The new toxic and bad legacy assets programs of the US Treasury: surreptitiously squeezing the tax payer and the Fed until the PPIPs squeak

Ecce! The Public Private Partnership Investment Program (or should that be the Public-Private Investment Program?) is here, albeit not yet with quite enough information on some of the key practical details to make a full assessment.

A picture is worth a thousand words, so here is my transcription of a picture from the US Treasury’s own website:

Investment Programmes
  • $75 to 100 billion of TARP&FSP capital
  • with financing from the FDIC and the Federal Reserve
    leverage $500 billion with potential to expand it to $1 trillion of
    purchasing power
Legacy Loans
Legacy securities
Capital Financing Capital Financing
Public-Private Investment Funds Funds will raise FDIC-Guaranteed Debt Public-Private Investment Funds
  • Combines USG and private guarantees
  • FDIC will guarantee debt
  • Combines private financing with USG
    capital and potential USG leverage
  • Leverage from Federal Reserve
  • Leverage up to 6 : 1
  • Builds on existing TALF framwork

There is very little Treasury money in it.

The first thing that struck me is how little money the Treasury appears to be putting in.  On reflection, this is not surprising. The government simply has no money in the kitty to recapitalise banks or purchase toxic or bad assets on any scale.  Of the $700bn TARP money, no more than $300 bn is left.  The Congress is in one of its more infantilist phases and will not, unless and until the threat of utter financial collapse becomes even more apparent, appropriate new money for saving US banking.

If future recapitalisations of US banks (and other systemically important institutions), the cleaning of the balance sheets of legacy toxic assets and guarantees or subsidies for new lending and borrowing are constrained to cost no more than $300 bn, God help us all.  If we have to wait too long for reality to dawn on the dunderheads in Congress, the decimal point on the $300.00 bn will surely have to be shifted one place to the right.

The present and previous administrations have not helped themselves by failing to realise that it is possible to saving banking – the activities, that is, lending, deposit-taking and borrowing – without saving the existing banks. If they did realise this, they failed to act on the realisation.

The US Treasury is putting  at most $100 bn into the PPIP pot.  “Using $75 to $100 billion in TARP capital and capital from private investors, the Public-Private Investment Program will generate $500 billion in purchasing power to buy legacy assets – with the potential to expand to $1 trillion over time.” The programme is hoped to do up to $1000 bn worth of toxic and bad legacy asset purchases.  Hope is good. Cash is better. Where is the remaining $900 bn going to come from?

The answer is loans or loan guarantees from the FDIC and the Federal Reserve and co-investment with private sector investors.

The answer differs for the two components of the PPIP, the Legacy Loan Program and the Legacy Securities Program. I will take them in turn.  The two tables below, with their illustrative examples, are again taken from the US Treasury’s own website.

Sample Investment Under the Legacy Loans Program

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.

The total amount of money put at risk by the private investor in this example is $ 6, the private equity investment.  The Treasury would also be on the hook for $6, its 5o% share of the total equity investment.  The FDIC would lend $72 or guarantee lending of that amount.  That’s what meant by the FDIC being “…willing to leverage the pool at a 6-to-1 debt-to-equity ratio.”

First note that the public sector as a whole (Treasury plus FDIC) is at risk for $78 out of a total investment of $84.  The public sector has the same upside as the private sector (through its $6 worth of equity).  However, the private sector gets this upside by putting only $6 at risk, against the public sector’s $84 at risk. Small wonder the stock markets loved this.  If there were a stock market for taxpayer equity, it would have tanked by a commensurate amount.

It must be recognised that the FDIC is in this picture only for cosmetic, window-dressing reasons.  The FDIC has no resources of its own to spend on leveraging the PPIP.  It cannot raise taxes and it cannot print money. It obtains revenue from the insurance premia paid by the banks whose deposits it insures, but that is hardly a secure source of income at the moment, let alone one that can be expanded drastically, should the need arise.  What little money the FDIC has is earmarked to meet future claims of depositors insured under its Deposit Insurance scheme (Congress has temporarily increased FDIC deposit insurance from $100,000 to $250,000 per depositor through December 31, 2009).  The FDIC has no money to spare.  Indeed, if any major deposit-taking bank were to go belly-up, the FDIC would have to rush to the Treasury for money.

