Richard Alford: Why Has the PPIP Scandal Been Swept Under the Rug?

By Richard Alford, a former economist at the New York Fed. Since then, he has worked in the financial industry as a trading floor economist and strategist on both the sell side and the buy side.

I long ago stopped reading the reports by SIGTARP and ceased following Treasury’s PPIP program. It was a mistake. The SIGTARP quarterly report released in October included audits of some aspects of the PPIP. This audit and a prior audit of the PPIP manager selection process reveals that the PPIP has not meet the goals set for it and has allowed the private participants to profit disproportionately to the money that they invested and the risks that they incurred.

I stopped paying attention to SIGTARP reports when Neil M. Barofsky, the Special Inspector General, criticized the Fed for not having a contingency plan in place when AIG encountered the difficulties that lead to its de facto nationalization. Even post-Bear, Treasury had no plans to deals with any crises beyond throwing the problem at the Fed. In short, the Fed was the contingency plan. Only with blood in the street and the financial world on the edge of a precipice after the Lehman, Prime Reserve Fund, and AIG episodes would the Treasury come up with TARP and ask the Congress for enabling legislation and funding. Barofsky’s statement made it very clear that he was more than capable of missing the obvious. Despite that total misread by the SIGTARP, I should have continued to read the SIGTARP reports.

The original TARP plan had TARP buy illiquid real estate assets from troubled eligible institutions, but the plan floundered in the absence of market prices that would allow the transfer of the assets at prices that were fair to both the taxpayers and the banks. The PPIP was the Geithner Treasury’s “improvement” on TARP. The stated objectives of the PPIP were a) help TARP-eligible institutions to improve their balance sheets by removing bad assets and b) improve the market transparency for those assets by creating a pricing mechanism.

As trial balloons containing details of the PPIP began to circulate, it was clear that it was an ill-conceived exercise. The initially proposed structure was based on an auction in which a reference price would set for the securities. The private sector participants would then contribute six per cent of the “value” of the securities (to be matched by public “capital”) and in return get one half of the upside with losses (shared with the public “capital”) limited to their contribution. In short, the private sector participants bought de facto call options and not the assets themselves. (The implied strike price was six percent below the auction “price”.) The Government would put up 94% of the money, but only get half of the upside and interest payments for the “leverage” that it supplied.

The structure incorporated numerous problems. The participants in the PPIP would only want to include assets with lots of upside price risk. (These were exactly the assets that the TARP-eligible institutions would be most reluctant to part with as any recovery in the prices would aid their profitability and capital positions. On the other hand, given the prospect of considerable upside risk and limited downside (limited to the capital contribution), the private interest in the PPIP would be immense, especially from managers who realized the potential to buy under-priced call options. The structure also left TARP-eligible institutions wondering why the Treasury just didn’t sell them “put” protection, which would have relieved market concerns about their financial health and allowed them to retain the upside while at the same time reducing the need for other forms of public assistance and decreasing the burden on the FDIC if the institution should fail.

I was troubled by the idea that Treasury could avoid the problem of the absence of market prices for the troubled assets by auctioning off derivatives when there were no prices for the underlying assets. (How is it possible to determine a fair price for options in the absence of the prices for the underlying?) How could the same premium across options on an array of disparate assets be fair to the buyers and the sellers?) I also wonder how much transparency the PPIP could actually supply to the relevant asset markets.

The PPIP turned out to be very controversial. As expected, TARP-eligible institutions didn’t want to sell assets to the PPIP; however Treasury was swamped with money managers who wanted to participate in the PPIP. It quickly became clear that it would be only a fraction of the planned size and that the private sector contribution would be larger than in the initial proposal. My interest waned.

SIGTARP recently performed an audit of the PIPP and the results were published in its October 2010 quarterly report to Congress. The SIGTARP audit results were surprising and very revealing.

The audit serves to highlight four aspects of the PPIP:
• the size — $30 billion,
• the lack of price and issue transparency,
• the lack of transparency and confusion in manager selection, and
• the rates of return realized by the private investors in the PPIP to date.

The original PPIP proposal calls for the purchase and removal of $1 trillion of assets from the balance sheets of troubled TARP-eligible institutions. The audit revealed that the PPIP has been capped at $30 billion. The actual size of the PPIP asset holdings relative to the initial plan raises some interesting questions. If the original target of $1 trillion of assets accurately reflected the size needed to restore the liquidity and functioning of the markets for these assets, then it is clear that the size of the PIPP is insufficient to realize those objectives. If on the other hand $30 billion of assets is all that is required, then one has to wonder why Treasury, after consultation with a set of asset managers, originally chose a target that was 33 times the required size.

