The Special Inspector General for the Troubled Asset Relief
Program (SIGTARP) is currently investigating
a series of suspect trades undertaken by one of the private fund managers
for the Treasury Department’s Public-Private
Investment Program (PPIP), according to the SIGTARP’s
latest quarterly report to Congress. Although Treasury and the fund manager
have denied any wrongdoing, the SIGTARP is recommending that Treasury take
additional steps to protect the government from the conflicts of interest—both
real and perceived—that are likely to arise due to the fact that the fund
managers are trading in similar types of assets for both the government and for
their private clients.
The PPIP is designed to 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. Under the PPIP’s Legacy Securities Program (LSP), Treasury is partnering with private-sector fund managers to create Public-Private Investment Funds (PPIFs) that will purchase legacy securities (a.k.a. “toxic assets”) from banks, insurance companies, mutual funds, pension funds, and other eligible sellers. The equity capital raised by the PPIFs will be matched by Treasury, and Treasury will also provide debt financing and guarantees for the PPIFs. Treasury has committed up to $30 billion in combined debt and equity for the program.
POGO has repeatedly raised concerns that the PPIP could result in major financial losses for the government, because while the government and the private fund managers will split any profits 50-50, it’s the government that will incur most of the losses if the investments go south since it is providing both equity and debt guarantees. We’re also worried about the serious potential for conflicts of interest involving fund managers that are handling similar types of assets for both the government and for their private clients. As the SIGTARP pointed out in an earlier report, “the increase in the price of such an asset will greatly benefit anyone who owns or manages the same asset, including the PPIF manager who is making the investment decision.”
One way to guard against these conflicts of interest is to require that the fund managers establish internal firewalls that separate the employees working on the PPIFs from the employees handling the firm’s private investments. Although POGO believes that firewalls alone will not be enough to completely protect the government from conflicts—especially if Treasury is relying on the fund managers to disclose and manage their own conflicts—they are nonetheless an important and sensible step in the right direction. But in an earlier report, the SIGTARP revealed that Treasury is inexplicably allowing the PPIF managers to operate without any kind of firewall.
Now, in its latest report, the SIGTARP describes one alleged conflict involving a fund manager that is handling a PPIF without any firewall in place:
“...a series of unusual trades undertaken in one of the PPIFs just weeks after trading began has highlighted the problems that can arise in the absence of a robust conflict-of-interest wall. The basic facts relating to these trades...are as follows. The PPIF management company in question operates both a PPIF and one or more non-PPIF funds that invest in similar securities (i.e., mortgage-backed securities (“MBS”)). In the case of this fund management company, the same person is the portfolio manager for both the PPIF and the non-PPIF fund. In late October, the portfolio manager directed that a particular MBS from the non-PPIF fund be sold after the security — in this case a residential MBS — had been downgraded by a rating agency. According to the company, multiple bids were received, and a quantity of the security was sold to a dealer. Within minutes of the sale, however, the same portfolio manager purchased, for the PPIF, the same amount of the same security from the dealer at a slightly higher price. Later in the day, the portfolio manager bought more of the security for the PPIF from the dealer at the original price.”
As the SIGTARP points out, even if this trading did not violate any of Treasury’s PPIF rules, it nonetheless raises questions about the integrity of the program:
“Was the initial purchase really arm’s length, or was the dealer aware that the portfolio manager was prepared to repurchase the securities immediately? How can a manager conclude that it is wise to sell a security at one price but then almost simultaneously repurchase the same securities at a higher price? Were these trades designed to push the risk of this downgraded security from the private, non-PPIF fund onto the taxpayer-supported PPIF?”
The SIGTARP also reports that one fund manager, AllianceBernstein, has created a firewall on its own initiative, despite Treasury’s claim that the creation of such firewalls is “simply not practical.”
We applaud the SIGTARP for keeping the pressure on Treasury to provide greater oversight of the PPIP, and we anxiously await the results of the SIGTARP’s investigation into these suspicious trades.
The SIGTARP’s latest report also examines the overall effectiveness of the TARP, which is now well into its second year of operations. Although there have been some encouraging signs of progress—such as the fact that many banks have raised enough capital to repay their TARP investments—the SIGTARP reports that many of the TARP’s goals, such as increasing bank lending, reducing foreclosures, and aiding small businesses, have not been met. The SIGTARP also points to a host of fundamental problems in the financial system that have not been addressed, such as the increase in size of many “too big to fail” firms, the creation of moral hazard thanks to the government’s bailout programs, an executive compensation system that encourages excessive risk-taking, and the risk of re-inflating the housing bubble.
Unless the government takes decisive action to address these underlying problems, the SIGTARP reports that we could soon be headed for another meltdown: “Stated another way, even if TARP saved our financial system from driving off a cliff back in 2008, absent meaningful reform, we are still driving on the same winding mountain road, but this time in a faster car.”
-- Michael Smallberg
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