The FDIC’s lending or guarantee of the loans to the PPIP is no more than a convenient way to move the Treasury’s exposure into supposedly independent ‘government agency land’.  The Treasury could have provided the loans or the guarantees itself.  As a guarantee involves only a contingent claim on the entity providing it, a Treasury guarantee would have created an off-balance-sheet liability for the Treasury.  Given the constrained state of the Treasury’s resources, even that was apparently deemed too much for comfort, and the FDIC was stuck with the task of providing the guarantee.  In  substance, however, this is a Treasury guarantee. The FDIC is there only to confuse Congress by making it difficult to follow the money.

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.

Under the Legacy Securities Program, the Treasury will provide equity of $100 for every $100 of private equity put in.  The Treasury will also lend up to $200 for each $100 of private equity.  So the Treasury puts at risk $300 to gain the same upside that the private sector will only put $100 at risk for.  Nice work if you can get it (if you work in the private sector). Again, the tax payers’ stock takes a hammering.

Enter the Fed

The Legacy Securities Program further enhances the quasi-fiscal role of the Fed, and turns the Fed even more blatantly into an off-balance sheet and off-budget special purpuse vehicle of the US Treasury.  It does this by extending the scope of the Term Asset-Backed Securities Lending Facility (TALF) to legacy asset-backed securities (especially mortgage-backed securities, residential and commercial and consumer debt-backed securities).  The original TALF was created to lend up to $1000 bn to private institutions willing to invest in newly originated mortgage-backed securities.  The US Treasury only guarantees up to $100 bn of this proposed lending, so in the worst-case scenario, the Fed could be in the hole for $900 bn, through its exposure to private credit risk.

I assume that this expansion of the scope of the TALF to include legacy assets will take place within the overall total ceiling of $1000 bn set for the TALF, but I fear that greater demands on the Fed will be made through the TALF in the future than is currently envisaged.

The role of the Fed in the PPIP, through the expanded TALF, is deplorable.  First, the main redeeming feature of the TALF was that it was focused on new securitisations of mortgages, in an attempt to revive the market for new securitised mortgages and through it new mortgage lending.  Diverting these resources to the ex-post insurance of losses that have already been made on legacy MBS (commercial and residential) and legacy consumer debt-backed securities is a serious waste of scarce public resources.  Using the good bank model of Bulow and Klemperer, Hall and Woodward, Buiter, Romer, Stiglitz and Soros, public resources (whether in the form of capital, guarantees, insurance or other subsidies, should be directed exclusively at new lending and borrowing by banks.  The legacy toxic and bad assets should be left with the shareholders and unsecured creditors of the ‘rump’ legacy bad banks, consisting of the old banks, minus insured deposits and good assets, plus the equity in the new good bank, minus their banking license, and minus any future government financial support.

The Fed is the financier of last resort for the PPIP

In the joint statement of the Board of Governors of the Federal Reserve System and the Department of the Treasury of March 23, we find the assertion that the “Treasury has in place a special financing mechanism called the Supplementary Financing Program, which helps the Federal Reserve manage its balance sheet. In addition, the Treasury and the Federal Reserve are seeking legislative action to provide additional tools the Federal Reserve can use to sterilize the effects of its lending or securities purchases on the supply of bank reserves.”

I would welcome the extension of the Fed’s arsenal to include the ability to issue Fed Bills and Fed Bonds, similar to Treasury Bills and Treasury Bonds, that is, non-negotiable interest-bearing bearer bonds, so the Fed can expand its balance sheet without expanding the monetary base.  At the moment, sterilisation of the monetary base impact of private sector asset purchases by the Fed either requires the Fed to reduce its holdings of Treasury securities (which could become exhausted) or it requires the US Treasury to engage in Treasury Bill or Treasury Bond sales, with the proceeds from the sale deposited in the Treasury’s deposit account with the Fed, which does not count as part of the monetary base.  The Supplementary Financing Program (created on September 17, 2008) is just the last of the two options mentioned above: The Treasury sells “…a series of Treasury bills, apart from Treasury’s current borrowing program, which will provide cash for use in the Federal Reserve initiatives.”

