Monday, March 23, 2009

well align public and private investor interests in order to maximize the long-run value for U.S. taxpayers

TO BE NOTED: From Financial Stability Dot Gov:

Public-Private Investment Program
$500 Billion to $1 Trillion Plan to Purchase Legacy Assets

Troubled real estate-related assets, comprised of legacy loans and securities, are at the center of
the problems currently impacting the U.S. financial system. The Financial Stability Plan,
announced on February 10th, outlined a broad approach to address this issue via the formation of
Public-Private Investment Funds (“PPIFs”). Today Treasury is announcing the Public-Private
Investment Program under which it will make targeted investments in multiple PPIFs that will
purchase legacy real estate-related assets.
Addressing the problems created by legacy assets should help to improve the health of the
financial institutions where they are held, leading to an increased flow of credit throughout the
economy, and helping improve market functioning in the near-term. Investments made by
Treasury under the Public-Private Investment Program are intended to complement the other
components of the Financial Stability Plan that have been announced, including the Capital
Assistance Program, the Capital Assistance Program, and the Consumer and
Business Lending Initiative, continuing the Obama Administration’s efforts to improve the
stability and functioning of the financial system.
The Legacy Asset Problem
A variety of troubled legacy assets ( TLAs DON ) are currently congesting the U.S. financial system. An initial
fundamental shock associated with the bursting of the housing bubble and deteriorating
economic conditions generated losses for leveraged investors including banks. This shock was
compounded by the fact that loan underwriting standards used by some originators had become
far too lax( NB DON ) and by the proliferation of structured credit products, some of which were illunderstood
by some market participants.
The resulting need to reduce risk triggered a wide-scale deleveraging ( CALLING RUN DON ) in these markets and led to
fire sales. As prices declined further, many traditional sources of capital exited these markets,
causing declines in secondary market liquidity. As a result, we have been in a vicious cycle in
which declining asset prices have triggered further deleveraging and reductions in market
liquidity, which in turn have led to further price declines( CALLING RUN DON ). While fundamentals have surely
deteriorated over the past 18-24 months, there is evidence that current prices for some legacy
assets embed substantial liquidity discounts( NB DON ).
The discounts currently embedded in some legacy asset prices are a significant strain on the
economic capital of U.S. financial institutions and have reduced their ability to engage in new
credit formation. At the same time, the difficulty of obtaining private financing on reasonable
terms to purchase these assets has limited the ability of investors to reduce these discounts. The
lack of clarity about the value of these legacy assets has made it difficult for some financial
institutions to raise new private capital.
The Public-Private Investment Program is designed to draw new private capital into the market
for these assets by providing government equity co-investment and attractive public financing( NB DON ).
This program should facilitate price discovery and should help, over time, to reduce the
excessive liquidity discounts embedded in current legacy asset prices. This in turn should free
up capital and allow U.S. financial institutions to engage in new credit formation. Furthermore,
enhanced clarity about the value of legacy assets should increase investor confidence and
enhance the ability of financial institutions to raise new capital from private investors.
The primary areas of focus for the government’s troubled legacy asset programs are the
residential and commercial mortgage sectors, including both whole loans and securitizations
backed by loan portfolios. These troubled assets are held by all types of financial institutions,
including those that predominantly hold them in the form of loans, such as banks, and those that
predominantly hold securities, such as insurers, pension funds, mutual funds and individual
retirement accounts. While the program may initially target real estate-related assets, it can
evolve, based on market demand, to include other asset classes.
The Public-Private Investment Plan: A Comprehensive Solution
A key principle of the chosen approach is to use private capital and private fund managers to
help provide a market mechanism for valuing the troubled assets. By creating partnerships with
private investors, this approach should serve to both protect the interests of taxpayers over the
long-term and help restore liquidity and enable price discovery in the markets for troubled assets
in the short-term.
The two key elements of the plan are:
• Legacy Loans Program: a program to combine an FDIC guarantee of debt financing with
equity capital from the private sector and the Treasury to support the purchase of troubled
loans from insured depository institutions.
• Legacy Securities Program: a program to combine financing from the Federal Reserve and
Treasury through the Term Asset-Backed Securities Loan Facility (“TALF”) with equity
capital from the private sector and the Treasury to address the problem of troubled securities.
The equity co-investment component of these programs has been designed to well align public
