Publications

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Over the course of the past several weeks, we have been inundated with a flood of massive new government programs designed to address systemic risk in the financial markets by stabilizing and recapitalizing banks, financial institutions and other critical market participants, restore frozen credit markets and address the inventory of illiquid troubled assets that continue to hamper recovery.

Two major developments in the past week provide the market with significant food for thought and action. The first was the announcement on March 23 by US Secretary of the Treasury Timothy Geithner of the much anticipated public-private investment program (PPIP). The second was the successful March 25 funding of the first loans under the Term Asset-Backed Securities Loan Facility (TALF) administered by the Federal Reserve Bank of New York.

The Week in Context

While it may seem to many that the government is not doing enough, quickly enough, to address the financial crisis, by historical standards the Administration is moving at a breakneck pace. Much has been accomplished in a very short time.

The legislative basis for the PPIP, the TALF and related programs is the Emergency Economic Stabilization Act of 2008, enacted by Congress on October 3, 2008. The initial $350 billion in funding that it provided was used by Treasury under the so-called Capital Purchase Program and other programs to recapitalize banks, to rescue other financial institutions and to fund loans to US auto manufacturers.

In November 2008, the Treasury and the Federal Reserve Bank of New York moved beyond stabilizing the financial system and announced the creation of the TALF, a loan facility to be made available to investors to fund the acquisition of newly originated AAA-rated securities backed by auto, credit card, small business and student loans with the goal of making new credit available to consumers by restoring critical securitization markets.

After the transition from the Bush Administration to the Obama Administration, on February 10, 2009, Secretary Geithner announced the Obama Administration’s Financial Stability Plan, which included six components:

1. A revised Capital Assistance Program to strengthen our financial institutions;
2. A Public-Private Investment Fund with $500 billion to $1 trillion of purchasing power to address the “legacy asset” (more popularly known as “toxic asset”) problem;
3. A Consumer and Business Lending Initiative, including the TALF, of up to $1 trillion to restore frozen markets, with a particular focus on securitization markets;
4. A Transparency and Accountability Agenda calling for greater transparency, accountability and conditionality for firms receiving “exceptional” government assistance;
5. A Housing Support and Foreclosure Prevention Program; and
6. A Small Business and Community Lending Initiative to unlock credit to small businesses.

The Treasury and related government agencies have been extremely active in developing each of these programs. Additional information is available almost daily. But last week, the most notable progress was made as a result of the announcement of the keenly awaited PPIP on March 23, and the actual funding of the initial TALF loans by the Federal Reserve Bank of New York on March 25.

One final recent event cannot be ignored when analyzing last week’s events – the public outcry over certain corporate bonuses and the reaction of the Administration and Congress. The bonus uproar, and the way it continues to unfold, could have serious implications for the success or failure of the Financial Stability Program in general. The concern is that potential investors will be discouraged from participating in the PPIP and other programs for fear that the rules of the game could change mid-course or that they could find themselves subjected to public criticism if they enjoy financial success. Somewhat less ominously, many potential investors are concerned that the regulatory burden of participating in these programs will simply be too great.

On the other hand, government sources have gone to great lengths to emphasize the critical importance of making these initiatives investor friendly to encourage private sector participation in these proposals. As noted by one official, if investors do not participate in restoring the markets, Treasury’s Plan B will be to purchase and hold these legacy assets. Such an act would reflect the reality that the markets will have ceased to operate for these assets, with devastating consequences.

The third alternative would be to do nothing at all, thereby prolonging the crisis. Not surprisingly, the strong message from the Administration is that, given the cirumstances, the success of these programs is the best possible result.

March 23: Public-Private Investment Program

As announced, the PPIP consists of two distinct programs – a program administered by the FDIC to address legacy loans currently held by US banks and thrifts, and a program administered by the Treasury to address the problem of legacy securities, primarily residential and commercial mortgage-backed securities that are impeding the recovery of our credit markets. As described below, these programs reflect a few recurring themes that run through the Financial Stability Program. The first three are specifically highlighted by the Treasury in its public releases: maximizing the impact of each taxpayer dollar; sharing risk and profits with private sector participants; and determining private sector price. To these, we would add the themes of taxpayer protection and transparency and accountability.

