The controversial Public-Private Investment Program (PPIP)—in which the government is partnering with private investors to purchase the toxic loans and securities that are clogging up the balance sheets of many financial firms—is finally ready to begin. The Treasury Department has announced that five of the nine asset managers selected for the PPIP’s Legacy Securities Program have each raised at least $500 million in equity from private investors, the minimum required to get official approval. This commitment in private equity will be combined with equity and debt financing from Treasury to form the Public-Private Investment Funds (PPIFs) that will be purchasing and managing the legacy securities.
The five asset managers that passed this initial hurdle are: Invesco Ltd., The TCW Group, AllianceBernstein, BlackRock, and Wellington Management Company. These firms have raised a combined $3.07 billion in private equity, which will be combined with the equity and debt financing provided by Treasury to give the PPIFs a grand total of $12.27 billion in purchasing power. Officials expect that the remaining four firms will raise the necessary capital by the end of the month.
For those who have been following the bailout closely, hearing the names of these firms will probably ring a bell. That’s because many of the PPIP asset managers are already working in other capacities to administer the government’s highly complex bailout programs. BlackRock and Wellington are both investment managers for the New York Fed’s $1.25 trillion agency mortgage-backed securities purchase program. BlackRock is also an asset manager for all three of the New York Fed’s Maiden Lane facilities. And AllianceBernstein is a manager of assets received by Treasury under the Troubled Asset Relief Program (TARP).
Although the PPIP has been scaled back since it was first announced, Treasury is still setting aside $30 billion in TARP funds for the program, in hopes that it will reignite the market for real estate-related assets, facilitate price discovery, increase investor confidence in the firms that carry these assets, and encourage the firms to increase lending to consumers and small businesses. But now that the first wave of private fund managers has been given the green light to purchase legacy securities, we wonder if the program will have as much impact as Treasury claims, and if the public really stands to benefit from these “partnerships.” As POGO and others have repeatedly pointed out, there are still a host of unresolved issues related to the PPIP:
- Incentives skewed in favor of private investors
As soon as the PPIP was first announced, commentators such as Joseph Sitglitz and Jeffrey Sachs raised concerns that the generous subsidies provided by the government would skew the incentives in favor of private investors. Although the government and the investors will split any profits 50-50, it’s the government that will have to incur major losses if the investments go badly since the government’s also providing debt guarantees. Supporters of the TARP have applauded the recent news that the government made a profit when some of the big banks repaid their TARP funds, but the PPIP is an area where taxpayers could still take a big hit.
- Potential for conflicts of interest
The Special Inspector General for the Troubled Asset Relief Program (SIGTARP) has had its eye on the PPIP for months now, sounding the alarm about the potential for conflicts of interest, collusion, and money laundering. In its most recent report to Congress, the SIGTARP announced that Treasury had adopted many of its recommendations, as reflected in the recently updated conflict of interest rules and ethical guidelines. But the rules are still far from perfect.
Of particular concern to POGO is the potential for conflicts of interest involving BlackRock and some of the other asset managers that have a significant financial interest in the same types of securities that they’ll be purchasing and managing for the PPIFs. One simple, albeit incomplete solution would be to implement internal firewalls that would prevent the employees working for the PPIFs from sharing insider information with the employees managing non-PPIF funds. But the latest SIGTARP report revealed that Treasury won’t even take this basic step, leaving the PPIP open to conflicts of interest that could result in financial losses for the government and an unfair competitive advantage for the private asset managers.
- Lack of participation by firms that hold legacy securities
An August report by the Congressional Oversight Panel observed that “the issue underlying the PPIP is the same as the question underlying virtually all discussions of troubled assets: valuation.” At the end of the day, even though the PPIFs are almost ready to go, Treasury still needs participation from the firms that are holding the legacy securities. And many of these firms are worried that the PPIFs will underpay for their assets, forcing them to incur losses on their books.
It’s possible that some banks are steering clear of the PPIP because of a recent decision by the Financial Accounting Standards Board—under pressure from Congress and the financial services lobby—to revise a key “mark-to-market” accounting rule that would have otherwise forced banks to report major losses on their troubled assets. Thanks to the rule change, banks now have more leeway to use creative accounting when estimating the value of the assets they hold on their books. Harvard Law Professor Lucian Bebchuk wrote in June that the new accounting rules “strongly discourage banks from selling any toxic assets maturing after 2010 at prices that fairly reflect their lowered value. As long as banks don’t sell, the policies enable them to pretend, and operate as if their toxic assets maturing after 2010 haven’t fallen in value at all.” If this is the case, it seems likely that the PPIP will continue to stall due to a lack of participation from banks that would rather hold the legacy securities on their balance sheets and avoid booking any losses.
Many of these same concerns also apply to the other half of the PPIP, the Legacy Loans Program (LLP), which targets whole loans rather than securities and is being administered by the Federal Deposit Insurance Corporation (FDIC). A few weeks ago, the FDIC announced a pilot sale in which Residential Credit Solutions, a Houston-based lender, will purchase mortgages from a failed bank that the FDIC is holding in receivership. The transaction is fairly complicated, but the bottom line is that the FDIC is providing most of the equity and debt financing for the sale. In addition to the generous government subsidies, several commentators have pointed out that there is something very strange about this deal: the investor will be purchasing assets from a bank that has already failed.
If the FDIC plans to continue facilitating the sale of assets for failed banks that it’s holding in receivership, this could have one positive side effect: any investors who overpay for the bank’s assets would also be helping to replenish the FDIC’s sorely depleted Deposit Insurance Fund. But a recent paper by Professor Linus Wilson shows that inflated prices won’t actually benefit the Deposit Insurance Fund in the long run. More importantly, we’re not sure how any test with a failed bank will produce useful results for banks that are still in existence or advance the government’s goal of increasing lending. And as the Congressional Oversight Panel report points out, the continued delay in assisting banks with legacy loans could have serious consequences for smaller and community banks, which tend to hold more whole loans than securities and are likely to be hit hard by any rise in defaults.
-- Michael Smallberg