"There's something happening here. What it is ain't exactly clear"
- Buffalo Springfield, For What It's Worth
A comment on my previous post, "The PPP is a Scam" asked me to do a follow up post now that the details are out. First off - I want to take this opportunity to clarify that I am not offering any sort of recommendation to buy or sell any type of security on this blog - and everyone should do their own research before trading. That said, I am certainly doing my best to provide accurate information and insightful analysys.
Now, the details are out, and the plan is officially called the PPIP - the Public Private Investment Program. The key difference between what I wrote about yesterday based on initial reports, and what the actual plan contains, is that the max leverage will be 12-1, not 30-1.
Don't be confused by the quoted 6-1 leverage in the plan press release - the way it works is this: The government will form up to 5 investment groups. Each PPIF (that's Public Private Investment Fund) will bid on packages of bonds. Let's say KidDynamiteCapital bids 84c on the dollar for $100MM in bonds, and we're the winner. The FDIC would provide 6-1 leverage (how? we'll get to that in a minute), which results in $12MM in equity which needs to be committed - which will be split between KDCapital and the Treasury (from TARP funds). Thus, KDCapital can buy $84MM in bonds with $6MM in equity, which is 12-1 leverage.
The strangest part of all of this is the FDIC's involvement. As I mentioned yesterday, the FDIC doesn't have this kind of money to commit. If you read the Treasury's white paper on the PPIP, they explain exactly how the FDIC will offer this funding, and this is the important part:
"The new PPIF would issue debt for the remaining $72 of the price and the debt would be guaranteed by the FDIC. This guarantee would be secured by the purchased assets."
In other words, KDCapital would the turn around and issue $72MM worth of bonds with an FDIC guarantee on them! How does the FDIC guarantee the bonds I'm selling? Simple - they use the toxic assets in question as collateral! If this makes your head smoke, or reminds you of my favorite applicable Tommy Boy quote: "Hey, if you want me to take a shit in a box and mark it guaranteed, I will - I've got the time" - well then, you're probably using your brain.
The next question is, who wants to buy my KDCapital bonds - and what interest rate would I have to pay to raise capital? That remains to be seen. The harder question is how can the FDIC provide this insurance when it clearly lacks the assets to cover the liabilities - when AIG did this we called it criminal. The concept of the FDIC providing a shadow guarantee on debt used to purchase questionable assets by using the underlying questionable assets as collateral really doesn't make much sense to me, but it almost confuses me into submission. I guess it's the theory that a guarantee doesn't cost you anything if you don't have to use it - we'll see. The FDIC will charge a "fee" for providing this insurance. What's also interesting is that the Treasury already has a program to guarantee debt issued by financial institutions - the TLGP (temporary liquidity guarantee program).
I'm interested to see what kind of interest rates the market demands on these FDIC guaranteed PPIF bonds. Back in November, GS sold 3 year notes under the TLGP at a cost of 200bps over comparable treasuries. I found this interesting at the time, as the market clearly prices in some risk (200 bps worth!) even though the Treasury is guaranteeing both its own debt and GS's debt issue. Other institutions have also used the program, with JPM issuing its own short term notes under the TLGP at a spread of roughly 121 bps over treasuries. We'll have to wait and see how the market likes this FDIC version of the TLGP, backed by toxic assets.
Obviously, the key will be in making sure that, as I explained yesterday, the banks who are selling the assets are in no way able to fund or interfere with the PPIF's, or to somehow bid on any of the paper themselves. Hopefully, by limiting the number of participating PPIF's, the government will be able to keep the process Kosher. There are a number of stipulations included to try to ensure that this is the case (ie, "Private Investors may not participate in any PPIF that purchases assets from sellers that are affiliates of such investors or that represent 10% or more of the aggregate private capital in the PPIF."). Unfortunately, if the process is on the level, the banks may still find themselves disappointed in the bids they receive - which has been the problem all along. And so it goes.
EDIT: ok - I just finished this post and I'm already editing it, because I read a comment on Paul Kedrosky's blog that said "The selling bank provides seller financing by purchasing FDIC-guaranteed debt issued by the buyer. $6 from the buyer + $6 from the Treasury + $72 from the selling bank to purchase FDIC guaranteed debt from the buyer = $84 paid for assets with a face value of $100."
I went and dug around some more in the Treasury Fact Sheets, and found this:
"Consideration paid to Participant Banks in exchange for purchased Eligible Asset Pools will be in the form of cash or cash and debt issued by the PPIFs. PPIF debt will be guaranteed by the FDIC."
For some reason, this bothers me greatly... The bank selling the asset is financing the sale by lending the PPIF money collateralized by the very assets they are selling. The problem with this is that if the assets turn out to be worth less than the banks think, the banks don't eat it - the taxpayers (via the FDIC) do.
I guess maybe it doesn't really matter who lends the money (translation: buys the PPIF debt) does it? The method where the banks make the loan without really having the risk bothers me so much more though.
EDIT 2: Ok - I think I figured out why this is bothering me so much: when the seller (The Bank) provides the financing (translation: buys the PPIF debt), it means they don't actually get the sale price for the bond... Instead of getting $84MM, they only get $12MM - the rest is received when the bond matures. If the bond actually has value, the PPIF pays the seller (the Bank) back. If the bond was as worthless as the market thought, the taxpayer (FDIC) pays the seller back. Of course, if the seller doesn't receive the money when it sells the bonds, there's that much less beneficial effect, and that much less capital that the seller has to redeploy via new lending - so the benefit has to be less than if the PPIF sold debt to the marketplace. If the purpose of the plan is to "get banks lending again," wouldn't we rather have the banks actually receive all the money for the assets they are unloading NOW, rather than receiving 1/6th of the sale price?
I'll try to close this post once and for all by restating the most important point of why I think the FDIC's involvement here is a bastardization: the purpose of the FDIC is to protect bank liabilities, not to protect bank assets. The deposit you have at the bank is a bank liability. The debt a bank purchases (or a mortgage it writes) is a bank asset. This entire program is basically a reversal of the purpose of the FDIC.