On March 23, 2009, the United States Department of the Treasury (the "Treasury") announced its rollout of the much anticipated Public-Private Investment Program ("P-PIP"), which is designed to raise new capital to purchase "legacy" or "toxic" residential and commercial mortgage loans and other assets backed by such loans currently held by banks and other financial institutions ("Legacy Assets"). Under P-PIP, the U.S. government's basic plan is to provide a combination of debt financing and equity capital to private investors who will use these government funds, along with their own equity capital, to purchase Legacy Assets. As a result of the illiquidity of Legacy Assets, banks and other financial institutions have had a difficult, if not impossible, time raising new capital. Moreover, consumers have generally found it much more challenging to obtain financing from banks or financial institutions at reasonable rates (if at all); this lack of financing has only further exacerbated the credit crisis and the collapse of the credit markets. The current plan is for P-PIP to provide up to $500 billion (with the potential of expanding to $1 trillion over time) in purchasing power to buy Legacy Assets. P-PIP intends to reinvigorate the credit markets through two main programs: the Legacy Loans Program and the Legacy Securities Program (which includes an expansion of the Term Asset-Backed Securities Loan Facility ("TALF")). According to the Treasury, P-PIP should work as follows:
Legacy Loans Program
Under the Legacy Loans Program, each qualified bank interested in participating in the program will work with regulators to identify pool(s) of eligible Legacy Assets that such bank wishes to sell (each an "Eligible Asset Pool"). The Federal Deposit Insurance Corporation ("FDIC") will then accept or reject such Eligible Asset Pool based on criteria that has not yet been provided by the Treasury or the FDIC. Once a pool has been accepted, the FDIC will work with an independent valuation firm to determine the maximum amount of leverage to accept for such Eligible Asset Pool. The FDIC anticipates that the debt to equity ratio for each Public-Private Investment Fund (each a "P-PIF"), which will be formed to purchase the Eligible Asset Pool(s), will not exceed six to one.
Private investors interested in purchasing any of the Eligible Asset Pools available under the Legacy Loans Program may participate in auctions for the sale of such Eligible Asset Pools; the auctions will be managed by the FDIC. Prior to the auction, the FDIC will conduct due diligence on the Eligible Asset Pool(s), and provide private investors with marketing materials that will contain information about the Eligible Asset Pool(s), as well as the amount of leverage available for such Eligible Asset Pool(s). Private investors will use this information to prepare and submit a bid, which will contain, among other things, the total amount of equity capital such private investor is willing to invest to purchase the Eligible Asset Pool. The Treasury has agreed to match a private investor's equity commitment such that a private investor and the Treasury would each invest 50 percent of the total equity investment for such Eligible Asset Pool(s) (although a private investor may elect in its bid to receive less than 50 percent of the total equity commitment from the Treasury). The FDIC has agreed, in return for a fee, to guarantee the debt that will be issued by the P-PIF. The highest bidder will win the auction, and the selling bank will then be given an opportunity to reject or accept the highest bid.
If the highest bid is accepted by the bank, a P-PIF will be created. The private investor that won the bid will select an asset manager, approved by the FDIC, to manage the P-PIF with oversight by the FDIC. The Eligible Asset Pool will be sold on a "servicing released" basis and the P-PIF equityholders will make decisions with respect to the servicing of the assets as provided in the governing documents for the P-PIF. To the extent such equityholders so elect, the selling bank may continue to service the transferred assets. The equity ownership of the P-PIF will be spilt equally (unless otherwise agreed) between the Treasury and the private investor, and the Treasury and such investor will share profits and losses in the P-PIF on a pro rata basis. The selling bank will receive a portion of the purchase price in cash, to the extent of the equity investment of the private investor and the Treasury, and will receive the balance thereof in the form of FDIC-guaranteed debt issued by the P-PIF. The FDIC's guarantee will be collateralized by the Eligible Asset Pool. The selling bank may sell the FDIC-guaranteed debt into the market if it elects. The following is an example of how the Legacy Loans Program is intended to work:
STEP 1: A participating bank and its regulators decide on a pool of Legacy Assets with a face value of $100 to submit for auction under P-PIP.