and private investor interests in order to maximize the long-run value for U.S. taxpayers( NB DON ).
Specifically, while the plan is designed to help reduce the liquidity discounts contained in legacy
asset prices in the near-term, the most important way to protect taxpayers is to ensure that the
government is not paying more for assets than their long-run value as determined by private
investors. Since TARP funds will be invested alongside private capital on similar terms, this
reduces the likelihood that taxpayers will be overpaying( NB DON ). At the same time, taxpayers will have
the opportunity to participate in the asset’s upside along with private investors. Similarly, the
debt financing components of these programs have been structured to protect taxpayer dollars
and the FDIC’s Deposit Insurance Fund from credit losses to the greatest extent possible.
Together, these two programs should help to restart markets for troubled assets, begin the
process of repairing balance sheets, and eventually lead to increased lending in comparison with
levels that would have occurred without this effort.
The Legacy Loans Program
In order to help cleanse bank balance sheets of troubled legacy loans and reduce the overhang of
uncertainty associated with these assets, the FDIC and Treasury are launching the Legacy Loans
Program. This program will attract private capital to purchase eligible loan assets from
participating banks through the provision of FDIC debt guarantees and Treasury equity coinvestment.
A wide array of investors are expected to participate. The program will particularly
encourage the participation of individuals, mutual funds, pension plans, insurance companies,
and other long-term investors. The program is intended to boost private demand for distressed
assets that are currently held by banks and facilitate market-priced sales of troubled assets.
The FDIC will provide oversight for the formation, funding, and operation of a number of PPIFs
that will purchase assets from banks. The Treasury and private investors will invest equity
capital in Legacy Loans PPIFs and the FDIC will provide a guarantee( NB DON ) for debt financing issued
by the PPIFs to fund asset purchases. The FDIC’s guarantee will be collateralized by the
purchased assets and the FDIC will receive a fee in return for its guarantee. The Treasury will
manage its investment on behalf of taxpayers( NB DON ) to ensure the public interest is protected. The
Treasury intends to provide 50% of the equity capital for each PPIF, but private investors will
retain control of asset management, subject to rigorous oversight from the FDIC.
Institutions of all sizes will be eligible to sell assets under the Legacy Loans Program. To start
the process, banks will identify to the FDIC the assets, typically a pool of loans, that they wish to
sell. Assets eligible for purchase will be determined by the participating banking organizations,
including the primary banking regulators, the FDIC, and the Treasury. In order to protect
taxpayer dollars from credit losses, the FDIC will employ contractors( ??? ) to analyze the pools and
will determine the level of debt to be issued by the PPIF that it is willing to guarantee. This will
not exceed a 6-to-1 debt-to-equity ratio. An eligible pool of loans, with committed financing,
will then be auctioned by the FDIC to qualified bidders. Private investors will bid for the
opportunity to contribute 50% of the equity for the PPIF with the Treasury contributing the
remainder. The winning bid for this equity stake together with the amount of debt the FDIC is
willing to guarantee (based on a predetermined debt-to-equity ratio), will define the price offered
to the selling bank. The bank would then decide whether to accept the offer price.
Once the initial transaction has been completed, the private capital partners will control and
manage the assets until final liquidation, subject to strict oversight from the FDIC. The FDIC
will play an ongoing reporting, oversight and accounting role on behalf of the FDIC and
Treasury. The exact requirements and structure of the Legacy Loans Program will be subject to
notice and comment rulemaking.
If a bank has a pool of residential mortgages with $100 face value that they are seeking to divest,
the bank would approach the FDIC. The FDIC would determine, according to the above process,
that they would be willing to leverage the pool at a 6-to-1 debt-to-equity ratio. The pool would
then be auctioned by the FDIC, with several private buyers submitting bids. The highest bid
from the private sector – in this example, $84 – would define the total price paid by the private
investors and the Treasury for the mortgages. Of this $84 purchase price, the Treasury and the
private investors would split the $12 equity portion. The new PPIF would issue debt for the
remaining $72 of the price and the debt would be guaranteed by the FDIC. This guarantee would
be secured by the purchased assets. The private investor would then manage the servicing of the
asset pool and the timing of its disposition on an ongoing basis – using asset managers approved
and subject to oversight by the FDIC. Through transactions like this, the Legacy Loans Program
is designed to use private sector pricing to cleanse banks’ balance sheets of troubled assets and
create a more healthy banking system.
The Legacy Securities Program
The Legacy Securities Program consists of two related parts. This program is designed to draw
