Public-Private Investment Program: The Legacy Securities Program (US)

In early 2009, huge markdowns on mortgage-related assets continued to afflict the banks in possession of them, consuming their capital and inhibiting their ability to make new loans (PPIP White Paper 2009). That March, in recognition of the risks associated with these assets, the Treasury established the Public-Private Investment Program (PPIP) with two primary goals in mind. The obvious aim was to create new demand for troubled mortgage-related assets, thus enabling financial institutions to sell them. At the same time, the Treasury wanted a considerable portion of new demand to be from private investors. In order to achieve this, it formed investment partnerships with them.

While the government could have purchased these assets on its own, it concluded that incorporating the private sector into its approach had three clear advantages: It would (1) “[leverage] the impact of each taxpayer dollar,” enabling for the purchase of more assets using less TARP funding; (2) reduce government exposure to risk, as the private sector would help to shoulder any losses on the investments; and (3) “provide a mechanism for valuing the assets,” helping the government to avoid paying the wrong price for them, which would have further distorted the dysfunctional market it sought to fix (PPIP Fact Sheet 2009; Elliott 2009; Financial Crisis Manual).

Created by Congress in October 2008 with the enactment of the Emergency Economic Stabilization Act (EESA), TARP enabled the Treasury “to purchase and insure certain types of troubled assets for the purposes of providing stability to and preventing disruption in the economy and financial system” (Public Law 110—343). The law defined troubled assets as:

(A) residential or commercial mortgages and any securities, obligations, or other instruments that are based on or related to such mortgages, that in each case was originated or issued on or before March 14, 2008, the purchase of which the Secretary determines promotes financial market stability; and (B) any other financial instrument that the Secretary, after consultation with the Chairman of the Board of Governors of the Federal Reserve System, determines the purchase of which is necessary to promote financial market stability, but only upon transmittal of such determination, in writing, to the appropriate committees of Congress (Public Law 110—343).

Legacy loans and securities that were eligible for purchase through PPIP largely conformed to the description in definition (A). However, given the existence of definition (B), the Treasury Secretary also had the authority to decide if other assets needed to be purchased and what characteristics to apply to them.^FThe definition of legacy securities under PPIP, for instance, ran afoul of definition (A) in EESA in that legacy securities only had to be “issued before 2009”—not March 14, 2008.

At the inception of PPIP, the Treasury committed up to $100 billion in TARP funding for its implementation. Utilizing a combination of TARP funding, private equity, and outside financing, the program was supposed to provide for the purchase at least $500 billion in legacy assets. Later on, however, it became apparent that the program would not be able to achieve this scope. By July 2009, the Treasury had reduced its commitment for the Legacy Securities Program to just $30 billion, while the status of the Legacy Loans Program remained “in doubt” (SIGTARP Q3 2009).

The Treasury sponsored the creation of the Legacy Securities Program and initially committed up to $100 billion in TARP funding for the implementation of it (although this amount soon was reduced to $30 billion). The Treasury’s primary responsibilities included: (1) conducting an application process pursuant to which it selected firms to become fund managers, (2) meeting the PPIFs’ funding needs (matching private capital raised by them and setting up credit facilities for those accepting Treasury debt), and (3) maintaining oversight of the PPIFs as they purchased assets with public funding but largely at their own discretion.

Throughout the program, the Treasury interacted with and received help from a number of government agencies and private firms. During the application period, Simpson Thacher & Bartlett, a law firm, assisted with drafting application materials and setting evaluation standards; individuals from other government agencies (including the Export-Import Bank and Overseas Private Investment Corporation) served on the Evaluation Committee, helping to choose responsible fund managers; and Ennis Knupp & Associates, a consulting firm, advised the Evaluation Committee as it reviewed applications.

