Bailing Out the Buyside [PPIP - Public-Private Investment Program]

Markets Media ^ | 7/7/2009 | Jonathan Miller, Analyst, TABB Group

[bruinbirdman]

The attractive risk/reward tradeoff of the Public-Private Investment Program (PPIP) has more than 100 buyside participants pounding on the gates of the Federal Reserve, but its potential positive impact on the economy is still under debate. From the perspective of the stock market, PIPP is at least a non-negative factor, with major US equity rising as much as 20 percent after losing roughly 30 percent from its peak in October 2007. Nevertheless, with potentially $950 billion in charges stemming from legacy loans and securities at the epicenter of the current crisis, PPIP carries a disproportionate amount of the burden among government programs to end the negative economic cycle while replenishing lost bank capital and restoring liquidity to the legacy securities markets.

PPIP could have the purchasing power to restore capital and liquidity to the marketplace. Five applicants will be selected and will each contribute at minimum $500 million in capital; with TARP funds ($75 to $100 billion have been pledged), matching government equity and possible government leverage of 6:1, $630 billion is potentially available to remove assets from banks' balance sheets. If participants take advantage of the maximum amount available under PIPP, 66 percent of the damage done by the legacy markets would be covered under the Federal Reserve's worst case scenario. Under the rosiest projections, nearly 90 percent of losses would be covered (see Exhibit 1).

The capital, then, is set for PPIP to work, yet the question lingers over whether the program can fulfill its original intention of halting the negative economic cycle where declining asset prices cause deleveraging, leading to further assets sales and markdowns. Assuming banks elect to participate, PIPP is an accounting maneuver that swaps banking with government leverage. Moreover, with potentially devastating losses for the taxpayer and possible management fees charged off points received from government financing despite favorable investment terms, PPIP amounts to a bailout of the program's fund managers. PPIP also attempts to solve core economic problems through cheap leverage and aggressive investing – the same problems that sparked the crisis. But even if successful, will PPIP address the heart of the negative economic cycle? Weak demand and poor fundamentals are the central, economic reasons behind the decline in asset prices – but does PPIP respond to these issues?

As businesses continue to reel and shed jobs, the consumer will become weaker, the underlying assets of legacy securities will suffer further and price declines in those assets will continue. There is a reasonable argument that the amount of money the government is investing in PPIP -- more than four times the amount of any other comparable government program -- fails to properly account for fundamental demand, which is at the core of the negative economic cycle, while placing the taxpayer at significant risk for absorbing both debt and equity losses of a public private fund (see Exhibit 2).

Some economists go even further and say that PPIP is at risk for causing further losses and price declines by promoting adverse selection. As participation and asset selection is completely discretionary, banks will auction only underperforming assets suffering from devaluation and retain healthier assets generating cash flow. The program's buyside participants, therefore, with limited downside and tremendous buying power, will likely be bidding for the worst of banks' legacy securities. The effect of adverse selection is magnified by the buyside participant's downside protection and purchasing power, which could result in severe overpayment for legacy assets. If buyside participants overpay for assets, abrupt devaluation and taxpayer losses are almost a certainty as weak fundamentals cannot support inflated prices.

Conversely, if the program's buyside participants do not overpay for legacy securities and submit bids that reasonably reflect risk and return, banks could refuse to sell their portfolios should prices represent further markdowns and losses. Such a “failed auction” process would result in a stalemate between the government, buy side and sell side, causing market confidence to erode, perpetuating the negative economic cycle. Additionally, banks would still retain legacy securities on their balance sheets with further markdowns, losses and capital shortfalls impending as the government would be fully aware of the inflated asset values quoted by the banks, worsening the financial crisis.

The financial crisis began with cheap leverage and overzealous investors purchasing underperforming assets from investment banks. Ironically, PPIP is replicating the exact circumstances that caused the crisis, the only difference being that banking leverage has been replaced by government leverage and market participants are limited to large asset managers. Beyond those changes, the same funds are being wooed to purchase the same toxic assets that spurred the crisis.

In order to qualify for PPIP, funds must have $10 billion in “eligible” assets under management as well as the ability to raise more than $500 million in a matter of weeks. The government is implying that large funds are trustworthy participants, but how can the Obama administration resolve this implicit trust with compensation reform and a financial regulatory overhaul underway? Moreover, if the government is granting capital to participating funds that collect management fees, then the funds should be scrutinized and followed in the same manner as banks that received bailout money. And with the government's recent announcement that PPIP funds are limited to legacy securities, the smaller, regional banks – more likely to be saddled by soured legacy loans to local businesses – have lost access to much of the program's benefits. Thus, institutions and structures that are being derided for greed and laxness are being trusted with the recovery of the financial system, with billions of taxpayer dollars at stake.

Furthermore, with FDIC-guaranteed debt, non-recourse loans through TALF and 50 percent equity contributions from the government, buyside participants could stand to reap massive profits from PPIP. However, should buyside participants overpay for legacy securities or the economy continue its downward spiral and assets suffer further devaluation, buyside participants would lose their 50 percent equity stake and the shaky underlying assets. Compared to the government's risk of guaranteeing loans, holding unwanted assets and losing the 50 percent equity stake, PPIP emerges as a bailout for the selected, massive buyside institutions based on the program's terms and generous upside for participating funds.

In addition to a bailout of select institutions, PPIP also represents an accounting game. Both the government and the banks want legacy securities off balance sheets, and PPIP is set to clean banks' holdings. However, PPIP does not prevent banks from trying to participate in the program – banks can indirectly invest in PPIP funds (Bank of America owns nearly half of BlackRock, for example), or directly invest in PPIP mutual funds or retail opportunities. By selling off legacy securities and simultaneously benefiting from government leverage and purchasing power, PPIP becomes an accounting game of transferring money between the buy and sell side according to mark-to-market rules.

PPIP may restore capital to ailing banks and provide liquidity to the legacy securities market, but the main factor behind the negative economic cycle is unaddressed. The housing market continues to spiral – the median price fell 14 percent in the first quarter of 2009 from a year earlier – while unemployment steadily climbed from 7.6 percent in January to 9.1 percent in May. The government could stand to profit from PPIP through FDIC fees, equity upside and lending interest, yet the fundamentals of the economy must assume greater focus if the United States is to emerge from this deep recession.

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[bruinbirdman]

100 applicants for 5 spots and $Trillions of toxics available. Perhaps not many deals will get done.

Kinda like if one house on your block is for sale at 50% of original purchase that sets the value of them all.

It would behoove all the neighbors to get together and pay full price for it and rent it out.