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PPIF and the Geithner 5

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Timothy F. Geithner, the United States Treasury secretary, recently proposed a public-private partnership to rid the nation's banks of troubled assets, or what the government delicately calls "legacy securities."

The Treasury's proposal is designed to get banks lending again and that is a worthy goal. But important aspects of the program are vague and some of the details that we do have are troubling. Indeed, the plan as written may even lead to greater systemic risk by expanding the "Too Big to Fail" club and restarting the entire process of allowing a few large firms, with little active regulatory oversight, to put the economy at further risk.

The Treasury's so-called Public-Private Investment Fund has two elements. One is the Legacy Securities Program, designed by the Treasury and the other is the Legacy Loan Program, created by the Federal Deposit Insurance Corporation. The differences between the two are revealing.

Let us begin with the Treasury orchestrated Legacy Securities Program, which is supposed to help banks shed the troubled assets that are sitting on bank balance sheets. Its first flaw is that is does not appear to prohibit firms from participating as both buyers and sellers of assets. This opens the possibility of rigged bids for securities.

Another unfortunate aspect of the program is that it invites only five players to manage the assets covered by the program. Call them the Geithner Five. Yes, Treasury is now recommending minority and women- owned firms become sub-contractors and is hinting that, after the five are up and running they may open it to more firms. Still, the plan requires that anyone who wants to participate in the potential upside of the program must invest in these firms, pay their management fees, and assume the firms pursue their fiduciary duties as carefully in these funds as they do in their non-government sponsored funds. Participants must also rely on the firms to get the best price for the securities purchased under the program.

Compare this to the FDIC managed Legacy Loan Program. Instead of relying on a chosen five firms, this program allows participation by any firm that can demonstrate historic experience managing assets of the types to be auctioned, thus providing the deepest mechanism for proper pricing of those assets.

Any auctioneer worth his salt strives to include the largest number of bidders in the process and naturally bars sellers from bidding on their own lots. To help minimize this risk, the Legacy Loan Program will rely on independent valuation firms not involved in the auctions to provide the F.D.I.C. with estimates of what bids might come in. This would allow the F.D.I.C. to consider the integrity of the bids before allowing the transactions to occur.

Treasury's Legacy Securities Program offers no specific price discovery mechanism and does not appear to consider a way to avoid the risks that may arise by allowing firms to participate as both buyers and sellers. Unlike the legacy loan program where large numbers of bidders would act to create credible pricing, the few firms selected to participate in the legacy securities program might have rational reasons to overpay for assets. Overpayment would make their own holdings appear more valuable and would generate a better reported performance numbers though it would harm the taxpayer.

This is no small risk. According to a recent article in the Wall Street Journal, two of firms that intend to participate in the program have seen 40% declines in their recently launched distressed-debt funds. If investor redemptions rose suddenly, the firms would become forced sellers of these already illiquid securities. Such selling could begin this crisis' vicious cycle anew

If each of the "Geithner Five" overpays for their peer's distressed assets, with the benefit of leveraged Treasury dollars, they would artificially lift prices and therefore increase the values of their private portfolios of these securities. The public currently has no way of knowing whether any of the five entities are already suffering either "mis-marked" or unrealized losses or is subject to potentially catastrophic risk from complex strategies in their derivative books of business. It seems reasonable to ask if, before rewarding these contracts, the SEC or Treasury should be required to do a due- diligence examination of these firms. To be sure, these firms are regulated investment advisors, but we have seen repeatedly that being regulated is no assurance of adequate oversight, oversight that is especially important given the size and political influence of these firms and the likely ability of these firms to extract terms and credit concessions from broker-dealers that would be all but impossible for smaller funds to receive.

How the "Geithner Five" are selected is also problematic. Each of the five firms allowed into the program will be expected to have portfolios of over $10 billion of distressed securities; a group so small by definition that Treasury is now suggesting that limit will not be rigid but rather part of a holistic determination. This suggests that the government is rewarding contracts to those firms that chose to accumulate the largest and riskiest exposures to the relevant collateral asset classes instead of awarding it to firms based on their investment performance and operational management of these assets.

Most market participants recognize that systemic risk results from allowing companies, without strong roots, to grown unconstrained and to become top-heavy at the same time that their roots become entangled with those of healthy institutions. But the selection of five firms to operate the Legacy Securities Program appears to concentrate and consolidate leveraged toxic securities in the hands of those institutions. Might that create material operational challenges or other new risks to the health of those institutions?

If those institutions were to become troubled the assets they purchased under the Treasury program would again be held by a small number of unsteady hands? If the Geithner Five got into trouble, won't the special relationship they share with the government result in an implied or potentially explicit government guarantee?

Several of the five possess financial risk profiles that demand consideration of the systemic risk that would be created by explicit and concentrated government exposures to these firms. Moreover, they have less oversight than banks, insurers or broker-dealers, are primarily funded with short-term borrowings, have large, long-term liabilities, are exposed to risks from redemptions, and have extraordinary amounts of interest rate and currency risk. These firms rely on complex derivatives strategies, are large trading partners with most of the troubled institutions and operate with large amounts of leverage. Adding gasoline to the mix, these five firms will be able to use the securities they buy under the Legacy Securities Program to invest in assets sold through another program, the Federal Reserve Bank of New York's TALF program.

It is amazing there has been no disclosures of the amount of leverage the government will provide to participants in through the combination of these programs. Butt is conceivable that the combined leverage could mean that for every dollar one of these firms put up the Government could be on the hook for $10 or $12 dollars. Treasury's funding of these firms without a clear determination of the leverage they will provide is troubling, especially given that almost all of the risk will be retained by taxpayers.

One of the unlearned lessons of the financial crisis is that there are enormous risks associated with fostering an environment that encourages institutions to become "too big to fail". Even as Treasury officials speak of the need for a new systemic risk regulator, they seem oblivious to an ongoing bias in favor of "too big to fail"
institutions. One of the painful paradoxes of the Public-Private Partnership is, in attempting to clean up the damage inflicted by poor oversight of an asset price bubble and "too big to fail" entities, the government appears likely to recreate the same scenario once again.