Private Sector Key to $1-Trillion Toxic Asset Plan

"Investors applauded and financial stocks rallied around the possibility that banks might finally have the help needed to shed some of the toxic debt that has grid-locked the credit markets in recent months," Frederic Ruffy, options strategist with the New York City-based WhatsTrading.com tells GlobeSt.com.

There are some details still missing, particularly in the Legacy Securities Program, the component of the plan aimed at the secondary markets. Still, though, Treasury has substantially added to the bare bones outline that it first unveiled--and was widely panned--earlier this year.

As for the missing details, which include lending rates, minimum loan sizes, and loan durations, Treasury says it is working with the industry to settle them. CMSA, for instance, "is recommending several proposals to Treasury and the Federal Reserve, both of which are directly aimed at enhancing liquidity and facilitating lending in the private commercial mortgage market," Kenneth Reed, managing director of the Commercial Mortgage Securities Association, tells GlobeSt.com.CMSA believes, he says, that the financing term should have a 5-year term and be free of mark-to-market provisions.

Individual investors, pension plans and insurance companies are among the long-term investors the Treasury Department hopes to woo with the now-released details of the PPPF. It is using a mix of FDIC debt guarantees, Treasury equity co-investment and Federal Reserve Bank financing to not only get toxic debt off of banks' balance sheets but also to jump start secondary lending in the following manner:

To start the process, banks will decide which assets--usually a pool of loans--they would like to sell under PPPF's Legacy Loan Program. The FDIC will conduct an analysis to determine the amount of funding it is willing to guarantee, with leverage not exceeding a 6-to-1 debt-to-equity ratio. Assets eligible for purchase will be determined by the participating banks, their primary regulators, the FDIC and Treasury. Financial institutions of all sizes will be eligible to sell assets.

The FDIC will then conduct an auction for these loans; the highest bidder will be able to access the PPPIF to fund 50% of the equity requirement of their purchase. Assuming the seller accepts the bid, the buyer would also receive financing by issuing debt guaranteed by the FDIC. The purchased assets would serve as collateral for the FDIC, which would receive a fee in return for its guarantee. Once the assets have been sold, private fund managers will control and manage the assets until final liquidation, with the FDIC providing oversight.

Treasury provided the following example to make clear the process. A bank with a pool of residential mortgages at a $100 face value would approach the FDIC. 
Assuming the FDIC decides it is willing to leverage that pool at a 6-to-1 debt-to-equity ratio, it would then be put out to auction by the FDIC. Say the highest bid is $84--if it were accepted, the winning investor would then form a Public-Private Investment Fund to purchase the pool of mortgages.
 Of this $84 purchase price, the FDIC would provide guarantees for $72 of financing, leaving $12 of equity. Treasury would then provide 50% of the equity funding--or $6--required on a side-by-side basis with the investor. The private investor also kicks in $6.

The next piece of Treasury's plan--its Legacy Securities Program--is aimed at the secondary markets. This consists of two related parts: debt financing from the Federal Reserve under the Term Asset-Backed Securities Loan Facility (TALF) and through matching private capital raised for dedicated funds targeting legacy securities. The former is a joint plan by Treasury and the Federal Reserve to create a lending program that will be incorporated into TALF.

Through this new program, non-recourse loans will be made available to investors to fund purchases of legacy securitization assets. Eligible assets will include certain non-agency residential mortgage-backed securities that were originally rated AAA and outstanding CMBS and asset-backed securities that are rated AAA.

This part of the program still needs to be further mapped out, at least judging by the details that have not been released. Haircuts, for instance, will be determined at a later date. Lending rates, minimum loan sizes, and loan durations have also not been determined.

This is what Treasury has announced: it will approve up to five asset managers, who will then have a period of time to raise private capital to target the designated asset classes. They will then receive matching Treasury funds under the PPPF. Treasury funds will be invested one-for-one on a fully side-by-side basis with these investors.

Asset managers will have the ability, if their investment fund structures meet certain guidelines, to subscribe for senior debt from the PPPF in the amount of 50% of total equity capital of the fund. The Treasury Department will consider requests for senior debt for the fund in the amount of 100% of its total equity capital subject to further restrictions.

Treasury provided the following example to illustrate. A fund manager submits a proposal for the Legacy Securities Program and is pre-qualified to raise private capital to participate in joint investment programs with Treasury. The government then agrees to provide a one-for-one match for every dollar of private capital that the fund manager raises and to provide fund-level leverage for the proposed PPPF.