Is PPIF in fact a Ponzi scheme in which the government is the sucker? We sure hope not,
but this admittedly-complex scheme reads to us like a heads-I-win, tails-you-lose bet
Treasury has made on behalf of global investors, many of them the largest firms that got
us all into this mess in the first place.

Why is PPIF a possible Ponzi scheme? Cutting through the complexity of the legacy
loan and MBS programs, PPIF puts up a few dollars to get other investors into the game.
These investors then leverage up their stake – getting their money off the table as fast as
possible – and go out and get still more investors to take the toxic assets off their hands.
Of vital importance in parsing the PPIF is to understand that Treasury and FDIC loans to
PPIF sponsors are non-recourse – that means the investor isn’t on the hook. This permits
still more leverage, but underneath all of this is Treasury’s initial capitalization for the
scheme and the non-recourse loans that finance it. Since all the PPIF investors have to
fear is loss of the toxic assets collateralizing the PPIFs, they can leverage up their
investment at no risk to themselves. If the assets sent back to Treasury when the loans
aren’t repaid aren’t worth what Treasury and the FDIC thought they were when
purchased, Treasury, not the PPIF investors, take the loss.

Treasury of course understands all this, or at least we like to think so. It’s betting that
none of this will come to pass because it believes – like the Paulson Treasury before it –
that the market’s problems are what the PPIF release describes as “embedded liquidity
discounts.” This means that stuff is worth more than the market will pay for it if only the
market could get over its funk.

However, as we’ve said before, the market’s problems go well beyond a liquidity squeeze
the likes of which no one’s ever seen. There is also a monstrous solvency problem at
work and not one from which the Administration and FRB can protect themselves by
clinging to AAA ratings. Perhaps the most inexplicable aspect of the MBS part of the
PPIF is the provision that eligible securities had to have been rated AAA at origination.
What this gets the Treasury is anyone’s guess given that all of those AAA ratings have
been proven at best optimistic and, at worst, fictitious. In fact, whatever the initial rating,
any MBS a financial institution is willing to sell to Treasury is one that, by definition, it
doesn’t want. The same holds true for the legacy loans in the PPIF Treasury has
structured with the FDIC – if it’s a good loan to a traceable borrower, banks will keep
them because that’s the business they’re in.

Has Treasury thought through the adverse-selection problem? We hope so, but there’s no
sign of it in any of the releases to date. Instead, Treasury seems to be betting that, by
putting in $100 billion of TARP capital, it can move $1 trillion in toxic assets. So, back
to our Ponzi scheme worries – all of this paper could move, but who will be left holding
the real risk buried in the PPIF? We just don’t believe that everything that will move
through the program is just having the market equivalent of a bad hair day – much of the
paper is, as we said, truly toxic and that’s why banks will give it to the PPIF. Leverage
sounds sophisticated and possibly not all that risky if contained within the limits included
in the PPIF (although 6:1 looks juicy to us). Combine leverage with non-recourse loans,
though, and the PPIF takes on the hallmark characteristics of a scheme in which the
investor who gets out first makes out best. As structured, taxpayers get out last from the
PPIFs. They’re going to have to make a whole lot of money to make that bet work.
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