STEP 2: The FDIC approves the pool of Legacy Assets submitted by the bank, as an Eligible Asset Pool that may be auctioned by the FDIC under P-PIP.
STEP 3: The FDIC then conducts due diligence on the Eligible Asset Pool, and, with the help of a valuation firm, determines that it would be willing to leverage the Eligible Asset Pool at a five-to-one debt-to-equity ratio.
STEP 4: The FDIC then provides interested pre-qualified private investors with marketing materials for the Eligible Asset Pool up for auction, which materials include the proposed financing terms and leverage ratio for the Eligible Asset Pool.
STEP 5: Interested private investors make bids based on the above information, with a high bid of $78 dollars. Ideally, the bank then decides to accept the bid.
STEP 6: The Treasury and the private investor each receive a 50 percent equity stake in the newly-formed P-PIF that is created to purchase the Eligible Asset Pool in exchange for their equity capital contributions of $6.50 each (based on the five-to-one leverage ratio).
STEP 7: The P-PIF issues the remaining $65 as debt to the bank, which debt is guaranteed by the FDIC and collateralized by the Eligible Asset Pool.
STEP 8: The private investor then selects an asset manager, approved by the FDIC, to manage the P-PIF with oversight by the FDIC.
Although many of the details of the Legacy Loans Program have yet to be provided, some of the advantages to hedge funds and other financial investors of investing in a P-PIF may include:
• Limited economic downside risk: Unless the US government decides to change the rules currently anticipated, a private investor could invest as little as 7.15 percent of the total initial value of a P-PIF, with the Treasury committing another 7.15 percent, and the P-PIF issuing non-recourse debt that is guaranteed by the FDIC and collateralized by the Eligible Asset Pool for the remaining 85.7 percent. The maximum downside risk for the private investor in this scenario is the loss of its 7.15 percent equity investment with an upside of 50 percent of the total value of the P-PIF after the sale or collection of all of its assets minus (i) the payment of the P-PIF's debt obligations, (ii) FDIC fees, and (iii) servicing fees and other expenses; subject to any changes in the capital structure of the P-PIF as a result of the warrants held by the Treasury (as discussed below).
• Low cost, non-recourse debt financing: The FDIC has not specified the terms on which the P-PIF will issue debt, other than stating that such terms will be determined on a pool-by-pool basis based, in part, on the risk profile of the Eligible Asset Pool. However, the Treasury has announced that the debt will be non-recourse, guaranteed by the FDIC (for a fee) and collateralized by the Eligible Asset Pool. This debt structure may provide a private investor with an opportunity to purchase such Eligible Asset Pool with limited risk (other than its loss of committed equity).
• Private bidders set the price: Under the Legacy Loans Program, private investors will set the price of the Eligible Asset Pools sold in the auction process.
• No detail on fee restrictions: The Treasury has not provided any detail clarifying whether a fund sponsor will be able to charge a management and/or incentive fee to any of its limited partners who invest in a dedicated fund to invest in P-PIFs.
• Passive private investors not subject to executive compensation restrictions under EESA: The Treasury has stated that passive private investors will not be subject to the executive compensation restrictions under Section 111(b) of the Emergency Economic Stabilization Act of 2008 ("EESA"). However, the Treasury has not specified who will qualify as a passive investor, or whether asset managers of P-PIFs and/or their employees will be subject to executive compensation restrictions.
Some of the disadvantages to hedge funds and other financial investors of investing in a P-PIF may include:
• Additional regulatory oversight: The Treasury has specified that P-PIFs will be subject to rigorous oversight by the FDIC, but it has not yet stated what such oversight will entail. Moreover, the Treasury has indicated that, in order to protect taxpayers, P-PIFs will be required to agree to waste, fraud and abuse protections, none of which have been clearly defined. In addition, P-PIFs must also agree to provide access, as needed, to information required by various U.S. government regulatory bodies. Until the Treasury provides more detail on the regulatory obligations to be placed on private investors, it will be difficult to determine the burden such obligations will impose.
