Public-Private Investment Program: The Legacy Securities Program (US)

By the fall of 2008, troubled mortgage-related assets had become inextricably linked to the onset of the Global Financial Crisis (GFC). Marked down to only a fraction of what they once were worth, these assets weighed heavily on the nation’s financial institutions, consuming their capital, raising concerns about their solvency, and inhibiting their ability to make new loans (PPIP White Paper 2009).

On September 19, 2008, U.S. Treasury Secretary Henry Paulson issued a public statement on the escalating crisis, calling troubled mortgage-related assets “the underlying weakness [of the U.S.] financial system” (Paulson Statement 9/19/2018). Two weeks later, Congress responded by enacting the Emergency Economic Stabilization Act (EESA), approving the creation of the Troubled Asset Relief Program (TARP) and giving the Treasury up to $700 billion with which to purchase these assets.

By the end of year, the Treasury had disbursed nearly $200 billion in TARP funding; however, it had yet to establish an asset purchase program. Two months earlier, it decided to halt the development of such a program, citing the exceeding complexity of designing one and the relative inefficiency using the funding to buy troubled assets as opposed to inject capital (Paulson Statement 11/12/2008).

By early 2009, the worst of the financial crisis had subsided, yet troubled mortgage assets continued to pose a threat to the broader financial system. Deep markdowns on these assets “[created] uncertainty around the balance sheets of financial institutions [holding them], compromising their ability to raise capital and their willingness to increase lending” (PPIP Fact Sheet 2009). The resulting drag on new credit formation threatened to exacerbate the ongoing recession (PPIP Fact Sheet 2009).

On February 10, 2009, in recognition of the risk of protracted financial and economic instability, the Obama Treasury announced a comprehensive Financial Stability Plan that was intended to “attack [the] credit crisis on all fronts” (Financial Stability Plan 2009). Given the prevalence of troubled mortgage assets and their role in instigating the crisis, a key focus of this plan was to “restart” primary and secondary markets for them, with the hope of giving financial institutions a chance to “cleanse their balance sheets” of them (Financial Stability Plan 2009).

On March 23, 2009, on the basis of a proposal outlined in the Financial Stability Plan, the Treasury, Federal Deposit Insurance Corporation (FDIC), and Federal Reserve (Fed) officially announced the Public-Private Investment Program (PPIP). The program was created to allow for the formation of public-private investment partnerships; “using $75 [billion] to $100 billion in TARP capital and capital from private investors,” these partnerships would aim to purchase up to $500 billion in “legacy assets” from U.S. financial institutions, providing a considerable injection of liquidity to the market for them (PPIP Fact Sheet 2009). PPIP consisted of two complementary programs designed to provide liquidity for certain mortgage-related assets: The Legacy Loans Program and the Legacy Securities Program. This case study discusses the design and implementation of the Legacy Securities Program. (For more information on the Legacy Loans Program, see Henken 2019.^FNHenken, Benjamin. “The Public-Private Investment Program: The Legacy Loans Program (U.S. GFC).” Yale Program on Financial Stability.)

The Legacy Securities Program revolved around the creation of public-private investment funds (PPIFs) that—using a combination of private and public finding—would purchase legacy securities in the open market. To begin the program, the Treasury conducted an application process, which resulted in it choosing nine private sector firms (fund managers) with which to form investment partnerships. Each fund manager was given responsibility over its own PPIF, which served as the conduit through which it purchased and held onto eligible securities. After raising capital from the private sector, receiving matching Treasury equity, and selecting one of two debt-financing schemes made available by the Treasury, the PPIFs began to invest in mortgage securities and were given a three-year window in which to do so. Over the next five years, they were then required to unwind any positions they had assumed.

Specific program processes, eligibility requirements, and other conditions are discussed in detail below.

Selecting Fund Managers

 At the inception of PPIP, the Treasury posted application materials online for firms that wanted to manage a PPIF under the Legacy Securities Program (Selecting PPIP Fund Managers 2010). The application consisted of questions gauging the potential applicant’s “qualifications and performance history,” requiring firms to detail the scope of their operations, their investment management experience, the capacity of their workforce, and their organizational structure. Applicants also had to develop a vision for their participation in the program, outlining how they would set up and staff a PPIF, pursue investment opportunities, and stay within the boundaries of relevant regulatory requirements (Fund Manager Application). Simpson Thacher & Bartlett LLP, a law firm, assisted the Treasury with drafting application materials and setting evaluation standards (Selecting PPIP Fund Managers 2010).

Potential applicants were given about two weeks to apply. However, after initially fielding weak interest from the private sector, the Treasury extended the deadline twice, ultimately settling on April 24 (Selecting PPIP Fund Managers 2010).

On April 24, the Treasury closed the application window, having received a total of 141 submissions, and assessed applicants in several rounds during the ensuing few months. An “Evaluation Committee” was charged with examining all application materials and was composed not only of Treasury officials but also individuals from other agencies, including the Export-Import Bank and Overseas Private Investment Corporation. Ennis Knupp & Associates, a consulting firm, was brought on to advise the committee throughout this process (SIGTARP Report, Selecting Fund Managers 2010). Applicants were evaluated based on how they measured against the following criteria:

1. “Demonstrated capacity to raise at least $500 million in private sector capital.”
2. “Demonstrated experience investing in Eligible Assets, including through performance track records.”
3. “A minimum of $10 billion (market value) of Eligible Assets under management.”
4. “Demonstrated operational capacity to manage the Funds in a manner consistent with Treasury’s stated Investment Objective^FNThe Treasury’s stated investment objective was to “generate attractive returns . . . through long-term opportunistic investments in Eligible Assets” (Legacy Securities Summary of Terms). while also protecting taxpayers.”
5. “Headquartered in the United States” (Fund Manager Application).

