonably seek healthy returns on their capital. It is logical to ask whether they will be willing to bear the additional risk that they will succeed in the venture, only to face populist demands to forfeit their profits.
While the possibility of retroactive action by the government cannot be ruled out, Treasury and the FDIC have gone to great lengths to emphasize that compensation restrictions on the recipients of TARP funds will not apply to private investors in the Loans Program. They draw a distinction between TARP funds being used to bail-out already struggling institutions and using public funds to incentivize investors and re-start broken markets. Further, the basic nature of the Loan Programs allows for the Treasury to share equally in equity returns with investors. Nonetheless, investors undoubtedly will seek maximum protection against after-the-fact punitive actions by the government.
Will the Banks Participate?
The largest question looming over the Loans Program is whether, and what, the nation’s banks will sell. For a number of excruciating months, a “pricing paradox” has clogged the financial system. The government and investors do not want to overpay for assets (including distressed loans) which are not actively trading. But the current owners – the banks – believe these assets are dramatically undervalued by the market. Importantly, the Loans Program contemplates a form of “reserve auction;” the selling banks have the option simply to refuse to sell even to the highest bidder. The possibility exists for inconclusive auctions and even a complete failure for the Loan Program to launch if eligible banks believe the offer prices will be unacceptably low.
It seems fair to assume, however, that Treasury and the FDIC will exert great pressure on depositary institutions to participate in the Loans Program. President Obama’s administration and Secretary Geithner in particular, now have invested substantial political capital in the PPIP and undoubtedly will be reluctant to see the Loan Programs fail due to lack of participation by regulated entities. It is quite possible that during the government’s “stress tests” to determine whether certain entities are viable, banks simply will be forced to sell certain loans to satisfy capital requirements or as part of the seizure process used by the FDIC with failed banks.
There is an additional question of which loans banks will auction. Treasury has indicated that the Loans Program is designed to rid banks of troubled residential and commercial real estate loans, but the Loans Program does not limit the types of loans that can be sold (other than a restriction that the loans and associated collateral must be predominantly located in the United States). It is therefore possible that commercial and industrial and “leveraged” loans, among others, could be included in the Loans Program, which in turn may attract groups of investors not interested in acquiring real estate loans.
How Will Acquired Pools be Managed?
While admirably detailed in certain areas, the Loans Programs is quite vague about how the PPIFs and the assets they acquire will be managed. Treasury explained in its white paper that private parties will have management and servicing authority over the PPIF’s loan portfolio, but within parameters set by Treasury and the FDIC and “subject to rigorous oversight from the FDIC.” It is not clear whether PPIF investors can also act as asset managers or if the investors will be required to hire third-party managers. Although investors and asset managers who wish to participate in the Loans Program must be approved by the FDIC, no guidance on the approval criteria has yet been provided. The Loans Program “Summary of Terms”, while noting definitively that Treasury will not have control rights through its equity investment, goes on to state without further detail that the FDIC and Treasury “shall establish governance procedures on the management, servicing agreement, financial and operating reporting requirements, exit timing and alternatives for each of the Eligible Pools,” preferably through standard documentation.
Investors will surely wish to study carefully the procedures and documentation that the government ultimately provides. Beyond those specifics, an overarching question will center on the amount of management discretion that, in practice, will be granted to investors and asset managers. Prudently managing a pool of distressed loans often requires difficult decisions regarding the enforcement of legal remedies against the borrowers, including foreclosure. It is not difficult to imagine the government, as a partner in a PPIF, being reluctant to foreclose on a residential or commercial mortgage in the midst of a historic recession, even if such action is in the PPIF’s economic interest. Potential investors will need substantially more information from the government regarding the management autonomy of PPIFs as they weigh participating in the Loans Program.
Another factor affecting the management of a PPIF is that all loans in the Loans Program will be subject to the Home Affordable Modification Program announced by Treasury on March 4th. Under that program, loan servicers are incentivized with payments from the government to modify the terms of eligible residential loans to reduce homeowners’ monthly payments. Additionally, on March 9th, the House of Representatives approved legislation that would allow a bankruptcy judge to alter, among other things, the value, the term and interest rate on a home loan to assist a debtor in avoiding foreclosure. The impact of these government measures on the relevant loans should be addressed before investors participate in the Loans Program.
The lawyers in Choate’s Finance & Restructuring, Real Estate and Private Equity practice groups are carefully monitoring the PPIF and the Loans Program and expect to provide more information as developments occur. Please contact any of the partners listed below if you would like to discuss this Notice or any aspect of the Loans Program.