• Risk of rules changing: Private investors participating in P-PIP may be at risk of having the rules of the programs change along the way in response to Congressional or public disapproval of P-PIP once it is already in place and active. Any changes may affect a private investor's anticipated return on investment.
• Treasury will receive warrants in the P-PIF: The Treasury has indicated that, consistent with requirements under the EESA, it will receive warrants in the P-PIF. The terms and amount of such warrants have not been specified, but presumably could reduce, or create uncertainty in, the potential return to private investors.
• Restrictions on asset management: The FDIC and the Treasury have stated that they will establish governance procedures on the management, servicing, reporting and exit timing and alternatives for each P-PIF; however, the specific details of such contemplated procedures have not been provided. The FDIC has indicated that there will be restrictions on a P-PIF's management discretion and exercise of remedies. For example, the FDIC has said that it expects that residential mortgage loans purchased by a P-PIF would be subject to the U.S. Government Loan Modification Program.
• Fees to the FDIC: The FDIC will be paid a fee for guaranteeing the P-PIF's debt. It also will receive a fee for its ongoing oversight of each P-PIF, and it will be reimbursed for any expenses related to such oversight. Neither the Treasury nor the FDIC has indicated the amount of these fees or how they will be paid. Such fees must be taken into consideration in order for a private investor to determine its anticipated return on investment.
• 5 percent bidder deposit: Bids will not be considered at auction unless accompanied by a refundable cash deposit for 5 percent of the bid value. In the event the bid is rejected or unsuccessful, the deposit will be refunded in full to the bidder. However, a bidder that wins the auction may be at risk of losing its deposit if it does not complete the transaction; the Treasury has not provided any information on this to date. Moreover, the Treasury has not clarified whether the deposit is composed of 5 percent of the total value of the Eligible Asset Pool, of the total equity component of a P-PIF, or of the private investor's equity component.
• No participation in affiliated transactions: Private investors may not participate in any P-PIF that purchases assets from banks that are affiliates of such investor or that represent 10 percent or more of the aggregate private capital in the P-PIF. The guidelines provided to date do not disclose the considerations for determination of affiliate status, although the FDIC has indicated that it anticipates that the determination will be along the lines of the Bank Holding Company Act's "common control" test.
• Undisclosed prequalification requirements: Potential private investors will be pre-qualified by the FDIC to participate in an auction to purchase Eligible Asset Pools. However, the FDIC has not stated the qualifications that investors must satisfy, other than to say that private investors who participate in the Legacy Loans Program are expected to include individual investors, pension plans, insurance companies and other long-term investors.
• Participant bank can reject highest bid: While the highest bidder wins the auction, the selling bank can refuse to sell the Eligible Asset Pool(s) at the highest bid and reject the bid.
Private investors, including hedge funds and private equity funds, might take advantage of the Legacy Loans Program by setting up distinct funds to raise capital to invest in and purchase these Legacy Assets. Unless the Treasury otherwise indicates in additional disclosures, an investor should be allowed to charge fees to its limited partners under such fund, including, without limitation, management and incentive fees. However, it is unclear whether private investors will be allowed to charge fees to the P-PIFs (although managers of Legacy Securities Funds, as defined below, may charge fees as indicated by the Treasury and discussed below).
Legacy Securities Program
The Legacy Securities Program consists of two parts: (i) the establishment of Legacy Securities P-PIFs to invest in certain commercial mortgage-backed securities and residential mortgage-backed securities issued prior to 2009 that were originally rated AAA, and (ii) the expansion of the TALF to include certain non-agency residential mortgage-backed securities that were originally rated AAA and commercial mortgage-backed securities and asset-backed securities that are rated AAA.