The Legacy Loan Program

In brief, the Legacy Loan Program seeks to cleanse FDIC-insured bank and thrift balance sheets of problem loans by selling those loans to individual Public-Private Investment Funds (PPIFs) funded through a combination of private equity, equity from Treasury and FDIC-insured debt. Under the program, an eligible institution, working with its primary regulator, would identify a pool of loans for sale and would submit the pool to the FDIC for review and approval. The FDIC would review the pool, with the assistance of one or more third-party valuation firms, to determine the amount of debt that it is willing to guarantee, up to a 6:1 debt to equity ratio. The FDIC would then conduct an auction for the pool. The winning private investor would then provide 50 percent of the equity of the PPIF and would control the management of the pool; Treasury would provide the remaining 50 percent of the equity, and the remaining funding would be provided through FDIC-guaranteed debt issued by the PPIF. The debt could be retained by the selling bank or sold to third parties.

As illustrated in the Treasury’s fact sheet, if a bank wishes to divest itself of a pool of $100 of residential mortgage loans, the FDIC approves the pool for a 6 to 1 debt to equity ratio, and the pool is auctioned for $84. The PPIF would then fund the purchase through $6 in equity from the winning bidder, $6 in equity from the Treasury and $72 in FDIC-guaranteed debt.

The FDIC anticipates that the initial focus of the program will be loans backed by residential and commercial real estate, including construction loans. But the FDIC has noted that it expects the program will expand over time. Any losses sustained by the FDIC under the program will be paid for out of fees charged for the FDIC guarantees and, if necessary, a special assessment on all FDIC-insured institutions.

Not surprisingly, there are many open questions about the details of this program. Among these questions: which qualifications will eligible bidders be required to satisfy? Will selling banks and thrifts be able to participate in the equity of the PPIF? How will the auctions be structured? How will diligence be performed? On March 26, the FDIC requested comment on these and other important issues for a two-week period. Read the FDIC request for comment here.

The Legacy Securities Program

The Legacy Securities Program seeks to restart the markets for legacy securities, specifically securities backed by residential and commercial mortgages and consumer debt, through two sub-programs. The first is the establishment of large PPIFs, with private and Treasury debt and equity funding, to engage in a long-term buy and hold strategy with the ultimate goal of maximizing returns to the taxpayer and private investors. The second is the expansion of the TALF to cover legacy securities, including non-agency residential and commercial mortgage backed securities that were rated AAA at the time of their original issuance.

Briefly, the Legacy Securities Program calls for Treasury to approve up to five asset managers for the program, with the possibility of approving others at a later date. Qualified fund managers will have the capacity to raise at least $500 million in private capital, will have experience investing in legacy securities, will have a minimum of $10 billion in legacy securities under management, will have the necessary operational capacity and will be headquartered in the United States.

Once approved, the Treasury will make an equity investment in a PPIF sponsored by the fund manager on a dollar-for-dollar basis with the private investors. Treasury will also provide debt funding to the PPIF in an amount equal to 50 percent of the total capital raised, and will consider additional debt funding up to 100 percent of the equity capital depending on the characteristics of the investments. Thus, if a fund manager raises $100 million in private funds, Treasury will invest $100 million in equity in the PPIF and will provide another $100 million to the PPIF in debt financing; Treasury would consider a second $100 million in debt funding, thereby providing a total of $300 to $400 million in total funding.

We note that, in light of the expansion of TALF to include Legacy Securities, the PPIF could further leverage its funds by borrowing TALF funds to acquire eligible legacy securities.

As with the Legacy Loan Program, many details of the Legacy Securities Program, including the terms of any TALF loans for Legacy Securities, have not yet been released.

Both programs are described in more detail in the Fact Sheet, Term Sheets, Frequently Asked Questions and related descriptions published by the Treasury on the date the PPIP was announced. You may read these documents here.

While the FDIC and Treasury are working hard to bring these programs to market as quickly as possible, there is much work yet to be done. Most market participants seem to believe that the first transactions under the Legacy Loan Program will not close until late in the second quarter or, conceivably, the third quarter, of this year at the earliest, and that the Treasury’s Legacy Securities Program may take a little more time.

