Currencies React to U.S. Treasury's Toxic Asset Plan

Last updated 3/23/2009 10:35 AM ET (GMT -5) 0 Comments - Add your comment

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Kathy Lien

Director of Currency Research, GFT

The Treasury has finally released the details on their Public Private Investment Program (PPIP) aimed at taking toxic assets off of bank balance sheets. Investors are cheering this announcement as they have been eagerly awaiting these details since the program was first announced 2 months ago. At that time, it was a nice idea that was full of holes with no information on how it would actually be implemented.  Geithner has now filled those holes and even went one step further by providing specific examples. 

The announcement has been received warmly by investors and the improvement in sentiment has been compounded by the 5.1 percent rise in existing home sales.  Stocks are higher and gold prices are lower but the U.S. dollar is actually rising against the Euro, British pound and Japanese Yen because the plan creates a floor for some of these toxic assets, which helps to reassure foreign investors. 

The effectiveness of the program hinges upon whether private investors will take the carrot that the Treasury is offering them.   In order to buy into the program, not only do they need to be confident that the assets will appreciate in value, but also that the U.S. government will not rescind on their offer or create some surprising rule like the retroactive tax on bonuses. Also, banks have to be willing to part with the assets, which may not make sense if they have already written them off. 

Nonetheless, it is clear that along with the Federal Reserve's Quantitative Easing program, the U.S. government is throwing everything including the kitchen sink at the U.S. economy and it could finally work.  The only catch is that the program will probably not begin until the end of the third quarter because applications are not due until May. 

The plan involves the collaboration between the Treasury, the FDIC and the Fed to provide cheap capital to encourage private participation.  The risk will be shared between the private and public sector and the private sector will determine what the toxic assets are worth. 

As for the numbers, $75 to $100B in TARP capital and capital from private investors will be allocated to the PPIP which the Treasury estimates will have $500B in purchasing power with the potential of expanding to $1 trillion over time. 

Fact Sheet from U.S. Treasury on Public-Private Investment Program

The plan has 3 basic principles:

1. Maximizing the Impact of Each Taxpayer Dollar

By using government financing in partnership with the FDIC and Federal Reserve and co-investment with private sector investors, substantial purchasing power will be created, making the most of taxpayer resources.

2. Shared Risk and Profits With Private Sector Participants

The Public-Private Investment Program ensures that private sector participants invest alongside the taxpayer, with the private sector investors standing to lose their entire investment in a downside scenario and the taxpayer sharing in profitable returns.

3. Private Sector Price Discovery

To reduce the likelihood that the government will overpay for these assets, private sector investors competing with one another will establish the price of the loans and securities purchased under the program.

According to the Treasury, this will be a much better approach than simply waiting for banks to work the toxic debt, or what they call "legacy assets" off their balance sheets, which would prolong the financial crisis and possibly turn the U.S. into Japan who fell into a 10 year phase of zero growth. By bringing in the private sector, taxpayers will not have to bear all of the risks.

Video: All About the Government's Public-Private Investment Plan

Breakdown of The Public-Private Investment Program

Treatment of Legacy Securities

The process for purchasing assets through the Legacy Loans Program will be the following:

The Treasury has even gone so far to provide an example:

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.

Treatment of Legacy Securities

Legacy Securities which involve instruments that are trading on the secondary markets but at levels below where they would be in normally functioning markets are going to be treated differently.  The goal of the Treasury's approach on these securities is to jump start the market once again.  Here are the details:

1.  Expanding TALF to Legacy Securities to Bring Private Investors Back into the Market: The Treasury and the Federal Reserve are today announcing their plans to create a lending program that will address the broken markets for securities tied to residential and commercial real estate and consumer credit. The intention is to incorporate this program into the previously announced Term Asset-Backed Securities Facility (TALF).

- Providing Investors Greater Confidence to Purchase Legacy Assets:  As with securitizations backed by new originations of consumer and business credit already included in the TALF, we expect that the provision of leverage through this program will give investors greater confidence to purchase these assets, thus increasing market liquidity.

