Updated from 4:28 p.m. EDTEarly signs indicated that the Obama administration's long-awaited plan to handle toxic assets weighing down the financial system may ultimately find success. The Public-Private Investment Program, or PPIP, unveiled by Treasury Secretary Timothy Geithner on Monday will provide up to $1 trillion in financing and guarantees to private investors to kick-start the frozen credit markets. The Treasury will start the lending program with $75 billion to $100 billion in capital, working with the Federal Insurance Deposit Corp. to entice private investors to buy illiquid pools of loans by offering leverage and guarantees. The FDIC will insure the majority of the purchase price of the deal, leveraging private funds at a six-to-one debt-to-equity ratio. The Treasury Department will then finance 50% of the remaining balance, leaving private investors responsible for coming up with about 7% of the capital required for the overall deal.
There was widespread criticism of the plan's potential downfalls even before details were officially released. Many feared that private investors might not see the risk-reward ratio in their favor. But glimmers of light were already emerging by Monday morning, as media reports indicated that the high-profile investment firms BlackRock ( BLK) and Allianz's ( AZ) Pacific Investment Management Co. planned to participate as investors, and that State Street ( STT), Bank of New York Mellon ( BK) and Northern Trust ( NTRS) were competing to handle servicing duties for the Treasury Department. The market responded positively to what may be a boon for investors, troubled financial firms and the broad economy, sending the Dow Jones Industrial Average up as much as 336 points, or 4.6% early in the day. Analysts estimate that there is about $2 trillion or more worth of troubled assets on banks' books, leaving little doubt that financial powerhouses like Citigroup ( C), Bank of America ( BAC), JPMorgan Chase ( JPM), Wells Fargo ( WFC), Goldman Sachs ( GS) and Morgan Stanley ( MS) will be eager to participate in the program. But banks may only complete such deals if they are able to sell troubled debt at higher prices than the fire-sale offers being made during the financial crisis. It remains to be seen whether the program will garner enough support to drive competitive bidding and close the vast valuation gap between sellers and bidders that has frozen the markets. "The PPIP provides substantial economic incentives for investors to bid higher and the regulators will presumably push banks to sell," says Douglas Elliott, a fellow at the Brookings Institute and a former investment banker at JPMorgan. "However, the valuation gap may simply be too large to bridge on reasonable terms for the taxpayer."
Another consideration is how the political high-wire act involving President Barack Obama, his charges and Congressional leaders plays out. If a bidding war drives prices too high, taxpayers will lose out on investments, as assets lose value within a deteriorated economy. If hedge funds and private equity firms book handsome profits on these deals -- despite having little skin in the game -- it might set off another public firestorm similar to the one related to bonus payments at AIG ( AIG), Merrill Lynch, Fannie Mae ( FNM) and Freddie Mac ( FRE), despite the fact that taxpayers will be profiting as well. There have been weeks of public protest regarding bonuses and economic strife, with AIG executives hiring security guards for their homes, as tour buses lined up in their driveways. Lawmakers followed up as expected, bashing financial firms and their well-compensated executives, and Sen. Charles Grassley (R., Iowa) going as far as to suggest that AIG executives commit suicide. The House passed a bill to tax bonuses at 90% in response to the public outcry, and executive compensation at banks receiving public money has already been capped at $500,000 -- before taxes. "
These programs will fail due to deep distrust an fear among the private capital providers, following radical actions in Washington," said a note from Fox-Pitt Kelton analysts on Monday. The administration promised on Monday that the FDIC will provide "rigorous oversight" of the program, and ensure a scenario with "the private sector standing to lose their entire investment in a downside scenario and the taxpayer sharing in profitable returns."
Still, details of the PPIP -- once called the Term Asset-Backed Securities Loan Facility, or TALF -- have been a work in progress for months as administration officials negotiated terms with the private sector to ensure that major players would participate. Elliott says the program was designed to "lure buyers in" and predicts that potential profits are "doubtless" to bring other candidates to the table besides BlackRock and PIMCO. But Lynn Tilton, CEO of the private-equity firm Patriarch Partners, criticizes restrictions on the size and objectives of participants. While any bank can opt to sell securities to the program, the Treasury Department will select buyers based on assets under management, and an objective to hold and carry assets rather than trade them. The secondary market program will only be open to five major fund managers in the distressed-debt markets. "You're either too big to fail or not big enough to play," she says. While PPIP includes many attractive incentives for deals that have been on hold amid ever-changing government plans, it is unclear whether the carrots will outweigh the sticks -- or the fear that such sticks will materialize amid public rancor. It is also unclear whether all three components of the plan -- taxpayers, banks and investors -- will benefit equally from the plan. But, if successful, the program has great potential to help stabilize or strengthen the global financial system and broader economy. Though the program was unveiled on Monday, the first indicators of performance probably won't be seen for months, and it could take years to reach a consensus opinion on the end result. "Unfortunately, we will not know until we see the program in actual operation," says Elliott. "There are substantial reasons to be concerned that the program will fizzle or prove to be too expensive for the taxpayer, but there are also some grounds for hope."