In addition to restoring liquidity to the asset markets, Treasury asserted that the PPIP would increase transparency by “…create(ing) a mechanism to determine market prices for trouble assets held by banks.” The existence of these prices would help restore market functioning.

The SIGTARP audit(s) reveal a problem with the PPIP with respect to the goals of helping to establish market prices and improving market functioning. The PPIP has not released any information about the specific prices paid or the securities acquired. Treasury has resisted efforts by the SIGTARP to make public (even with considerable lags) issue-specific information. (It does release some aggregate information on prices paid by class of security purchased.) In short, the PPIP has not contributed to transparency in the market.

Treasury processed 141 applications by asset managers who wanted to be selected as one of the PPIP managers. Nine were eventually selected. Unfortunately, the absence of transparency in activities of the PPIP is mirrored in the absence of transparency, the confusion and uncertainty in the manager selection process. The SIGTARP performed a separate audit of the selection process. To quote the SIGTARP:

Between February 10, 2009, and the beginning of the PP IP fund manager application process on March 23, 2009, Treasury officials held conversations with private investment firms BlackRock, Inc. (“BlackRock”), Pacific Investment Management Company, LLC (“PIMCO”), and the Trust Company of the West Group, Inc. (“TCW”) to seek advice on the structure of the plan…Treasury told SIGTARP that it consulted the companies on the market feasibility of different proposed structures… including the size of the program and the amount of capital that could feasibly be raised by the private sector for such an effort, and the relative impact of differently sized programs on a liquid securities markets. Treasury officials told SIGTARP that Treasury contacted these three firms because each has successfully developed distressed asset funds and raised private capital for their own investors similar to the funds Treasury envisioned for PPIP. Treasury did not document on its conversations with the three firms…

Treasury’s published selection criteria created confusion and uncertainty among applicants. While Treasury published five criteria, it did not state how many of these criteria applicants will be required to meet, or to make clear how applicants could demonstrate that they had met the criteria…

While Treasury refined its criteria during the selection process, its public statements did not eliminate applicants’ confusion and undisclosed changes impaired the transparency of the process…

Treasuries published selection criterion that fund managers have at least $10 billion in assets under management risk to unnecessarily discouraging applications from smaller asset managers that might have had significant expertise the eventual size of the PPIP and the fact that two thirds of the selective managers fail to meet the threshold suggest that it was unnecessary.
Treasury gave an advantage to larger applicants with respect to the requirement that the applicants demonstrated capacity to raise $500 million in private capital….

It should be pointed out that PIMCO and the TCW, two of the three firms with which Treasury consulted on the design of the PPIP and the manager selection criteria, both withdrew from participation in the PPIP.

Given the lack of transparency in manager selection, the size of the PPIP compared to the size deemed necessary to meet its objectives, and the failure of the PPIP to increase pricing transparency, the question remains — how well did the investors in the PPIP fare? According to the SIGTARP, they have done very well.

The SIGTARP audit indicates that the private sector contribution had been increased from 6% to approximately 25% (With the government supply an equal as capital and twice as much again as a loan earning and interest payment ,but entitled to share in any profits.). Table 2.33 on page 139 of the SIGTARP’s October 2010 report shows the PPIP funds cumulative net internal rates of return since inception (in the fourth quarter of 2009). The returns range between 19% and 52%. The fund that earned a net internal rate of return of 19% was limited to CMBS. The average net internal rate of return for the remaining seven funds was nearly 39%. Not bad at all considering the limited downside.

The SIGTARP report did not disclose the methodology behind the calculated returns. It leaves a number of questions.

Are the returns calculated based on the paid-in “capital” – the matching private/public capital contributions? If so, what is the blended return on the Government investment capital and debt financing provided? Given that the Government supplied three times as much of the funding as did the private sector and shared profits 50/50, the blended rate of return on the total public investment should be roughly one-third of the return on the private investment. (This ignores interest payments to the Government for supplying debt financing and fees paid to private managers) The pattern of returns differs dramatically from the distribution of the downside risk — losses evenly split until the private capital is exhausted, with the remaining risk borne by the public alone. One also must wonder what the return on capital to the private sector investors would have been if the leverage had remained as originally specified.

In short, PPIP has not meaningfully advanced the advertised goals of increasing transparency and liquidity in the markets for real estate assets. In additions, it is clear that the design of the program and the manager selection process and transparency of the PPIP itself are faulty. However, the PPIP has allowed the private investors to reap returns disproportionate to their shares of the risk and monies invested. It ought to be a scandal for numerous reasons.