Wednesday, October 7, 2009

PPIP to the rescue

The "bad bank" program to purchase loan assets from the balance sheets of banks called PPIP was supposed to be the mother of all bank balance sheet cleanups. The program was divided into two components: the loan program and the securities program - the Treasury would provide leverage and investors will come for the returns. The loan program was supposed to buy actual loans from banks - mortgages, consumer loans, leases, commercial property mortgages, etc. Great idea in principle, but there was a problem.

Banks don't mark loans to market, particular loans they originate (banking book). Instead banks take reserves for impaired loans or loans about to become impaired. With the reserves taken into account, the carried value of these loan portfolios had been over 90 cents on the dollar. But as an investor would you pay 90+ cents for a mortgage loan portfolio? Even with leverage, you would probably bid less, probably much less. If there is one thing investors learned from the crisis, it is that having access to cheap leverage does not justify overpaying for assets. But banks can not sell these assets at steep discounts simply because they would immediately wipe out a chunk of their already thin capital base and some would become insolvent. They need those assets to stay at 90+. Therefore the FDIC-led loan PPIP just didn't work.

So that leaves the securities portion of the PPIP, spearheaded by the US Treasury. Since generally just the larger banks were involved in running portfolios of securities backed by loans (vs. loans themselves), this portion of PPIP would only help the larger banks. All those struggling small and regional banks will have to muddle through on their own. The justification the Treasury will give for trying to help the larger banks is that the securities PPIP will raise senior tranche prices, which may stimulate new securitization (nice pipe dream), which in turn will stimulate new lending and refinancing. Somewhere down the road this would help the smaller banks. Right.

But unlike the loan program that had a major price disconnect between buyers and sellers, the securities program had a better chance. Many of these securities have been marked to market (sort of). So the Treasury offered to do the following (see attached term sheet):

Option I (called "Full Turn"):
1. Investor commits $1 of equity to invest in RMBS or CMBS senior tranche securities that used to be "AAA" (currently sitting on Jumbo Bank's balance sheet.)
2. The Treasury commits $1 for the same investment (co-invest).
3. The Treasury commits to lend $2 to finance this portfolio.

This way a dollar of private funds generates $4 of buying power and 1:1 (debt to equity) leverage (hence "full turn"). The loan term is 10 years and investor's money is locked up as well. The cost is basically LIBOR + 1%, which is what makes this attractive. The investor has 3 years to "trade" the portfolio, after which point any sale goes to pay down the government's loan.

Option II (called "Half Turn"):
Investors also have a choice to take $1 instead of $2 (in the example above). This puts the leverage at 0.5 : 1 (hence "half turn"), but allows the investor to get additional leverage. For example if these are CMBS assets, the investor can get financing via TALF in addition to the PPIP. That could really juice up the leverage.

And here is the result. The Treasury has committed $40 billion to PPIP (corresponding to $10 billion of private money). So far $12.5 billion (out of 40) has been done, all with Option-I, corresponding to $3 billion of private money. The Treasury of course is claiming success as RMBS and CMBS have rallied since the program was announced earlier in the year. We are to believe that a $12.5 billion investment has moved pricing significantly on a $2+ trillion market. But hey, in this euphoria driven credit market, who is counting?

Securities PPIP Term Sheet

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