The U.S. Treasury Department’s recently unveiled Public Private Partnership Investment Program for Legacy Assets offers a unique approach to helping rid bank balance sheets of “toxic” assets, but am I missing something?  It looks like a recipe for almost certain future taxpayer losses – borne by the FDIC.

Here’s how the Treasury lays out the process for Legacy Loans:

Sample Investment Under the Legacy Loans Program

Step 1: If a bank has a pool of residential mortgages with $100 face value that it is seeking to divest, the bank would approach the FDIC.
Step 2: The FDIC would determine, according to the above process, that they would be willing to leverage the pool at a 6-to-1 debt-to-equity ratio.
Step 3: The pool would then be auctioned by the FDIC, with several private sector bidders submitting bids. The highest bid from the private sector – in this example, $84 – would be the winner and would form a Public-Private Investment Fund to purchase the pool of mortgages.
Step 4: Of this $84 purchase price, the FDIC would provide guarantees for $72 of financing, leaving $12 of equity.
Step 5: The Treasury would then provide 50% of the equity funding required on a side-by-side basis with the investor. In this example, Treasury would invest approximately $6, with the private investor contributing $6.
Step 6: The private investor would then manage the servicing of the asset pool and the timing of its disposition on an ongoing basis – using asset managers approved and subject to oversight by the FDIC.

So in the case of the private investor, he’s putting up about 7% of the capital and receiving 50% of the profit.  This serves to generate more interest in the program from private investors, but also has the “benefit” of inflating bids on what are likely to be poor quality assets – after all perhaps I can afford to bid a bit higher since I only need to put up $6 today. 

Isn’t that what got us into the housing crisis in the first place - terms that were too easy for the buyer and thereby incentivized speculation? Did our leaders learn nothing, or is this program meant to intentionally deceive the general public into believing that there is a profitable way of providing aid to the banking system?

More importantly, when has it ever been sound business judgment as a creditor (which banks were in the case of the housing crisis and the FDIC is in the case of the PPPIP) to lend money on a highly leveraged basis to fund a really risky investment?

From an implementation perspective it looks like there are also plenty of ways to game this from the seller’s perspective by either setting up a private entity to bid on your own assets or encouraging interested parties to do so.  Let’s walk through an example. 

Let’s assume a “legacy asset” is on the bank’s books for $0.50.  The bank sets up a partnership and bids $0.84 for the assets in question.  The bank puts up $0.06, government puts up $0.06 and FDIC insures $0.72.  So effectively the interested party has:

1.      Taken toxic assets off the bank’s balance sheet for a cash outlay 12% of what they’re currently on the books at.

2.      Enabled the bank to write the value back up from $0.50 to $0.84 on their balance sheet.

3.      Retained ½ any future upside in value

4.      Have downside limited to the $0.06 put up.

Mark our words, the PPPIP will end in another tragic loss for taxpayers.