Reggie Middleton on PPIP, Part II

By: Reggie Middleton | Thu, Mar 26, 2009
Print Email

This is part 2 of Reggie Middleton on the government's Public-Private Investment Plan. You can find part 1 here: Reggie Middleton's Overview of the Public-Private Investment Program

Public-Private Investment Program

Impact on Lending

The program's aim to ensure that banks kick start lending is most likely overly optimistic. The program's core premise that the banks are reluctant to lend due to a overhang of legacy assets is based on a false assumption. The many reasons banks are unwilling to lend - not withstanding a dearth of capital - include fast deteriorating economic conditions, poor credit quality of borrowers, increased risk aversion, and the tumbling prices of underlying assets. Banks will continue to remain cautions unless, and until, the real economy stabilizes or risk acting against the best interest of their shareholders (and their bonus programs), defeating the very (stated) purpose of the program. Any program which focuses only on securities without focusing on fundamentals that affect the underlying assets (economic fundamentals) would fall short of its intended purpose. Common sense from my perspective, but I've always been sort of different so maybe I see things in,,, differently...

Lack of liquidity

The second basic premise of the plan's success lingers upon adequate participation from private investors. Even based on the assumption of maximum leverage granted by FDIC to everybody for everything that can possibly be purchased by anybody in the program (6:1) private investors would have to come up with $68 bn of funds (in this investor scary environment) to achieve the $500 bn target of legacy assets and $136 bn to purchase the full stated $1,000 bn of legacy assets promised to be leveraged into by the government. If the Fed's valuation committee is just slightly more conservative in its valuation estimates and uses lower (but more realistic, at least on average) leverage (ex. 4:1) granted to everybody for everything that can possibly be purchased by anybody in the program, then private investors would need to raise $188 bn to achieve the target goal of $500 bn and $375 bn to achieve target of $1,000 bn. Lest we show our short term memory propensity, do not forget that there are $2 trillion+ of these assets out there, not $1,000bn! So even with the government program maxed out to the fullest, we are still touching only 50% of the asset pool, as the underlyings to these assets are still in rapid descent.

Let me put this into perspective for you. The entire hedge fund industry is currently only about $1.5 trillion in assets under management (with many of those assets still fleeing as the lockups expire and the exit gates that were thrown up last year to prevent a run on the fund start to open). Garnering such an enormous amount of capital from private investors would require a significant amount of time and persuasion that could significantly delay the process and further depress the asset prices and the economy along with it. That is assuming it can be done at all - after looking at and digesting the numbers above appear to be increasingly unlikely. Despite all of these very real facts, the broad market participated in the biggest rally ever, in the history of exchange traded stocks in the US. What's next, see the graph here: Bear Market Rallies Shake Out Weak Hands!

(In Billions) $500   $1,000
Total Legacy
$250 $250 $500 $500 $500 $1,000
Min Pvt
Leverage 6: 1 4: 1   6: 1 4: 1  
to make the plan FIDC / Federal Reserve $214 $200 $414 $429 $400 $829
work Treasury $18   $18 $36   $36
  Private Investor $18 $50 $68 $36 $100 $136
Max Pvt
Leverage 1: 1 1: 1   1: 1 1: 1  
to make the plan FIDC / Federal Reserve $125 $125 $250 $250 $250 $500
work Treasury $63   $63 $125   $125
  Private Investor $63 $125 $188 $125 $250 $375

Risk and Reward in the PPIP!

Now, to be fair to Geithner, et. al., he (they) never declared the PPIP to be a be all and end all. What he did state was that this was a method of facilitating price discovery. It was to be bundled with a variety of other tactics, from quantitative easing to forcing capital down the throats of banks that fail government mandated stress tests. Well, looking at everything as a package, it does tend to make sense. The caveat is that although I definitely see the logic in the whole plan, the market seems to have misconstrued what I see as somehow being positive for extant bank common and preferred shareholders - NOT!!!! It may very well end up being a positive for the banking system, but I wouldn't even buy a bank stock with YOUR money!. Now, on to the biggest potential problem with the plan...

