Making sense of the Public-Private Investment Program

Tim Geithner unveiled a good amount of detail on the much-awaited financial sector resuscitation package over the last week. Apart from addressing the core issue of unfreezing the credit market and hence imrpoving liquidity, the Treasury also clearly articulated the broad guidelines of new financial sector regulation.

Let's try to make sense of the PPIP - the plan basically envisages the government putting its skin-in-the-game to push/incentivize private sector participants (read money managers) to take that elusive step forward - buy distressed assets and securities. The government's share of risk is through a mix of FDIC guarantees, direct Fed loans and Equity participation. To make sense of the program, let's look at the Legacy Assets and Legacy Securities program separately.

Legacy Assets PPIP program - This envisages private parties (meeting certain eligibility criteria) to bid for defined pools of troubled assets as made available by banks. Once the best bidder is decided for each pool, the government would match equity contribution. But the bigger piece of the puzzle here is the FDIC guarantee - FDIC would employ consultants to value each pool and provide debt guarantees up to 85% of the total bid value of the pool. The actual guarantee percentage for each pool (85% or lesser) would eventually determine total credit risk assumed by the government. Assume a USD 100 million RMBS pool with a bid value of USD 80 million (to account for potential losses in the portfolio), if the FDIC provides a debt guarantee up to 85% of bid value, it basically means the government is taking a risk of USD 6.0 mn in Equity + additional losses if the actual realizable value of the asset pool is lesser than 68 million. This is fine in case the overall PPIP plan does turn back the market to normalcy; but its a significant risk to the Treasury's balance sheet otherwise...another 12 million (15%) value drop on the portfolio is not beyond practicality! In a nut shell, there is enough risk sharing from the government to bring in private investment - but on the same note, an ineffective execution can expose the treasury balance sheet signficantly. Considering the vary nature of the base asset (loans as against negotiable securities), initial participation is bound to be tepid, unless the securties PPIP program picks up speed and loosens the secondary market.

Legacy Securities PPIP program - The basic premise of the plan is similar to the assets program described above, but the modus operandi is a bit different. It starts with the treasury inviting bids from large assets managers (again, defined eligibility criteria) to select up to 5 asset managers to run the program. These managers would form distressed securities funds with disclosure on fund amount, investor mix, asset selection strategy, asset management strategy, fees etc. The treasury would commit an equal share of equity and on top of that, provide a matching share or in some cases (based on analysis of target investment pool, strategy etc) even twice the matching share in the form of senior debt. Assuming the maximum share of senior debt from the treasury/FDIC, this basically means, there's an open risk beyond a value depletion of 25% on the base assesses value of the securities pool. Given the fact that several large global funds have already raised significant money targeted at distressed securities, this plan should drive active participation and free up liquidity in the market.

From the above, its clear that its a well-thought out plan from the Treasury, but its no magic wand. As in any other solution, it does assume rational markets (and market participants) and hence does imply significant balance sheet risks to the treasury - up to 800+ billion, a large number considering the 9 trillion + balance sheet size. But, given the already-distressed value of the base assets and latent investor appetite for such assets, i would bet my money on the plan gradually unleashing liquidity over the next few quarters. The dark horse here is the impact that freshly unveiled regulatory changes (read registration, increased disclosures and hence constariend investment strategies) will have on the existence and volumes associated with critical participants like hedge funds, venture capital funds and private equity funds.

Why are we wasting our energy - and getting so pseudo-moralistic?

Last week saw an unprecendented amount of corporate CXO-bashing from politicians, public and the media in general. A sudden surge of moral anger seem to have been generated by the AIG bonus news. I don't personally support the AIG bonuses, but none the less, i cannot fathom the logic behind doing a witch hunt for the bonus recipients. We are living in a capitalistic economy and hence there's little merit in arguing on the lines of rich-getting-richer/ poor-getting- poorer.

Let's try to look at it from another angle. The past few decades saw unprecendented growth and as a result, an accumulation of personal wealth and a consistent increase in personal spending across most classes in society. This unfortunately came at the cost of lax supervisory oversight and poor market discipline. Every one shared the gains, but leaders in the financial services space which drove or at least facilitated most of the economic expansion reaped the largest gains through windfall corporate profits and hence astronomical bonuses. We are seeing a drastic correction, which is forcing us to look at the value of fiscal prudence, savings and long-term sustainability. So, all of a sudden the same media and public voices which ga-ga-ed at Bill Clinton's talk of 'we do it large because we can afford it' turns around and moves to a position of extreme fiscal prudence and conservatism.

I am not saying the correction's not warranted - but whole heartedly agree with the 'back-to-the-basics' move towards increased savings, financial prudence and controlled markets. However, it has to stop being a witch hunt - if we go over board with governmental oversight and regulations, we would be committing a big mistake. What gain will come out of revealing the names of individual bonus recipients at Merril Lynch or for that matter AIG? Even worser, you have state AGs investigating why tax payer money went to honor counter-party obligations of AIG related to its CDS portfolios!! The government can and should use more subtle means to discipline firms who received tax payer funds - but stop at being moralistic. Do we REALLY expect businesses to stop honoring legal commitments, contractual norms and focus on reviving the economy and ensuring money flow? I hope not...there's a lot else that's left to be done before we spend our collective energies on discussions around economic philosophy.

- By now, we know that no stimulus/bail out package can succeed unless flow of money is restored in the larger economy - but we haven't YET seen anything substantial/serious from Tim Geithner and team to revive the financial services sector. While we saw individual firms like Citi forming 'bad money' banks and trying to separate out the wheat from the chaff, we still haven't seen any further light on the ambiguously termed larger 'public-private' partnership that was announced many weeks back. This is imperative to re-energize bank balance sheets and enable them to work 'normally'and do what they are supposed to do - lend money and facilitate money flow.
- We haven't seen any details on revised accounting norms for mark-to-market valuation.
- Nor have we seen any serious/informed discussion on the nature and form of regulations for the Securities and Investments industry that can prevent what happenned.

As a result, we have a financial services sector that's still stuck in a quagmire, with out either the ability or the willigness to circulate government and tax-payer funded money that's flowing in! While the government, media and many others have litle time but to debate whether CXOs deserve to earn their million dollar bonuses!