The Public-Private Investment Program. An Overview

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The Public-Private Investment Program is a U.S. program to buy up bad loans and securities, dubbed legacy loans and legacy securities. The plan was adopted by the U.S. Treasury Secretary Timothy Geithner on March 23, 2009, as part of a package of the  Obama administration’s remedial measures to the economic crisis that had been created by the credit crisis of 2007-2008.

The plan works through the Treasury, the U.S. central bank and the Federal Deposit Insurance Company, together with private investors.

After the fall of one of the largest commercial banks, Lehman Brothers in September 2008, the whole system on mortgages and consumer loans reacted negatively. The derivatives market was completely halted and banks were in acute need of money because the interbank lending choked.

Actions by central banks of pumping large amounts of money into the banking system, as well as lowering interest rates to virtually zero, had little effect.

The market reacted in a disappointed fashion after the program was announced, as the biggest problem was the difficulty of valuation of toxic derivatives. The new plan offered a solution to price-fixing done on auctions, and provided for two components:

   – Legacy Loans: bad loans on the balance sheet (and whose value can be determined). Such loans could be offered by each party in special auctions, the entry fee will be doubled by the Treasury and the FDIC with a guaranteed loan from the Fed increased sixfold.
   – Legacy Securities: off-balance packaged loans, whose value is indeterminable. A limited number of asset managers (5-10) are enrolled, the Treasury participates on a 1:1 basis or in some cases on 1:2 basis.

According to the press release of the Treasury, the plan is based on three basic principles: the greatest gains for the taxpayer, sharing of risk with private investors and evaluation of the private market.

The legacy securities program was only for a select group of asset managers with proven experience in the trade of toxic loans. They were supposed to buy derivatives. The state took 50% share, and all loans would be guaranteed.

The initial reception of this program was one of a win-win situation: banks, investors and taxpayers would be able to derive benefits. Banks got rid of their toxic assets, investors found a fertile ground and the government shared in the profits.

However, many problems were identified by role players and observers on the ideas put forward, and these were as follows:

    – The risk of the government was many times greater than that of investors. The 6:1 leverage afforded by the FDIC, meant that the taxpayers carried more risk, six times that borne by investors.
    –  Banks were using various vehicles, and every bad assets purchases meant the federal guarantee suddenly no longer held any risk that would justify the balance.

    – Large investors in one particular bank may affect the stock price itself if they invested in bad loans, more than compensated by the capital gain.
    – Banks would offer only their worst loans, and recapitalisatiion of the banks was only possible by selling far above the market price.

 

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