Initial Market Reaction

In contrast to the steep market decline on February 10 when Secretary Geithner first announced the Financial Stability Plan, market reaction to the announcement of the PPIP was quite positive, with the Dow Jones Industrials rising by almost 800 points on that day. Other domestic stock indices reacted with comparable movements.

Although some of these gains were given up as a result of losses posted in subsequent trading sessions, overall the market is looking at the operation and viability of the PPIP with cautious optimism and seems to be regarding it as potentially positive for the US financial system. However, despite these favorable sentiments, certain long-term questions and concerns remain for potential participants in these programs.

Price Discovery

Perhaps the single biggest issue that haunts these new programs is the ongoing question of pricing: will sellers and buyers be able to agree on market-clearing prices for legacy loans and securities? To date, many buyers are offering fire-sale prices for these assets, and sellers are unwilling to part with their assets at these bargain rates. Buyers are unwilling to purchase these assets for the prices sellers are demanding, for fear of further price declines or making the mistake of trying to “catch the falling knife.” Anecdotal evidence continues to indicate that the spread between the bid and the ask for these Legacy Loans and Securities remains significant. While market participants recognize that favorable funding terms for PPIFs through these programs will narrow this gap significantly, it is still unclear whether these programs will be sufficient to allow a significant volume of transactions to take place.

The Valuation Problem

Complicating this analysis is the widely held concern that many banks and financial institutions are holding legacy loans and securities at valuations that exceed current estimated market prices, which many believe are unreasonably depressed in light of the frozen markets.

Under mark-to-market accounting rules as currently applied, sellers have been reluctant to sell legacy loans and securities, or even to put them out for bid, for fear that a sale of one such asset at a distressed price (or even the receipt of a bid price that is rejected as inadequate) would cause their auditors to require the write-down of their entire portfolio of similar assets. Such a writedown would create further losses and result in a need for additional capital infusions. Once again, the PPIP should alleviate this problem to a degree by providing inexpensive funding and thereby allowing the PPIFs to make somewhat higher bids for the Legacy Loans and Securities. But many are concerned that the federal programs will not be enough to close the gap.

The Role of the Government, and Its Consequences

Each of these programs involves a close partnership with the federal government, in which the government is providing the vast majority of the capital. This is one of the most significant concerns being raised by potential investors and participants in the marketplace. The PPIFs for both the Legacy Loan and the Legacy Securities Program will be subjected to “strict” review and oversight of operations and management, to assure that waste, fraud and mismanagement, as broadly defined, are eliminated as much as possible. In addition, it is clear that legacy loans held by PPIFs will be required to be serviced in accordance with applicable government programs, such as those implemented to avoid home foreclosures.

But beyond regulation of the PPIFs for misconduct and compliance with existing programs, some have expressed the concern that the PPIFs will be subject to ongoing government direction in the management of their portfolios to achieve future government policy objectives rather than simply to maximize recoveries. More broadly, there is concern that the government might one day, under political pressure, change the rules of the game. The bonus uproar has heightened these fears. Understanding the concerns of the market, Secretary Geithner stressed, in an interview on March 29, the importance of not having retroactive changes to these programs.

“Unjust Enrichment” Concerns

Similarly, potential investors and fund managers have expressed concern regarding reputational and financial risks if they are perceived as being too successful in managing the legacy loans and securities. No one wants to risk Congressional hearings, punitive taxation provisions or other similar treatment in return for participating in these programs.

Potential Funding Uncertainties

In connection with the PPIF Legacy Securities Program, Treasury reserves, at all times, in the exercise of its sole and absolute discretion, the right to refuse to fund any undrawn commitments in the provision of funding for the specific application of the programs in question.

As a result, participants may find themselves with a radically restructured level of support by the government, once initial outlays and investments have already been made.

Executive Compensation Issues

In addition, while Secretary Geithner has confirmed, and the Term Sheets for the programs in question indicate, that passive investors in the Legacy Loan and Legacy Securities programs will not be subject to the executive compensation limitations established for participants in the Troubled Asset Relief Program (TARP), as further elaborated in the American Recovery and Reinvestment Act of 2009 (ARRA), questions exist concerning the definition of the term “passive” and other important concepts under these programs.

