Last week, the U.S. Department of the Treasury released the details regarding its Public-Private Investment Program (PPIP).
Through the PPIP, the government hopes to free up bank balance sheets and make credit more available to households and businesses.
The program is twofold: the first part deals with distressed loans that are sitting on the books of financial institutions (legacy loans), and the other part tackles securities on the balance sheets of these firms (legacy securities).
Securitization market participants generally welcomed the program, although they raised some concern about the issue of how to price these assets. Without an agreement between the sellers and the buyers on how much these assets are worth, this collateral might never be sold off in the auctions contemplated by the program.
"This is a well-designed program, and one that would permit modification in the future," said Michael Youngblood, a principal at Five Bridges Capital. "At this point, however, we don't specifically know how the auctions will be conducted. Will the seller and buyers be able to come to an agreement?"
Youngblood added that Fannie Mae and Freddie Mac still publish daily commitment rates, so there's a clear understanding in the market on where newly originated collateral should clear. "But it becomes problematic with more distressed assets," he said.
Ron D'Vari, CEO of NewOak Capital, views the PPIP as a catalyst and not a cure. "If this works out, then the banks will be able to lend more money. The market will worry about what happens later," he said.
D'Vari explained that before the PPIP, there was no way to leverage the distressed assets on financial institutions' books. "Market yields were so high and distressed investors were not so much interested in creating further leverage," D'Vari said.
By creating a demand for these assets, he said that should drive prices on these assets higher. "Cheaper financing with respect to the asset underneath leverages the expected returns in a positive way," he said.
However, D'Vari is apprehensive about further credit deterioration that may occur in the underlying assets. "People are basing prices on current assumptions, but later on they may find out that things are getting worse than they assumed," he said. "They might be blindsided by the new facts and actual defaults. Then we would end up having to cure the system all over again."
For instance, D'Vari said that, in terms of the CMBS sector, deteriorating performance is not yet behind us. "Things might be worse than the current forward-looking assumptions, and the leveraged investor might feel worse about the results. Leverage is a double-edged sword. It's like the bad being magnified," he said.
Program Summary
Under the Legacy Loans Plan, the participating banks will be identifying the loans they want to sell. After these financial institutions set apart these loans, the Federal Deposit Insurance Corp. (FDIC) will review the loan pool to determine financing terms and to provide leverage of up to six times equity. These pools are then auctioned to the highest bidder by the FDIC, while the bidder will need to have access to the PPIP to fund 50% of the investment's equity. The final buyer could issue debt that is guaranteed by the FDIC to finance the purchase of up to six times leverage. The FDIC, meanwhile, will receive a fee for its services, and private managers will be managing the assets under strict oversight by the government agency.
The Legacy Securities Plan expands the Term ABS Loan Facility (TALF) to acceptable legacy CMBS and RMBS assets - specifically, legacy non-agency RMBS that were originally triple-A as well as outstanding CMBS and ABS that are currently triple-A. Additionally, the Treasury will also support the public-private investment fund (PPIF), as in the legacy loan program, through a one-on-one equity matching. The support will also come in the form of additional financing of up to 100% of the total equity capital through senior debt.
Some Issues with the Legacy Programs
Experts said that the ability of the PPIP to spur loan trading is still up in the air. "Will loan pools trade? We don't know yet," Youngblood said.
One problem that Youngblood noted is that once a bank sells these assets, it risks having its own internal audit and compliance staff utilize the price used in the auction for valuing the remaining assets that the particular institution holds on its books. "The auctions are supposed to be transparent, and that is clearly a risk for these institutions, which might be unwilling to accept a loss on the loans that they still have on their books. It might open a Pandora's box in terms of valuations."
He explained that ultimately, the success of the legacy loan and securities programs would depend on the values achieved in the auction and not on other securities that are held by the sellers. "If the seller can be assured that the instruments they are auctioning will not influence the value of the assets that they continue to own, that will go a long way toward encouraging participation in the programs," Youngblood said.
There will also be some issues in terms of consistency in the reps and warranties and sales agreements for these transactions, according to Youngblood.
"Will there be a standard set of reps and warranties? Will they be negotiated auction by auction?" Youngblood asked. "Sales agreements are also another bone of contention, and any transaction that involves the physical settlement of mortgage loans is complicated even more."
For instance, Youngblood said that the seller and the buyer might be using different FICO scores or AVM calculations. "There are countless issues and inconsistencies that may occur," he said. "The devil is in the details, and the success of the auction would depend on these operational details being ironed out."
