The Public-Private Investment Program Lives?

The Federal Deposit Insurance Corporation (FDIC) is apparently indicating that (its own) reports of the death of the Public-Private Investment Program (PPIP) are largely exaggerated. In fact, the FDIC has completed a deal to sell some toxic assets through its part of the program. But don't get too excited: the seller of those securities didn't exactly participate by its own free will. It was a bank that the FDIC took over last November. Let's dig in!

First, here's some detail of the deal to sell the $1.3 billion mortgages portfolio, via the New York Times:

Under the deal, the F.D.I.C. will create a joint venture with Residential Credit Solutions of Fort Worth, a three-year-old company founded by Dennis Stowe, a veteran of the subprime mortgage industry.

Residential Credit will put up $64 million of its own money to obtain a 50 percent stake in the venture, which will hold and manage the $1.3 billion pool of mortgages from Franklin Bank.

The F.D.I.C. will own the other 50 percent stake in exchange for providing the loans as well as the bulk of the financing. Instead of taking cash for the loans, the F.D.I.C. will accept a government-guaranteed note for $727.8 million with an interest rate of 4.25 percent.

So what you've got here is an investor who knows his subprime mortgages running a shop designed to extract value from exactly these kinds of assets. Residential Credit, no doubt, is betting that it can collect enough on these assets to make a nice return on the price it paid. If it's right, by participating in this program, it could make particularly substantial gains. How substantial? Let's consider a scenario.

The FDIC provides a nice diagram (opens .pdf) of how the transaction works. The investor is only putting down a mere $64 million and paying an additional 4.25% per year in financing costs to obtain a return on its $650 million share of the portfolio. Now, that portfolio will likely incur some losses. But unless those losses total more than 30%, they won't even touch the principal paid. And the mortgages in these portfolios also collect interest and fees that will likely cushion some of those losses.

So let's say, in the first year, that the portfolio does incur exactly 30% losses, but the principal left returns a mere 6% on interest and fees (a very low return for non-prime mortgages). That would provide Residential Credit with around a 19% return on its initial investment, including the cost of interest it's paying for financing. If the portfolio returns 8%, then Residential Credit makes a whopping 33% on its initial investment.* And remember: that assumes the portfolio takes a 30% loss.

What if the deal goes bad? Residential Credit is on the hook for as little as $64 million. Meanwhile the FDIC could be on the hook for at least 12 times that, given the 6 to 1 leverage ratio and guaranteed loan it provides. Sounds like a pretty sweet deal to me, unless you're the FDIC.

This can hardly be called a true success for the PPIP, since no bank willingly sold assets through the program. This portfolio comes from a bank that the FDIC seized last year, so it's directing the bank to sell assets under the program. You might recall that one of the major criticisms of the PPIP was that banks might not be willing to participate, because they might not be able to stomach the losses they would have to incur the assets they sell. In this case, the bank would be forced to immediately write-down 30% of the value of these loans, given the discount. But since it failed already, that probably doesn't bother Franklin Bank or the FDIC.

Why did the FDIC bother? I can only guess to try to disperse some of the risk it holds for these assets. It sold away exactly 5% of the risk to Residential Credit and also obtains an interest payment from them on the financing. Of course, it also consequently only gets 50% of the potential return on the portfolio, and takes an immediate 30% loss. It looks to me like it's giving up its ability to reap all of the return for selling a little, tiny bit of the risk.

The big question, I think, is whether or not any financial institutions will ever want to voluntarily sell any assets through the plan. As banks and the economy have become healthier, this might not be so likely: they can now more easily stomach holding onto the stuff, rather than take significant losses on its sale. Still, it's interesting to see the program in action.

* It won't work exactly like this, however, since the financing must be repaid first from any money collected from the mortgages in the portfolio, according to the Washington Post. As a result, this is likely a long-term investment for Residential Credit. But if the mortgages do yield something like 6% or 8% per year, then its annualized returns should be similar to what I described.