The U.S. Department of the Treasury is taking direct aim at the troubled assets the Troubled Asset Relief Program was originally designed to ameliorate. Residential mortgages and the multitude of securities that have been created using them as a base have clogged the balance sheets of banks, insurance companies, investment companies and many others since the beginning of the credit crisis in August 2007. That was when high default-rates began to appear in subprime loans as the housing bubble popped. As the credit crisis worsened, the market for mortgage securities (and derivates, such as credit default swaps) dried up completely as investors and banks lost confidence in such investments. With no market, there has been no reasonable method to assess the value of the mortgage securities and derivatives, which has frustrated certain efforts like evaluating the relative health of banks, implementing programs designed to get credit markets flowing again (TARP, TALF, etc.), and the general functioning of credit markets (high credit spreads are the result of uncertainty over banks’ balance sheets). The Treasury’s Public Private Partnership Investment Program seeks to reestablish a market for mortgage loans, securities, and derivatives, which the programs refers to as “legacy assets” by providing up to $500 billion, with the potential to expand to $1 trillion.
According to the Treasury, the program will operate under three basic principles:
- Maximizing the impact of each taxpayer dollar
- Shared risk and profits with private sector participants
- Private sector price discovery
Funding for the program will consist of $75 to $100 billion from TARP capital and capital from private investors, with additional funding provided by the FDIC and the Federal Reserve. By using funds from TARP and the Fed’s balance sheet, no new legislation or Congressional approval is necessary.
The Public-Private Investment Program is split into two parts: purchase of legacy loans and legacy securities.
The process for purchasing legacy loans:
- Banks identify the assets they wish to sell
- Loan pools auctioned off to highest bidder
- Financing provided through FDIC guarantee
- Private section fund managers manages the assets until final liquidation
Sample Investment Under the Legacy Loans Program
Step 1: If a bank has a pool of residential mortgages with $100 face value that it is seeking to divest, the bank would approach the FDIC.
Step 2: 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.
Step 3: The pool would then be auctioned by the FDIC, with several private sector bidders submitting bids. The highest bid from the private sector – in this example, $84 – would be the winner and would form a Public-Private Investment Fund to purchase the pool of mortgages.
Step 4: Of this $84 purchase price, the FDIC would provide guarantees for $72 of financing, leaving $12 of equity.
Step 5: The Treasury would then provide 50% of the equity funding required on a side-by-side basis with the investor. In this example, Treasury would invest approximately $6, with the private investor contributing $6.
Step 6: 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.
The mortgage loans of course are easier to deal with than the securities. After all, the loans are collateralized by real property, and even though house prices have dropped significantly, a price, or value, of the collateral can still be determined. Thus, while holding the loan still carries credit risk (the ability of the borrower to repay the loan on a timely basis), the value of the loan is, at the very least, the value of the collateral. Securities are an interest in the repayment streams of a pool of mortgage loans. Thus, securities have maximum credit risk, and the holder of a security has no collateral. Derivatives carry the same problem, and generally they are bets on the risk, like credit default swaps. It is exponentially more difficult to put a price on securities and derivatives than on the loans themselves.
And so, the legacy securities side of the Public-Private Investment Program is much more complex. First, the Term Asset-Backed Securities Loan Facility (TALF) is expanded to legacy securities. The Program Fact Sheet explains it like this:
Providing Investors Greater Confidence to Purchase Legacy Assets:As with securitizations backed by new originations of consumer and business credit already included in the TALF, we expect that the provision of leverage through this program will give investors greater confidence to purchase these assets, thus increasing market liquidity.
Funding Purchase of Legacy Securities: Through this new program, 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 commercial mortgage-backed securities (CMBS) and asset-backed securities (ABS) that are rated AAA.
Working with Market Participants: Borrowers will need to meet eligibility criteria. Haircuts will be determined at a later date and will reflect the riskiness of the assets provided as collateral. Lending rates, minimum loan sizes, and loan durations have not been determined. These and other terms of the programs will be informed by discussions with market participants. However, the Federal Reserve is working to ensure that the duration of these loans takes into account the duration of the underlying assets.
The Treasury will then partner with experienced asset managers who will raise private capital to purchase, with matching Treasury funds, designated asset classes.
Sample Investment Under the Legacy Securities Program
Step 1: Treasury will launch the application process for managers interested in the Legacy Securities Program.
Step 2: A fund manager submits a proposal and is pre-qualified to raise private capital to participate in joint investment programs with Treasury.
Step 3: The Government agrees to provide a one-for-one match for every dollar of private capital that the fund manager raises and to provide fund-level leverage for the proposed Public-Private Investment Fund.
Step 4: The fund manager commences the sales process for the investment fund and is able to raise $100 of private capital for the fund. Treasury provides $100 equity co-investment on a side-by-side basis with private capital and will provide a $100 loan to the Public-Private Investment Fund. Treasury will also consider requests from the fund manager for an additional loan of up to $100 to the fund.
Step 5: As a result, the fund manager has $300 (or, in some cases, up to $400) in total capital and commences a purchase program for targeted securities.
Step 6: The fund manager has full discretion in investment decisions, although it will predominately follow a long-term buy-and-hold strategy. The Public-Private Investment Fund, if the fund manager so determines, would also be eligible to take advantage of the expanded TALF program for legacy securities when it is launched.
A fact sheet on the Program may be viewed here.
Gregg D. Killoren
victoria1014