In addition, PricewaterhouseCoopers (PWC) and the Bank of New York Mellon (BNY Mellon) helped the Treasury to set up an extensive regulatory and oversight system. PWC supervised PPIFs with respect to rules concerning fraud and abuse of funds, while BNY Mellon served in the role of “administrative agent, custodian, and valuation agent” for the PPIFs (SIGTARP Q4 2009 report).

This timeline allowed for PPIFs to make long-term investments rather than short-term and speculative deals. The Treasury’s stated goal of these investments was to: “generate attractive returns for taxpayers and private investors through long-term opportunistic investments in Eligible Assets . . . by following predominantly a buy and hold strategy” (PPIP quarterly reports).

Because the private market was hesitant to invest in legacy securities, the government needed to provide an incentive for it to do so as part of the Legacy Securities Program. The program aimed to do this “by providing government equity co-investment and attractive public financing” to these investors (PPIP White Paper 2009).

Public funding for asset purchases included matching Treasury equity as well as debt financing from the Treasury and/or outside financing sources. As described above, half turn financing offered PPIFs access to Treasury debt worth 50% of their aggregate capital—while giving them the opportunity to obtain debt elsewhere—and full turn offered them access to Treasury debt worth 100% of their total capital—while prohibiting them from accepting other funding (Legacy Loans Program Summary of Terms 2009).

Loans from the Treasury were nonrecourse, which served to limit potential losses for private stakeholders to only the equity they contributed. In addition, the loans were extended at interest rates of 1-month Libor + 100 basis points (full turn) or 1-month Libor + 200 basis points (half turn).^FFor PPIFs choosing half turn financing, this rate was subject to increases depending on the leverage they assumed from elsewhere (Financial Crisis Manual). Altogether, the terms of the funding were intended to be “attractive” to private investors, and the rates were considered by some to be “well below” what it would have cost to finance the purchase of these assets elsewhere (PPIP Fact Sheet 2009; Dash 2010).

At the same time, the provision of cheap public financing was also supposed to increase investor tolerance for paying higher prices for them (Financial Crisis Manual). In this way, the program would encourage holders of these assets to now choose to sell them (Financial Crisis Manual).

Realized profits and losses were divided among investors in line with their shares in each PPIF (notwithstanding the Treasury’s privilege to an additional portion of profits—should there be any—per the warrants it received) (Financial Crisis Manual).

A key facet of Treasury’s arrangement with fund managers was that they were required to invest at least $20 million of their firm’s funds in their own PPIF. This was done to ensure that they had “skin in the game”—i.e., a vested interest in the performance of their own fund (SIGTARP Q3 2009). As noted above, fund managers—like other investors—were prepared to forfeit this equity should their investment decisions yield results that wiped it out (PPIP White Paper 2009).

In addition to this requirement, as shown in Figure 4, fund managers were forced to abide by a number rules that were intended to shield the Treasury’s investment, including restrictions on leverage, the use of a third party to value PPIF portfolios, and detailed conflict-of-interest directives (SIGTARP Report, Q3 2009).

Source: SIGTARP Report, Q3 2009

Finally, as the program was developed throughout 2009, the Treasury responded to a number of concerns about potential misuse of public funding. It instituted rules barring devious behavior such as “asset crossing,” “asset flipping,” and “round tripping”—all of which essentially involved a fund manager conspiring with other firms to earn side profits on transactions—and reducing opportunities for fund managers to favor the interests of their clients and subsidiaries over those of the Treasury’s (SIGTARP Report, Q3 2009). (For more information on concerns raised and rules implemented in response to concerns raised by SIGTARP, see Table 2.25 on pages 91 and 92 of the Special Inspector General for TARP’s 3rd Quarter 2009 Report to Congress.)

Direct participation in the program was limited to private sector firms chosen to serve as PPIF fund managers. The Treasury initially anticipated choosing five fund managers, although it ultimately chose nine after receiving 141 applications for the position. Even if a private sector firm were not chosen to be a fund manager, it could participate in the program in the form of a regular investor and purchase an equity stake in individual PPIFs. According to Davis Polk & Wardwell, this option was available even to foreign firms (Financial Crisis Manual).