Legacy Securities P-PIF
One part of the Legacy Securities Program will provide a combination of debt financing and equity capital to dedicated funds ("Legacy Securities Funds") purchasing qualified mortgage-backed securities issued prior to 2009 ("Legacy Securities") from regulated U.S. financial institutions described in Section 101(a)(1) of EESA. The Treasury will participate as an equity investor matching private investors in the Legacy Securities Funds.
The Treasury will initially approve up to five asset managers (and perhaps more) to manage the Legacy Securities Funds. Interested asset managers must complete an application provided by the Treasury, which demonstrates, among other things, (i) a track record of purchasing Legacy Securities; (ii) a capacity to raise at least $500 million of private capital; (iii) a minimum of $10 billion of Legacy Securities under management; (iv) an operational capacity to manage the Legacy Securities Funds in a manner consistent with the Treasury's stated objectives; and (v) headquarters in the U.S. Such asset managers must have submitted the application to the Treasury no later than 5 p.m. (EST) on Friday, April 24, 2009, to be pre-qualified to raise capital to invest alongside the Treasury in a Legacy Securities Fund. The Treasury currently contemplates informing applicants of its preliminary approval on or prior to May 15, 2009.
Once pre-qualified by the Treasury, asset managers will have a limited period of time (which has yet to be specified) to raise at least $500 million of private capital to purchase Legacy Securities designated by the asset manager in its application, and to demonstrate committed capital prior to receiving matching final approval from the Treasury. Under the Legacy Securities Program, approved asset managers will receive funds from the Treasury in an amount equal to the private capital raised by such asset manager. Any capital received by an asset manager from the Treasury will be invested one-for-one on a fully side-by-side basis with private investor funds for a term no greater than ten years, unless otherwise extended with the Treasury's consent. Asset managers may charge management and incentive fees, as proposed in their respective applications to the Treasury.
A Legacy Securities Fund also will have the ability, if its fund structure meets certain guidelines, to subscribe for senior secured non-recourse loans from the Treasury in an amount up to 50 percent of the total equity capital of such Legacy Securities Fund (and the Treasury will consider requests for senior debt of up to 100 percent of such Legacy Securities Fund's total equity subject to certain restrictions, including restrictions on asset level leverage, withdrawal rights, and disposition priorities) ("Treasury Debt Financing"). Any Treasury Debt Financing provided to purchase Legacy Securities for a Legacy Securities Fund will be secured by the Legacy Securities of the borrower. A Legacy Securities Fund may, however, finance the purchase of Legacy Securities through qualified TALF loans or through debt financing from private sources as long as the equity capital of the Treasury and the private investors is leveraged proportionately from such private debt financing sources. Any TALF loans used to finance purchases by a Legacy Securities Fund will be senior to any Treasury Debt Financing for such Legacy Securities Fund. An example of a Legacy Securities Fund may look as follows:
STEP 1 : Asset manager interested in Legacy Securities Program submits application for pre-qualification (application must, among other things, provide details of the asset manager's fund raising plan).
STEP 2: Asset manager is pre-qualified by Treasury and begins raising capital for Legacy Securities Fund, which private capital raised will be matched by the Treasury. The Treasury also agrees to provide debt financing to the Legacy Securities Fund for an amount equal to 50 percent of its total equity commitment.
STEP 3: Asset manager is able to raise $500 of private capital for the Legacy Securities Fund. The Treasury matches the $500 with its own $500 equity commitment, and provides the Legacy Securities Fund with $500 of senior debt financing, which will be secured by the Legacy Securities purchased by the Legacy Securities Fund.
STEP 4: Asset manager now has $1,500 to invest in Legacy Securities and can charge management and incentive fees as approved in its application.