private capital into the markets for legacy securities by providing matching equity capital under
the Treasury’s Public-Private Investment Program and debt financing from the Federal Reserve
and Treasury under the TALF. However, any private investor, even those who do not partner
with Treasury( NB DON ) under the Public-Private Investment Program, will also be able to access the
TALF to purchase legacy securities. The goal is to restart the market for these legacy securities,
which will allow banks and other financial institutions to free up economic capital and stimulate
the extension of new credit. The resulting process of price discovery should also reduce the
uncertainty surrounding financial institutions holding these securities, potentially enabling them
to raise new private capital.
Expansion of TALF for Legacy Securities
The Treasury and the Federal Reserve are creating a lending program that is targeted at the
broken market for legacy securities tied to residential real estate, commercial real estate, and
consumer credit. The intention is to incorporate this program into the previously announced
TALF, which may total as much as $1 trillion.
Through this expansion of the TALF, non-recourse loans will be made available to investors to
fund purchases of legacy securitization assets. Eligible assets are expected to include certain
non-agency residential mortgage-backed securities (“RMBS”) that were originally rated AAA,
and outstanding and commercial mortgage-back securities (“CMBS”) and ABS that are rated
AAA. Borrowers will need to meet certain eligibility criteria. Haircuts will be determined at a
later date and will reflect the riskiness of the assets provided as collateral( NB DON ). Lending rates,
minimum loan sizes, and loan durations have not yet been determined. These and other terms of
the program will be informed by discussions with market participants. As with securitizations
backed by new originations of consumer and business credit already included in the TALF, the
provision of leverage through this program should give investors greater confidence to purchase
these assets, thus increasing market liquidity.
Legacy Securities PPIFs
In conjunction with these efforts, the Treasury is also announcing a program to partner with
private fund managers to support the market for legacy securities.
Under this program, private investment managers will have the opportunity to apply for
qualification as a Fund Manager (“FM”). Applicants will be pre-qualified based upon criteria
that are expected to include a demonstrable historical track record in the targeted asset classes, a
minimum amount of assets under management in the targeted asset classes, and detailed
structural proposals for the proposed Legacy Securities PPIF. Treasury expects to approve
approximately 5 FMs and may consider adding more depending on the quality of applications
received. Approved FMs will have a period of time to raise private capital to target the
designated asset classes and will receive matching equity capital from Treasury. FMs will be
required to submit a fundraising plan to include retail investors, if possible. Treasury equity
capital will be invested on a fully side-by-side basis with these private investors in each PPIF.
Furthermore, FMs will have the ability, to the extent their fund structures meet certain
guidelines, to subscribe to Treasury for senior debt for the PPIFs in the amount of up to 50% of a fund’s total equity capital, and Treasury will consider requests for senior debt for the PPIFs in
the amount of up to 100% of a fund’s total equity capital subject to further restrictions on asset
level leverage, redemption rights, disposition priorities, and other factors Treasury deems
relevant. This senior debt will have the same duration as the underlying fund and will be repaid
on a pro-rata basis as principal repayments or disposition proceeds are realized by the PPIF.
These senior loans will be structurally subordinated to any financing extended by the Federal
Reserve to these PPIFs via the TALF.
Treasury expects the PPIFs to initially target non-agency RMBS and CMBS originated prior to
2009 with a rating of “AAA” at origination.
Treasury will launch the application process for managers interested in the Legacy Securities
Program. An interested FM would submit an application and be pre-qualified to raise private
capital to participate in joint investment programs with Treasury. Treasury would agree to
provide a one-for-one equity match( NB DON ) for every dollar of private capital that the FM raises and
provide fund-level leverage for the proposed PPIF. The FM would commence the sales process
for the PPIF and raise $100 of private capital for the PPIF. Treasury would provide $100 of
equity capital to be invested on side-by-side basis with private capital and would provide up to a
$100 loan to the PPIF if the fund met certain guidelines. Treasury would also consider requests
from the FM for an additional loan of up to $100 subject to further restrictions. As a result, the
FM would have $300 (or, in some cases, up to $400) in total capital and would commence a
purchase program for targeted securities. The FM would have full discretion in investment
decisions, although the PPIFs will predominately follow a long-term buy and hold strategy.
Depending on the amount of loans provided directly from Treasury, the PPIF would also be
eligible to take advantage of the expanded TALF program for legacy securities when that
program is operational.

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