He said that a solution to these roadblocks would be to make the assets more transparent so that the buyers know what they are purchasing. One way to do this is by using TRACE (Trade Reporting and Compliance Engine) to make prices for these assets more transparent, which is the way it's done in the municipal and corporate bond sectors. Standardizing the reps and warranties is also a solution to limit the differences between the parties to the auction.
"We may find out that what seems like a viable program could break down for any number of reasons," he said. He enumerated instances such as buyers and sellers not agreeing on a price, sufficient volume might not clear, and there might be performance deterioration even after the sale is conducted. "There are numerous moving parts," he said. "Even parties who are acting out of good will and are perfectly reasonable commercially can have problems given the current housing market and the pressure on local labor markets."
Youngblood also mentioned that it takes time for the investor to determine that the pool he bought is actually the same as the one that was delivered to him, which might not be the case if performance deterioration between the time of purchase and delivery occurs. A solution to the problem of collateral deterioration is the Treasury Department and the FDIC providing implicit guarantees on the reps and warranties as well as on the performance of the loans, according to Youngblood.
Some More Issues with Pricing
A Merrill Lynch report released last week enumerated other issues with pricing, which include different institutions having troubled assets marked at varying prices.
Financial institutions that have already marked down troubled assets, according to Merrill, will have increased incentive to sell, while the institutions that did not write them down sufficiently to reflect current market prices will be hesitant to sell as a result of the impact on their capital situation. An example of market prices not being reflected in the assets would be when the collateral is in the banks' held-to-maturity accounts.
Merrill analysts also said that losses on troubled assets are very reliant on the characteristics of the underlying collateral. They emphasized that ultimate losses could differ significantly depending on the type of mortgage product - whether it be Jumbo, Alt-A or subprime - and the origination year, as well as the mortgage issuer. Additionally, the direction of home prices could also play a role. It should also be taken into account that even with deals from the same mortgage issuer, the loss expectation could be substantially different on each deal, depending on the delinquency pipeline. This is aside from the other factors already listed.
The third factor Merrill mentioned is that the current owners of the troubled assets will have better data than the Treasury or the money managers the Treasury has picked to manage the Troubled Asset Relief Program (TARP) regarding what the likely credit performance of the institutions' troubled assets will be. This creates an "information asymmetry problem," analysts said.
Legacy in Numbers
In research released after the PPIP's details were announced, FTN Financial analysts said that the market for legacy is somewhat hard to determine. From information derived from different sources, they know that the overall size of the U.S. residential mortgage market is roughly $10.5 trillion.
According to analysts, of that total, the agency MBS market is $5 trillion, the non-agency RMBS market is about $2.5 trillion and the remaining $3 trillion or so is on bank balance sheets. With the assumption that the government has alternative programs to address the agency MBS market - the Federal Reserve mandate of $1.25 trillion, the $850 billion mandate each at Fannie Mae and Freddie Mac and the U.S. Treasury program to purchase agency MBS - the combined non-agency and loan market is around $5.5 trillion, according to FTN analysts.
"Therefore, as an initial proposition, $75 to $100 billion looks a little small to have an impact," analysts said. However, they said that with the envisioned leverage available under PPIP and TALF, the dollars that could be invested might fall between 10% and 20% of the total market of $5.5 trillion in non-agency securities and loans.
Impact on CMBS
Analysts are generally positive on the PPIP's expansion of TALF to cover CMBS. Merrill Lynch analysts said that this is especially true for the top of the capital structure.
They added that a positive significant impact will be felt if the plan actually succeeds in freeing up capital, generally benefiting the commercial real estate markets.
The Treasury's move responded to industry needs as evidenced by the request put forth by the Commercial Mortgage Securities Association (CMSA) when it submitted a formal proposal to the Treasury and Federal Reserve on March 16. Addressing the fact that clogged assets on balance sheets are compromising lenders' ability to raise funds, the CMSA recommended several specific steps to enhance market liquidity. One of them was to resolve the lender "legacy assets" issue.
In the proposal, the CMSA said that lenders are saddled with legacy assets intended for securitization, taken as security for the extension of credit or otherwise retained on balanced sheet. Such legacy assets now constrain lenders' capacity to provide new financing, as they clog their balance sheets and inflict unprecedented levels of valuation volatility. Before lending can restart, lenders need to liquidate these legacy assets. The association recommended doing this through two ways: extending TALF to cover outstanding legacy CMBS and creating a public-private investment fund to offer an outlet for other existing legacy assets.
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