Expansion Of TALF
The second part of the Legacy Securities Program will expand TALF to include loans to purchase certain non-agency residential mortgage-backed securities that were originally rated AAA and outstanding commercial mortgage-backed securities and asset-backed securities that are rated AAA. Eligible borrowers will have to meet the criteria set out under TALF in order to qualify for these TALF loans. The minimum capital investment that an eligible borrower will be required to make to receive such TALF loans (which will be based on the risk profile of the underlying assets), as well as the lending rates, minimum loan sizes and loan durations under TALF for this newly expanded class of Legacy Securities, have yet to be determined by the Treasury. However, the Federal Reserve says it is working to ensure that the duration of these TALF loans take into account the duration of the underlying assets securing them.
Some of the advantages to hedge funds and other financial investors of investing in the Legacy Securities Program may include:
• Low cost, non-recourse debt financing: The Treasury has not specified the terms on which it will provide debt financing to Legacy Securities Funds (or TALF loans for the purchase of Legacy Securities). However, the Treasury has announced that the debt will be non-recourse.
• Highly rated securities: Private investors may purchase qualified commercial and residential mortgage-backed securities that were originally rated AAA or equivalent (or, in the case of TALF, qualified asset-backed securities that are currently rated AAA) and that are directly secured by the actual mortgage loans, leases or other assets.
• Control of the process: Asset managers (and private investors under TALF) will be able to control the process of asset selection and pricing, as well as asset liquidation, trading and disposition. This provides asset managers with great flexibility to determine when, what and how they will invest in and divest the Legacy Securities (although the Treasury anticipates that Legacy Securities Funds predominantly will follow a long-term buy and hold strategy and that trading will be limited).
• Passive private investors (and eligible borrowers of TALF loans for Legacy Securities) are not subject to executive compensation restrictions under EESA: The Treasury has stated that passive private investors will not be subject to the executive compensation restrictions under Section 111(b) of the EESA. However, the Treasury has not specified who will qualify as a passive investor, or whether asset managers and/or their employees will be subject to executive compensation restrictions.
Some of the disadvantages to hedge funds and other financial investors of investing in the Legacy Securities Program may include:
• Limited pool of asset managers. The Treasury will select only five asset managers of Legacy Securities Funds (unless it otherwise indicates). Based on the qualifications required by the Treasury to be an asset manager, this may be limited to certain large asset management companies.
• Treasury's ability to pull funding: The Treasury will retain the right to cease funding of committed but undrawn Treasury equity capital and debt financing for a Legacy Securities Fund in its sole discretion.
• Treasury will receive warrants in the Legacy Securities Fund: The Treasury has indicated that, consistent with requirements under EESA, it will receive warrants in each Legacy Securities Fund. The terms and amount of such warrants has not been specified (although the Treasury has said this will be based in part on the amount of Treasury debt financing taken by the fund). Such warrants presumably could reduce, or create uncertainty in, the potential return to private investors in a Legacy Securities Fund.
• Reporting through third party: The prices of Legacy Securities must be tracked using third party sources and annual audited valuations by a nationally recognized accounting firm.
• Withdrawal restrictions: Legacy Securities Funds will not be eligible to receive Treasury Debt Financing if private investors are offered voluntary withdrawal rights from the Legacy Security Fund. This restriction may limit the marketability of the Legacy Securities Fund.
Private investors may take advantage of the Legacy Securities Program by applying to be an asset manager (or by investing in a fund of a selected asset manager that invests in such Legacy Securities) or by setting up a separate fund to raise capital to invest in a Legacy Securities Fund. Such a structure might look as above.
A private investor also may choose to invest in the expanded TALF loan program by setting up a separate fund that invests in TALF-eligible Legacy Securities or other TALF-qualified securities. The fund created by the private investor should, unless otherwise announced by the U.S. government, be able to charge a management and incentive fee. A structure of such a fund might look as below.
The information provided to date on P-PIP from the Treasury is preliminary. The Treasury currently expects to inform asset managers that submit timely applications to participate in the Legacy Securities Program of their preliminary qualification on or prior to May 15, 2009. However, the timeframe for the Legacy Loans Program has not yet been provided by the Treasury.
Published June 1, 2009.