Possible loopholes

The plan specifically provides for the exclusion of SIVs (off balance sheet Structured Investment Vehicles of banks) from investing in the bank's legacy assets through PPIP by excluding affiliates of banks participating in distressed assets. So technically a bank cannot set up an SIV with a more than 10% stake and overbid for those assets.

However there is no such mechanism as such to prevent private investors to engage in collusion and overbid for securities, risking tax payers' money since both the parties stand to gain in such an event (out of this three party affair).

"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."

Seller Bank A   Seller Bank B
Face value 100.0 Input Face value 100.0 Input
Price determined by auction 80.0 Input Price determined by auction 90.0 Input
Current fair value in books, cents to dollar % 60.0% Input Current fair value in books, cents to dollar % 80.0% Input
Debt-Equity ratio 6.0 Input Debt-Equity ratio 6.0 Input
Debt FDIC Guaranty 68.6   Debt FDIC Guaranty 77.1  
Equity by private investor, Bank B 5.7   Equity by private investor, Bank A 6.4  
Equity by treasury 5.7   Equity by treasury 6.4  
Interest on FDIC Debt 4.0% Input Interest on FDIC Debt 4.0% Input
Fair value, cents to dollar %, actual at EOP 25.0% Input Fair value, cents to dollar %, actual at EOP 30.0% Input

As seller of Legacy Assets to PPIP
  Bank A Bank B
Gain on
sale to
20.0 10.0
Bank B (assuming it has purchased Legacy asset of Bank A)
  Value at EOP Gian (loss) Interest on FDIC debt Gain to equity investor Gain / loss to Private investor* %
Gain / loss to Tax Payer
on FV
  $25.0 ($55.0) $2.7 ($57.7) ($5.7) (100.0)% ($52.3)
Bank A (assuming it has purchased Legacy asset of Bank B)
  Value at EOP Gian (loss) Interest on FDIC debt Gain to equity investor Gain / loss to Private investor* %
Gain / loss to Tax Payer
70% discount on FV   $30.0 ($60.0) $3.1 ($63.1) ($6.4) (100.0)% ($56.9)
Net Gain (Loss) Bank  
  Bank A Bank B Taxpayer
As seller of Legacy Asset $20.0 $10.0   <--As long as bid value is greater than economic value banks stand to gain as seller
As Investor ($6.4) ($5.7)   <--Maximum loss as pvt investor is only to the extent of equity
Net Gain (Loss) Bank A $13.6 $4.3 ($109.2) <--Maximum loss to tax payer virtually unlimited. Banks stand to gain both from sale of legacy asset and as investor.

In the model above (which you can download for free for your own use: PPIP full model, with collusion and implied leverage 2009-03-26 01:00:41 202.00 Kb) we have assumed that Bank A and Bank B both participate in the PPIP program. Current fair value of Bank A's asset are at 60 cents on the dollar while Bank B's assets are at 80 cents on the dollar. However during the auction Bank A's and Bank B's assets are sold at 80 and 90 cents on the dollar, respectively. Bank A purchases Bank A's asset with equity investment of $6.4 while Bank B purchases Bank A's asset with equity investment of $5.4. At the end of period the actual value for these assets of Bank A and Bank B (originator) were 40 cents and 60 cents on the dollar, respectively.

Although both the banks lost 100% of their respective equity under the PPIP they were considerably better off (and I do mean considerably) selling each other their legacy assets, (effectively, selling them to the Treasury) with tax payers taking the ultimate hit. This should be safeguarded against. No need to worry, unless bank management takes out this blogger in the near future, I and my team will have our eyes out for such shenanigans. I can't guarantee I will catch it, but I wouldn't bet against me, either!

The Implied 14x Leverage Effect

Jeff S. posted the following comment on BoomBustBlog:

Am I mistaken in that the "Treasury Equity" is being funded by the remaining TARP balance? If so, is this not a deceptive title in that this "Equity" is really no different than the additional PPIP funds, and therefore, should be classified as "Debt?" And if so, does this not make the leverage ratio 14:1 (84/6) and not the stated 6:1?

Me thinks we are being lied to again. But I could be wrong.

Please advise...