The Treasury appointed nine fund managers at the conclusion of a months-long application process. It established an Evaluation Committee and charged it with judging applicants according to the evaluation standards listed below:

1. “Demonstrated capacity to raise at least $500 million in private sector capital.”
2. “Demonstrated experience investing in Eligible Assets, including through performance track records.”
3. “A minimum of $10 billion (market value) of Eligible Assets under management.”
4. “Demonstrated operational capacity to manage the Funds in a manner consistent with Treasury’s stated Investment Objective^FThe Treasury’s stated investment objective was to “generate attractive returns . . . through long-term opportunistic investments in Eligible Assets” (Legacy Securities Summary of Terms). while also protecting taxpayers.”
5. “Headquartered in the United States” (Fund Manager Application).

Although the Treasury later clarified that these criteria were intended to be flexible—i.e., that failing to meet one or more would not necessarily rule out an applicant—the government wanted to ensure that fund managers were capable of raising capital from the private sector and making sound investments. Moreover, analysts at the Center for American Progress deemed these criteria to be important because the government needed (1) to be able to trust fund managers with public money, (2) to ensure that PPIF activity acted to support market functioning, and (3) to be able to count on fund managers to work in support of related efforts, such as foreclosure prevention programs (Ettlinger et al. 2009).

EESA gave a particularly broad description of financial institutions, defining them as “any institution, including, but not limited to, any bank, savings association, credit union, security broker or dealer, or insurance company, established and regulated under the laws of the United States or any State, territory, or possession of the United States, the District of Columbia, Commonwealth of Puerto Rico, Commonwealth of Northern Mariana Islands, Guam, American Samoa, or the United States Virgin Islands, and having significant operations in the United States, but excluding any central bank of, or institution owned by, a foreign government” (Public Law 110—363).

As opposed to other government programs, which sought to promote new issuance of asset-backed securities, the Legacy Securities Program was designed to “restart the [secondary] market for legacy securities” that had already been issued and were held by banks and other financial institutions. According to the Treasury, the prevalence of these assets impeded the financial system’s ability to make new loans and jeopardized the country’s recovery from recession.

As such, the Treasury defined eligible assets so as to target these securities. Eligible assets included non-agency (not issued by a government agency or government-sponsored enterprise) RMBS and CMBS that were (1) “issued prior to 2009,” (2) “originally rated AAA or an equivalent rating by two or more national recognized statistical rating organizations without ratings enhancement,” (3) “secured by the actual mortgage loans, leases or other assets and not [by] other securities,” at least 90% of which were located in the United States, and (4) owned by a U.S. financial institution, as defined by the EESA (Legacy Securities Summary of Terms). Because securities had to be secured by actual loans or leases, AAA-rated CDOs were ineligible for the program.

In announcing such a decision, the Treasury reasoned that it developed the PPIP to leverage private sector resources and expertise for purchasing legacy assets and the TALF with the Fed for funding legacy assets. Therefore, asset managers or private investors participating in PPIP were exempt from executive compensation restrictions if the PPIFs are structured such that the asset managers themselves and their employees are not employees of or controlling investors in the PPIFs, and other investors are purely passive (FAQ April 6, 2009).

In February 2009, the Obama Treasury announced its Financial Stability Plan. Even though a wide array of financial stability efforts were already underway, the Obama Treasury saw the need for a second wave of crisis-fighting programs—ones specifically designed to “attack the credit crisis on all fronts” (Financial Stability Plan 2009). The plan involved the participation of several government agencies and—in addition to PPIP—included proposals that ultimately became the Supervisory Capital Assessment Program (SCAP), Capital Assistance Program (CAP), expansion of TALF, Small Business Administration Section 7(a) Securities Purchase Program, and foreclosure prevention programs including the Home Affordable Modification Program (HAMP) and Home Affordable Refinance Program (HARP).