- Funding Purchase of Legacy Securities: Through this new program, non-recourse loans will be made available to investors to fund purchases of legacy securitization assets. Eligible assets are expected to include certain non-agency residential mortgage backed securities (RMBS) that were originally rated AAA and outstanding commercial mortgage-backed securities (CMBS) and asset-backed securities (ABS) that are rated AAA.

- Working with Market Participants: Borrowers will need to meet eligibility criteria. Haircuts will be determined at a later date and will reflect the riskiness of the assets provided as collateral.

Lending rates, minimum loan sizes, and loan durations have not been determined. These and other terms of the programs will be informed by discussions with market participants. However, the Federal Reserve is working to ensure that the duration of these loans takes into account the duration of the underlying assets.

2.  Partnering Side-by-Side with Private Investors in Legacy Securities Investment Funds: Treasury will make co-investment/leverage available to partner with private capital providers to immediately support the market for legacy mortgage- and asset-backed securities originated prior to 2009 with a rating of AAA at origination.

-           Side-by-Side Investment with Qualified Fund Managers: Treasury will approve up to five asset managers with a demonstrated track record of purchasing legacy assets though we may consider adding more depending on the quality of applications received. Managers whose proposals have been approved will have a period of time to raise private capital to target the designated asset classes and will receive matching Treasury funds under the Public-Private Investment Program. Treasury funds will be invested one-for-one on a fully side-by-side basis with these investors.

           Offer of Senior Debt to Leverage More Financing: Asset managers will have the ability, if their investment fund structures meet certain guidelines, to subscribe for senior debt for the Public-Private Investment Fund from the Treasury Department 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.

Sample Investment Under the Legacy Securities Program

Step 1: Treasury will launch the application process for managers interested in the Legacy Securities Program.

Step 2: A fund manager submits a proposal and is pre-qualified to raise private capital to participate in joint investment programs with Treasury.

Step 3: The Government 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 Public-Private Investment Fund.

Step 4 : The fund manager commences the sales process for the investment fund and is able to raise $100 of private capital for the fund. Treasury provides $100 equity co-investment on a side-by-side basis with private capital and will provide a $100 loan to the Public-Private Investment Fund. Treasury will also consider requests from the fund manager for an additional loan of up to $100 to the fund.

Step 5 : As a result, the fund manager has $300 (or, in some cases, up to $400) in total capital and commences a purchase program for targeted securities.

Step 6: The fund manager has full discretion in investment decisions, although it will predominately follow a long-term buy-and-hold strategy. The Public-Private Investment Fund, if the fund manager so determines, would also be eligible to take advantage of the expanded TALF program for legacy securities when it is launched.

Finally, the Treasury also applauded themselves for the progress on helping families refinance their mortgages and avoid foreclosures.  This past month, the 30% increase in mortgage refinancing demonstrated that working families are benefiting from the savings due to these lower rates.

The Treasury has also posted the White Paper on the announcement and FAQs at http://financialstability.gov

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About The Author

Kathy Lien began her FX trading career 10 years ago at J.P. Morgan Chase. After graduating New York University’s Leonard Stern School of Business at the age of 18, Kathy joined the bank's interbank FX trading desk and eventually moved to the cross markets proprietary trading desk. In the interbank market, her ability to create solid fundamental and technical analysis from the myriad of information on the market helped her trade forex spot and options. Her experience eventually led her to be chief strategist at Daily FX where she worked until she joined GFT in 2008.

With her knowledge of forex, as well as her experience trading other products, such as interest rate derivates, bonds, equities, and futures, Lien has built a reputation as an international currency analyst. She is frequently quoted on CNBC, Bloomberg, Fox Business and Reuters. Lien has also written for publications like Active Trader, Futures, and SFO magazine. She is the author of the newly updated Day Trading the Currency Market: Technical and Fundamental Strategies to Profit from Market Moves, and the co-author of Millionaire Traders: How Everyday People Are Beating Wall Street at Its Own Game with Boris Schlossberg.

To buy Kathy’s newly updated Day Trading and Swing Trading the Currency Market: Technical and Fundamental Strategies to Profit from Market Moves, click here.