Parsing the PPIF: Big Honey Pot, If It Lasts
In this report, we analyze the PPIF as released Monday (see Client Report PPIF) and in light of our subsequent analytics. This report provides FedFin’s assessment of the program and key issues to consider when structuring transactions or considering political risk (looking here not only at the compensation question, but also at structure, counterparty and other questions sure to be raised that could retroactively complicate transaction structures). Because the MBS part of the PPIF was, we believe, structured in close consultation with large asset managers, we also look at the issues embedded here and possible PPIF revisions that could result. We conclude that, absent realized political risk – a big assumption – both the whole loan and MBS programs should be hugely profitable to participating banks (even taking mark-to-market into account), investment advisers and investors. Numerous transaction-structure issues are also discussed – e.g., how to use Treasury’s equity positions in loan pools to whet investor appetite and further increase return. We forecast a rocky start for the PPIF comparable to that for the TALF, in part because small banks are readying a formidable challenge to the FDIC’s role in the program.
Before discussing the most toxic political risk in the toxic-asset disposal program – compensation restrictions and retroactive conditions – we first review key transaction and policy issues raised in each of the PPIF programs. We below segregate our discussion of the whole-loan versus the MBS program; the analytics in each are sharply different and lumping the programs together – as in several recent discussions – complicates transaction and policy decisions.
1. Legacy Whole Loans
Here, we will run through key issues and our conclusions on them:
Eligible Assets: Nothing in the releases actually specifies which loans or “other assets” will move through this part of the PPIF. Although much in the Treasury press release focuses on real estate-related assets, the details are actually very vague. Thus, banks sitting on non-mortgage obligations they want to move through the PPIF should, FedFin believes, think very carefully about which could be liquidated through the PPIF and how capitalization would be affected as a result.
Discretion to Sell: FedFin anticipates that bank regulators will play a very direct role in deciding which assets a bank can sell and on what terms, based on the results of the stress tests at the largest institutions and on exam reports for smaller banks. Banks will thus need to weigh the offsetting issues of mark-to-market, reserve recovery and any interests allowed in the PPIF to anticipate supervisory demands and prepare their own asset-disposition programs.
Bank Participation: The releases are also ambiguous as to the role a selling bank could play in the resulting PPIF. Analysis of the program has already identified the significant conflict of interest that would result and FedFin expects this will be addressed in the FDIC’s proposal to implement the PPIF. How “participation” is defined and where “conflicts” are seen to occur will nevertheless drive profit impact assessment for selling banks.
Social-Policy Issues: Nothing in any of the releases commits the selling bank or resulting PPIF to goals such as mortgage loan modification. Further, nothing in the initial documents addresses any social-policy issues related to qualifying assets – e.g., does the mortgage comply with bank rules or was it “predatory.” Any policy obligations that flow through the PPIF process will also drive structuring and resulting profitability.
Treasury Capital: Although the releases stipulate a Treasury equity position in the loan PPIFs, it also suggests that Treasury would consider alternative structures. It is most unclear how this might be done, although guarantees that reduce the risk weighting of the entire new asset pool for bank investors or enhance its rating for pension funds and insurance companies should be carefully considered.
FDIC Risk: This is potentially significant because the FDIC will be guaranteeing, for a fee, the non-recourse notes issued by the PPIFs to the selling banks. With a maximum 6:1 leverage, the FDIC’s risk will be significant unless its third-party valuation consultant pushes sales prices down to the lowest possible valuation. Doing so would, though, protect the FDIC at the expense of the PPIF because banks simply won’t sell into it unless forced to do so (see above). Getting this balance right will be very, very tricky and FedFin expects policy will err in favor of FDIC risk versus PPIF problems. Treasury can’t afford another aborted program.
FDIC Fees: Reflecting the risk noted above, the FDIC plans to charge PPIF fees for the non-recourse loans. Small banks will focus hard on these fees to determine the degree to which they compensate surviving banks. They, not taxpayers, are on the hook for FDIC risk. Again, though, high fees will quash PPIF participation, and we expect fees also to err on the PPIF’s side, not the FDIC’s. This could lead to political problems for the PPIF, problems already evident at the FinServ hearing earlier this week (see Client Report RESCUE44).
Finally, we turn to the GSE implications of this program. In essence, the legacy loan part of the PPIF is a government secondary market for loans that now don’t have one. Theoretically, any mortgage that could go to Fannie or Freddie has already been sold to them, but small-bank capacity to do so is strained. The PPIF could provide a new vehicle for these banks. More importantly, the PPIFs create investment opportunities for the GSEs that comply with their charters even if the loans in the PPIFs don’t. This could move a lot of paper quickly despite all the strains on the GSEs, making the PPIFs functional quickly with less cost to the FDIC (the GSEs can raise funds on their own) and added risk to Treasury.
