Treasury’s public-private funds for toxic assets: How much ‘skin in the game’ will they require?

Exclusive analysis for FinReg21 by Darrell Delamaide

The administration’s complex program to remove toxic assets from banks’ balance sheets drew a step closer to reality with the announcement this week that more than 100 potential fund managers had applied for the securities program.

The Treasury Department will select five fund managers initially as part of its Public-Private Investment Program to assemble funds (PPIFs) that will buy “legacy” securities – that is, primarily mortgage-backed securities (MBS) that banks can no longer sell because these markets have become virtually illiquid.

Treasury said it will notify the qualifying fund managers around May 15, and they can begin raising funds for the PPIFs. A separate program managed by the Federal Deposit Insurance Corp. for banks’ “legacy” or toxic loans will begin with a small pilot auction, probably in June, according to an FDIC spokesman.

The open question is whether these complicated and finely balanced programs will actually work. Some banks, such as J.P. Morgan Chase, have announced they will not be selling any assets in these programs – presumably because they think the assets are worth more than they could get in a sale.

But even if other banks are willing to sell these toxic assets, the PPIP faces a number of challenges – not least of which is a public perception that its terms may be too generous to the private investors and too risky for the taxpayers, creating the potential for a political backlash that may discourage investors from taking part.

The special inspector general for TARP warned in his report last week that the entire program was so big – involving up to $2 trillion – and so generous to investors that it could skew the incentives. “[T]he sheer size of the program…is so large and the leverage being provided to the private equity participants so beneficial, that the taxpayer risk is many times that of the private parties, thereby potentially skewing the economic incentives.”

In the securities program managed by Treasury, for instance, the selected fund managers will each raise a minimum of $500 million in equity capital that will be matched dollar-for-dollar by Treasury, using funds from its Troubled Asset Relief Program (TARP), and then the entire amount can be leveraged up to 100% by nonrecourse loans from Treasury.

Additional, and considerable, leverage will be available if the purchase is made using financing from the Federal Reserve’s Term Asset-Backed Securities Loan Facility (TALF), which has been expanded to accept legacy MBS. It is here that the troubles begin.

The whole idea of the public-private partnership is to enlist private investors who, because they have equity – “skin in the game” – will use their expertise and due diligence to get the correct pricing for these hard-to-price assets and get the best deal for themselves and for the taxpayer.

But the ability to finance the purchase of these MBS through TALF will reduce this skin in the game for the private investor to as little as 7% of the overall value of the securities, according to the inspector general’s report. That is, the private investor stands to reap 50% of any profit, but will lose only 7% of the overall value if the investment is a total loss.

TALF is designed so that for non-PPIF investors, this 20% discount from face value (referred to as a “haircut” in Wall Street jargon) is totally represented by investor equity. As the PPIFs are currently designed, only one-third of the 20% haircut would be covered by private investor equity, with the other two-thirds covered by Treasury equity and loan.

In a white paper on PPIP, the law firm Mayer Brown speculates that Treasury may adjust the terms to avoid this much leverage. “Treasury may be sensitive to criticisms of providing substantial leverage to private investors in a political climate which ascribes leverage in the financial system as a systemic risk,” the Mayer Brown paper says.

In fact, the special inspector general, Neil Barofsky, explicitly recommends that Treasury take steps to mitigate the added leverage to the PPIFs buying the toxic securities through TALF, because it dilutes the incentive for private investors to exercise due diligence.

“Treasury should not allow Legacy Securities PPIFs to invest in TALF unless significant mitigating measures are included to address the dilution of this incentive,” Barofsky said in his report. These could include “prohibiting the use of leverage for PPIFs investing through TALF or proportionately increasing haircuts for PPIFs that do so.”

Barofsky was already worried about the scope for conflicts of interest and collusion in the PPIFs, and sees these risks enhanced by the dilution of the private investors’ skin in the game.

PPIF managers, he says, may be tempted to overpay for some securities, because they have similar securities on their own books or in other funds they manage, and this will enable them to sell those securities at more than they are worth. Or fund managers may be tempted to pay a seller too much for a security and get a kickback from the seller. Both of these temptations increase if the potential loss for mispricing is only 7% of the investment, Barofsky warns.

A week ago, President Barack Obama signed into law a measure that considerably enhances the powers of the TARP inspector general. Among the provisions of the new law is that Treasury must provide Congress with reasons if it chooses not to follow any of the inspector general’s recommendations.

So whenever around May 15 Treasury announces its fund managers for the securities program, and presumably the terms for the PPIFs, it will be interesting to see what measures it takes to reduce the leverage in its original design and how much skin in the game investors will have to keep to participate. And then it will be interesting to see if private investors put money into the PPIFs.

Darrell Delamaide is a veteran financial journalist who has worked for Dow Jones, Bloomberg, Institutional Investor, among others. He is based in Washington, D.C.