In response:

There are 2 parts of the plan - the Legacy Loan Program and the Legacy Securities Program.

The Legacy Loan Program would purchase legacy loans through the Fed Guaranty (limited to leverage of 6:1) and the balance would be contributed equally between Treasury and Private Investor.

As a result under the assumption of maximum leverage (6:1 D/E) the effective Debt/Equity for the participant is 13:1, or leverage of 14.0x. We have highlighted the same in the structure, although probably not in the most lucid way, and we believe that Fed has provided sufficient information on the same without the intent of misleading the investment community,

Debt / Equity* Contribution by FDIC Contribution by Treasury Contribution by Pvt Investor Every $100 Dollar Invested Effective D / E for Pvt Investor Effective Leverage
Contribution by FDIC Contribution by Treasury Contribution by Pvt Investor
6: 1 6.0 0.50 0.50 86 7 7 13x 14x
5: 1 5.0 0.50 0.50 83 8 8 11x 12x
4: 1 4.0 0.50 0.50 80 10 10 9x 10x
3: 1 3.0 0.50 0.50 75 13 13 7x 8x
2: 1 2.0 0.50 0.50 67 17 17 5x 6x
1: 1 1.0 0.50 0.50 50 25 25 3x 4x



Reggie Middleton

Author: Reggie Middleton

Reggie Middleton

Reggie Middleton

Who am I?

Well, I fancy myself the personification of the free thinking maverick, the ultimate non-conformist as it applies to investment and analysis. I am definitively outside the box - not your typical or stereotypical Wall Street investor. I work out of my home, not a Manhattan office. I build my own technology and perform my own research - in lieu of buying it or following the crowd. I create and follow my own macro strategies and am by definition, a contrarian to the nth degree.

Since I use my research as a tool for my own investing to actually put food on my table, I can stand behind it as doing what it is supposed too - educate, illustrate and elucidate. I do not sell advice, I am not a reporter hence do not sell stories, and I do not sell research. I am an entrepreneur who exists just outside of mainstream corporate America and Wall Street. This allows me freedom to do things that many can not. For instance, I pride myself on developing some of the highest quality research available, regardless of price. No conflicts of interest, no corporate politics, no special favors. Just the hard truth as I have found it - and believe me, my team and I do find it! I welcome any and all to peruse my blog, use my custom hacked collaborative social tools, read the articles, download the files, and make a critical comparison of the opinion referencing the situation at hand and the time stamp on the blog post to the reality both at the time of the post and the present. Hopefully, you will be as impressed with the Boom Bust as I am and our constituency.

I pay for significant information and data, and am well aware of the value of quality research. I find most currently available research lacking, in both quality and quantity. The reason why I had to create my own research staff was due to my dissatisfaction with what was currently available - to both individuals and institutions.

So here I am, creating my own research for my own investment activity. What really sets my actions apart is that I offer much of what I produce to the public without charge - free to distribute and redistribute, as long as it is left unaltered and full attribution is given to the author and owner. Why would I do such a thing when others easily charge 5 and 6 digits annually for what some may consider a lesser product? It is akin to open source analysis! My ideas and implementations are actually improved and fine tuned when bounced off of the collective intellect of the many, in lieu of that of the few - no matter how smart those few may believe themselves to be.

Very recently, I have started charging for the forensics portion of my work, which has freed up the resources to develop the site to deliver even more research for free, particularly on the global macro and opinion front. This move has allowed me to serve an more diverse constituency, which now includes the institutional consumer (ie., investment turned consumer banks, hedge funds, pensions, etc,) as well as the newbie individual investor who is just getting started - basically the two polar opposites of the investing spectrum. I am proud to announce major banks as paying clients, and brand new investors who take my book recommendations and opinions on true wealth and success to heart.

So, this is how I use my background and knowledge in new media, distributed computing, risk management, insurance, financial engineering, real estate, corporate valuation and financial analysis to pursue, analyze and capitalize on global macroeconomic opportunities. I have included a more in depth bio at the bottom of the page for those who really, really need to know more about me.

Copyright © 2007-2016 Reggie Middleton

All Images, XHTML Renderings, and Source Code Copyright ©