2. MBS Program
The Treasury release suggested a major role for the FRB, but this was not evident in the details of the legacy MBS announcement. However, the program was released in tandem with a unique statement from the FRB and Treasury on their respective responsibilities. In this, the FRB says it will not take credit risk – a surprise in light of all the credit risk it has in fact taken on in the Bear Stearns and AIG rescues and in the TALF (see Client Report TALF2). We infer from this statement that the FRB has now had about enough credit risk and is working with Treasury to structure its involvement in the PPIF. Until an agreement on this is reached, the MBS part of the PPIF is a Treasury affair, with the Department taking on all of the risk through both its equity position and any loans it provides. Key issues here include:
Eligible Assets: Here, the release is clear – eligible assets at the start are residential and commercial MBS that were AAA-rated at origination. The program will be open over time to alternative asset classes, but this is likely subject to ongoing negotiations with the FRB, which is looking first at adding corporate loans to the TALF and/or this program. There is no price discipline in this program comparable to that in the FDIC one. As a result, the selected fund managers (FMs) will have very broad discretion to price assets, likely seeking to do so as cheaply as possible to push investor returns up as high as they can. This will almost surely ensure that the assets sold through the PPIF are those already marked to very low market prices – i.e., MBS in the trading book or those deemed available for sale. This should significantly aid the investment banks, insurance companies and others taking hard hits of late, possibly also giving some of the Federal Home Loan Banks a chance to clear their strained capital decks.
Eligible Sellers: In contrast to the loan program, eligible sellers here include anyone covered by EESA. This includes not just banks, but also insurance companies, credit unions and anyone else deemed a “financial institution” by Treasury and the FRB. Given that Treasury and the Fed found a way to lump the automakers into this category, the wave of sellers could be very large. Here too, transaction structuring will be critical, with hedge funds and pensions likely among the most immediate non-traditional sellers into the PPIF if assets have been written down low enough to entice the FMs.
FM Conflicts: These will be legion because any eligible FM is also already an investor in the assets it will then package for third-party investors. This might discipline its pricing a bit, but not go anywhere near far enough to address potential conflicts. Reflecting this, the Treasury papers are full of statements about standards to come in this area, as well as the fact that FMs must agree to GAO audit and other restrictions. We expect to see conflict issues addressed not only in the FM applications, but also in each PPIF structure, as these will need individually to be vetted by whomever is still breathing at Treasury.
Loans: Treasury is offering financing to support the PPIFs, likely on non-recourse terms. Treasury’s loans here are intended to support establishment of the FM’s structure, which would (apart from the FM’s own equity stake) then quickly be offered to investors (including retail ones in BlackRock’s hoped-for mutual fund). Investors would not themselves receive funding – in sharp contrast to the loan PPIF. FMs could, though, still make a killing on the Treasury support for as long as they need it, depending on the as-yet-unannounced terms and conditions and/or the degree to which Treasury agrees to finance more than the purchase price of obligations sold into the FMs for structuring to third-party investors.
This is, of course, a source of profound concern in light of the AIG debacle. The Treasury documents repeatedly indicate that “passive investors” would be exempt from compensation restrictions, but it does not define how the rules would apply to other PPIF players. FDIC Chairman Bair has reportedly said that banks selling assets into the PPIF would not come under compensation restrictions, but this is unclear because EESA in fact applies these and other restrictions to entities that sell assets to the Treasury. The FDIC and Treasury appear to be reading the law as governing the PPIFs, not banks sellers; for example, Treasury notes that it will need to take warrants in all of the PPIFs because of applicable EESA requirements. If so, then any one playing a role in a PPIF that is not passive – e.g., the FMs – would come under the compensation restrictions – whatever these are whenever Congress gets done with them.
A good deal of fear has also been raised about retroactivity – that is, Congress will claw back profits if the PPIFs are too plentiful. We view this risk as remote. First, any such clawback is of dubious constitutionality if the individual contracts between the PPIFs and Treasury are well crafted. Secondly, it is complex to accomplish and Treasury and the FDIC will fight Congress all the way in any such quest. This is not to say, however, that individual FMs are free and clear – if investigative reporting suggests they played too close a role in structuring the program, Congress could pull the plug on the PPIF in its entirety before it even gets off the ground.