In addition to caps on salary and bonus payments, participants may also be subject to restrictions on hiring H-1B visa holders as well as on travel, expenses and corporate jet usage. These limitations cover entities determined to be TARP participants or recipients of TARP funds as defined under ARRA. Greater guidance from the Treasury will be necessary before these and other important questions may be answered.

Other Uncertainties

As noted above, Treasury will need to provide further definitions and guidance before these arrangements can be fully understood and analyzed. For example, none of the relevant loan terms for the PPIFs has been announced. Importantly, each of these programs requires that Treasury be granted warrants in the PPIFs. The terms of these warrants have not been announced. Limitations on investment strategies and hedging are anticipated, but have not been developed. As in the past, the possibility exists that these standards, once articulated, may well be contrary to the broad expectations of the investor community.

Fund Structuring Issues

With respect to the legacy securities PPIFs, decisions will have to be made regarding whether the funds’ securities should be registered to access the retail market or, instead, will be limited to qualified purchasers (to avail the fund of the Section 3(c)(7) exemption under the Investment Company Act of 1940). Similarly, it will need to be determined whether to limit participation by investors covered under the Employee Retirement Income Security Act (ERISA), so as to avoid ERISA status and its resultant regulatory complications, for the vehicle in question. As an alternative, should retail investors be identified as a potential class of acquirers to hold interests in the relevant funds, then registration of these entities as closed-end mutual funds, as required by the 1940 Act, and distribution through an underwritten public offering, would typically be required. Listing of these securities on a stock exchange would also be likely in connection with these distribution arrangements.

March 25: TALF Brings Further Market Optimism

A second source of market optimism was the first funding under TALF on March 25. Briefly, TALF, as originally implemented, is a program administered by the Federal Reserve Bank of New York under which non-recourse loans are available on favorable terms through the Federal Reserve’s primary dealer network to investors in newly originated securities backed by certain consumer and small business loans. The goal of this program, referred to as “TALF 1.0” by some market participants, is to restart the securitization markets that provided a large portion of consumer credit in recent years. The Federal Reserve Bank of New York continues to work on “TALF 2.0,” which will extend the program to newly originated residential and commercial mortgage-backed securities with the goal of restarting credit to those markets. Finally, “TALF 3.0” is the extension of TALF to legacy securities mentioned above.

TALF was first announced in November 2008. The details of the program were refined through February 2009, the first subscription for TALF funds closed on March 19 and the first transactions closed on March 25. We understand that approximately $8 billion in new asset-backed securitizations closed involving auto loan-backed transactions and a credit card-backed transaction. These issuances far outpaced anemic new issuance, in January and February of this year.

Of particular interest is that of the approximately $8 billion of asset backed securities sold, only about $4.7 billion of the securities were purchased with TALF loans. This indicates that traditional investors participated in these transactions independently of the availability of TALF funding.

We understand that market reaction to the successful closing of these new transactions was very positive, with spreads on similar securities tightening significantly, reflecting hopes that liquidity will return to the markets.

The next subscription period for TALF 1.0 funding is scheduled for April 7, with funding to occur on April 14. Expectations are for twice as many transactions in dollar amount, totaling roughly $16 billion.

Also of interest has been investor reaction to customer agreements that primary dealers have required investors to execute in connection with obtaining TALF funding. Many provisions of these agreements, notably certain representations and indemnities, have been controversial and continue to be the subject of much discussion in the marketplace. We understand that many investors that had shown initial strong interest in participating in last week’s transactions ultimately declined to proceed based on these concerns. Notably, to address these concerns, one market participant formed a new trust to act as the investor and execute the customer agreement. That newly formed trust, in turn, issued securities to investors backed by the newly issued asset-backed securities. Market participants expect more investors to come to the table as these issues are resolved.

As noted in the introduction, Treasury and other officials believe that private sector participation in these programs is essential. The government has indicated its willingness to continue to work with the private sector to make these programs acceptable to investors. It is to be hoped that, as additional transactions are effectuated and feed-back is obtained from investors and other participants, open issues will be resolved, these programs will succeed and markets will be restored.