None of this addresses the issue of the massive private sector credit risk the Fed is taking on its balance sheet, a risk greatly enhanced by the modification of the TALF to include legacy toxic assets.  Even if the short-run consequences for the monetary base of enhanced Fed operations under the TALF are sterilised, the Fed will, should it suffer major capital losses on its investments in private sector securities, have no option but to expand the monetary base to maintain its solvency, unless the US Treasury comes to its rescue.  The terms of the TALF (with the US Treasury guaranteeing only 10 cents on the dollar, if the full $ 1 trillion is lent by the Fed) suggest that the US Treasury cannot and will not come to the rescue of the Fed.  Monetisation of the Fed’s capital losses and inflation will be the inevitable consequence of the lack of fiscal firepower of the US sovereign.

This threat of future inflation from Fed decapitalisation through losses on its portfolio of private assets is in addition to the threat of future inflation caused by doubts about the reversibility of the Fed’s forthcoming purchases of Treasury securities through its quantitative easing (QE) policy.  The recent Chinese comments on finding/creating a substitute for the US dollar as the international reserve currency demonstrate that concerns about the medium-term and long-term inflation consequences of the Fed’s QE, its credit easing and its quasi-fiscal rescue efforts of large US banking and shadow-banking institutions, are growing.

The plan muddles up toxic assets and bad assets

The legacy assets to be purchased by the two legs of the PPIP are legacy securities and legacy loans.  The legacy securities are toxic assets.  Toxic assets are assets whose value cannot be established with any reasonable degree of accuracy, because there are no liquid markets for them and because their complexity prevents too much faith being put in mark-to-model valuations.

The legacy loans, however, are just bad assets.  They are plain vanilla household and commercial loans that have become impaired.  Their value can be calculated quite readily by any reasonably competent banker.  It is likely to be low relative to the notional or face value of the loan.  That’s sad and too bad, but not a reason for getting the state involved through the PPIP.

By bundling toxic assets and bad assets, the Treasury muddles up price discovery issues and the recapitalisation of or subsidies to loss-making banks.

Participation is voluntary where it ought to be mandatory.

Banks with toxic assets on their balance sheet can choose to keep them there rather than participate in the Legacy Loans or Legacy Securities Programs.  Citigroups and Bank of America already have government insurance/guarantees for hundreds of billions worth of toxic and bad assets.  They are not going to be in a hurry to clear their balance sheets.  By making participation voluntary the Treasury has created an adverse selection machine.  Only those whose toxic or bad assets are priced higher than the reservation value of the banks who hold them will offer them for sale.  Surely, the designers of the scheme must have read George Akerlof’s famous ‘lemons’ paper (JSTOR access required)?  Participation in the programs should have been mandatory for all FDIC-insured banks with balance sheets in excess of $100 billion.

The proposal safeguards all unsecured creditors

The Treasury is desperate to make whole anyone senior to the holders of preference shares (possibly even anyone senior to ordinary shareholders) in the capital structure of the banks.  Two quotes from Geithner’s Opinion piece in the March 23 Wall Street Journal make this clear.

“This requires those in the private sector to remember that government assistance is a privilege, not a right. When financial institutions come to us for direct financial assistance, our government has a responsibility to ensure these funds are deployed to expand the flow of credit to the economy, not to enrich executives or shareholders.”


“Our nation deserves better choices than, on one hand, accepting the catastrophic damage caused by a failure like Lehman Brothers, or on the other hand being forced to pour billions of taxpayer dollars into an institution like AIG to protect the economy against that scale of damage.”

So unsecured creditors other than insured depositors, which get recourse up to $250,000.00 from the FDIC, are off the hook – even those holding subordinated debt.  Because even the holders of senior unsecured bank debt have earned interest rates higher than those on Treasury debt of similar maturity, it was clear that such senior unsecured bank debt was subject to default risk.  The investors in such risky instruments should not get ex-post insurance from the tax payer, after cashing in the ex-ante excess returns over Treasuries.

Treasury Secretary Geither also appears to accept at face value the assertion that the failure of Lehman caused catastrophic damage.  Although I accept that the failure of Lehman was handled very badly by the authorities and did unnecessary damage, I also believe that it was, even at the time the choice was made to pull the plug, the right thing to do (see an earlier blog post of mine on the issue and a fascinating event study of the Lehman debacle and the financial cardiac arrest that followed it by John Taylor of Stanford University).  The ‘rescue’ of Merrill Lynch by Bank of America undoubtedly did more damage, both to the institutions directly involved and to the reputation and stability of the US financial sector.

