Last week, we focused on the PPIF’s heads-I-win, tails-you-lose bet for participating
investors. This week, we’ll look at the alchemical aspects of the program. It’s
fundamentally an effort to turn dross into gold – convert toxic assets into long-term
earning investments from which the government could profit. However, based on the
very different incentives that drive banks – making money – from those of the
government – macroeconomic hope against hope – we expect the private sector quickly
to game the government and profit handsomely thereby.
In looking at the PPIF and the TALF before it, we find ourselves oddly back in the way-
back, remembering the dregs of a doctoral dissertation on organization theory. That was,
we dimly recall, about the different concepts of “rationality” that drive governmental
versus business decisions, a study that concluded that business can’t do what government
should do because public interests are sacrificed to private profit; conversely, government
can’t do what private enterprise does well because government is rightly focused on
lowest-common-denominator, public-welfare concerns. When government treads into
private markets, it must be very, very careful to do so only when private markets are truly
unable to meet public objectives that cannot be better met through direct government
intervention. Translation for the PPIF and TALF: if the government doesn’t get these
complex programs very, very right, it would have done better simply to close banks and
take on the assets.
How could banks beat the government in the PPIF? Let’s start with the legacy-loan
program (LLP). The FDIC hopes to limit its risk by hiring someone to value assets for it.
Who could do this how for the complex portfolios of whole loans is unknown, so the
FDIC then hopes that an auction or similar sales program will root out any unduly high
valuations from banks seeking to transform their toxic assets into cash. Here comes the
good part – the FDIC now tells us it’s also considering letting banks invest in the very
PPIFs that would hold the assets they “sell” to the program.
Presto-chango, a bank has a chance to enhance its own interests coming and going
through whole-loan sales into the PPIF. It can essentially sell the Treasury-sponsored
PPIF whatever it wants at prices that don’t force reserving or write-downs on what it
elects to keep. With the sale, the bank gets a goodly sum of cash for assets it knows
aren’t worth what the PPIF has decided to pay because the FDIC doesn’t know as much
But wait, it gets better. The bank takes an equity stake in the PPIF constructed from its
paper. The discipline of third-party private investors was supposed to protect Treasury
and the FDIC from self-dealing asset valuation. But the selling bank is the investing one
and, even better, the PPIF owns the collateral. So, the bank gets paid up front for its
loans and then still gets to keep whatever’s left that’s worth anything if the loans can
never be sold at a profit, funding all this through a non-recourse loan. Leveraged up,
recovering set-aside reserves and benefited by the capital-arbitrage opportunity of turning
toxic assets into FDIC-guaranteed loans atop Treasury-shared investments and the magic
gets even more dazzling.
The PPIF is premised on the view that the alchemist’s stone in its rationale is the buy-
and-hold strategy PPIFs would be forced to adopt. Treasury and the FDIC are basing the
program on the expectation that the market’s real problem is what they call “embedded
liquidity discounts.” If so, providing government subsidies to wait out the market might
be an appropriate use of government resources to fix a broken market. If, though, the
bulk of the assets sold into the PPIF are in fact real trash – see again the adverse-selection
issue – against which the FDIC lends too much money because of this conflict of interest
– then buy-and-hold only means the government won’t realize what it’s done until well
after it’s too late to fix any of this.