In any case, the uniquely vulnerable category of stand-alone US investment banks, without a special resolution regime (SRR) and the associated prompt corrective action (PCA) apparatus, no longer exists.  No US bank is too large or too interconnected to be put into the SRR administered by the FDIC.

Will it stop banks from failing?

The answer depends in part on how generous the valuations are that are put on the legacy securities and loans.  I fear that, despite the involvement of competing private parties with responsibility for valuing the toxic securities, the assets will only leave the balance sheets of their owners at a price well above fair or fundamental value.  That represents a poor use of public resources, and an unnecessary one, if the government were to pursue one of the ‘good bank’ solutions on offer.

The one consolation is all this is that the amount of money the Treasury is putting on the table ($100 bn at most) and the money the FDIC can honestly put on the table (zero) amount to so little that not too much damage is done by wasting it on the PPIP.  My worry is that the Fed will be induced to put a lot more than this on the table.  I can easily envisage a situation where, directly or indirectly, the Fed finances $800 bn or so of the $ 1 trillion envisaged for the PPIP.  That would be a huge waste of public resources, as well as a deplorable debauching of the Fed.

The proposal encourages price discovery for the toxic assets.

To reduce the likelihood that the government will overpay for these assets (or perhaps better: to reduce the magnitude of the virtually certain overpayment for these assets), private sector investors competing with one another will establish the price of the loans and securities purchased under the program.  This is valuable even if it were to just reveal something closer to fundamental or fair value for the existing toxic assets, because it would reduce the size of the subsidy of the tax payers to the shareholders and unsecured creditors of the banks.  It would be even more valuable if some of the toxic assets belong to asset categories that do have a long-term future, but that have become temporarily illiquid due to exceptional and extraordinary circumstances.  My suspicion is that rather few of the toxic assets will turn out to fall into these potentially sustainable categories.  Most of the CDO junk, and indeed most of the fancier securitisations ought never to have been created in the first place and, with a bit of luck, will never be created again.  There are therefore unlikely to be major market-recreation benefits from the price discovery in the Legacy Securities Program.


The PPIP is a bad program, but it could have been worse.  With the Treasury out-of-pocket and not yet properly staffed at the key senior levels, it is amazing an almost-implementable plan was birthed at all.

Even within the parameters of the PPIP, it should have been made mandatory for all US banks with a balance sheet over $100 billion, to offer up for sale/auction all their asset-backed securities and other complex structured products.  The impaired but non-toxic loan arm of the PPIP should have been omitted altogether, because – unless the Fed goes wild under a much expanded TALF . There simply is no money to do it on any scale.

It would have been preferable to nationalise the dodgy banks (they know who they are), possibly by using the SRR, and to pursue a good bank – bad bank solution for them.  Even better would have been to use the SRR to pursue a good bank solution along the lines of Bulow-Klemperer and Hall-Woodward for the majority of the large, cross-border US banks.

Doing anything right, effectively and honestly would, however, require much more than the $100 bn the US Treasury is willing/able to put up – much more even than the $300 bn that is still in the TARP kitty. Indeed more that the $1 trillion that is the current limit of the Treasury’s ambitions.  When the Treasury talks about ‘leveraging’ tax payers’ money, it is talking window-dressing and financial shenanigans.  In the TALF, the US Treasury is ‘leveraging’ the US tax payer 10 to 1, by debauching the Fed.  US citizens will not thank the Treasury for that in the future.  The abuse of the innocent word ‘leverage’ and the repeated use of special-purpose vehicles and off-balance-sheet entities to hide the economic and financial reality from scrutiny, reveal how close current and past Treasury officials are to the very practices that brought the US private financial sector to its knees.

So stop ‘leveraging’ the tax payers’ money. Stop using the Fed as an opaque SPV of the Treasury. Tell the people the truth.  Ask for more resources and pay for them by raising taxes or cutting public spending.

Maverecon: Willem Buiter

Willem Buiter's blog ran until December 2009. This blog is no longer active but it remains open as an archive.

Professor of European Political Economy, London School of Economics and Political Science; former chief economist of the EBRD, former external member of the MPC; adviser to international organisations, governments, central banks and private financial institutions.

Willem Buiter's website