Funding the PPIFs

 On July 8, 2009, the Treasury announced the appointment of nine private sector fund managers, each of which was responsible for overseeing the operations of its own PPIF. Following their selection, fund managers set out to raise the private capital portion of their funding base. Each fund manager was obliged to raise no less than $500 million in private capital during the ensuing 12 weeks—at least $20 million of which had to be supplied by its own firm. Neither a fund manager nor other investors could obtain a share of more than 9.9% in any PPIF (Legacy Securities Summary of Terms).

The Treasury agreed to match all private equity raised by the PPIFs up to an initial limit of $1.1 billion per fund. As the program took shape, the Treasury opted to match private equity raised by some fund managers in excess of this limit, and ultimately capped its combined capital commitment at a total of $10 billion (SIGTARP Report, Q1 2010).

In addition to private and government capital, each PPIF was given the option of selecting one of two debt-financing schemes made available by the Treasury: half turn or full turn. Half turn financing gave PPIFs access to Treasury debt worth 50% of their total capital base, while full turn financing gave them access to Treasury debt worth 100% of that amount (Legacy Securities Summary of Terms).

Despite offering PPIFs half as much debt from the Treasury, half turn financing did afford them the opportunity to borrow from other sources, provided that they did not take on gross leverage of more than 5:1. This design was intended to allow PPIFs to borrow from the Term Asset-Backed Securities Loan Facility (TALF), a program established by the Fed and Treasury to support certain securitization markets (SIGTARP Report, Q3 2009).

In either case, Treasury debt was made available to each PPIF in the form of a “senior-secured multiple-draw term loan facility.” PPIFs could draw on these facilities at any time until the close of the program’s investment period. Loans were nonrecourse—secured only by the assets they were used to purchase—and were extended at rates of 1-month Libor 100 basis points (full turn) or 1-month Libor 200 basis points (half turn) (Legacy Securities Summary of Terms). In return for its commitment, the Treasury received warrants in each PPIF, giving it “the right to receive a percentage of the profits that would otherwise [have been] distributed to the private partners;” for half turn financing, the warrant percentage was 1.5%, whereas for full turn it was 2.5% (Treasury PPIP Homepage). PPIFs accepting outside financing were required to set up “a subsidiary to finance, acquire, and hold the assets” purchased using this debt; third-party lenders had no recourse beyond the assets of the subsidiary established directly in relation to them (SIGTARP Q3 2009; Financial Crisis Manual 2009).

Figure 1 is a simplified example of how the two funding schemes might have contributed to a PPIF’s funding base and thus determined its overall purchasing power, based on an example given by the Special Inspector General for TARP. As shown in Figure 1, by choosing full turn financing, a fund manager with $100 in total equity would have received access to a Treasury credit facility worth that same amount, giving him or her access to a total of $200 to invest in eligible securities (SIGTARP Report, Q3 2009).

Half turn financing, however, provided fund managers with the opportunity to take on considerably more leverage if the haircut on the securities they wanted to purchase was low enough to allow for it. Suppose, for example, that certain eligible securities were subject to a haircut of 20% under TALF and that a fund manager had $100 in total equity to invest in them. In this scenario, a fund manager would have been able to commit $100 in equity for the purchase of $500 in securities. As a result, the fund manager would have sought $400 in loans to complete the purchase; having already received access to a $50 credit facility from the Treasury, the fund manager would have turned to TALF for the remaining $350 (SIGTARP Report, Q3 2009). While this example conveniently keeps the fund manager in line with the 5:1 leverage limit prescribed by the Treasury for PPIP, officials at the Treasury and Fed noted that TALF haircuts on securities would be tailored such that no PPIF would violate the 5:1 leverage limit (Financial Crisis Manual 2009).

Source: Adapted from SIGTARP Report, Q3 2009

Investing in Securities

Once they finished raising private capital, PPIFs were given three years to invest in eligible securities. The government delegated all investment decisions to the fund managers and charged them with the mission of “[generating] attractive returns for taxpayers and private investors through long-term opportunistic investments in Eligible Assets . . . by following predominantly a buy and hold strategy” (PPIP Quarterly Reports). Private investors paid fund managers a fee “similar to what they [charged] for other fund products,” while the Treasury paid a fee of 0.20% (Financial Crisis Manual 2009). When investing in securities, fund managers used private and Treasury capital in equal proportion to each other. Following the investment period, PPIFs were given an additional five years during which to manage and eventually to dispose of assets (PPIP White Paper 2009).

Eligible Assets

PPIFs could purchase non-agency residential mortgage-backed securities (RMBS) and commercial mortgage-backed securities (CMBS) that were (1) “issued prior to 2009,” (2) “originally rated AAA or an equivalent rating by two or more nationally recognized statistical rating organizations without ratings enhancement,” (3) “secured by the actual mortgage loans, leases or other assets and not [by] other securities,” at least 90% of which were located in the United States, and (4) owned by a US financial institution, as defined by the EESA (Legacy Securities Summary of Terms).

Profit- and Loss-Sharing

Profits and losses realized from investments were divided by a PPIF’s stakeholders—including the Treasury—commensurate with their equity contributions (Legacy Securities Summary of Terms). Because credit extended to the PPIFs was nonrecourse, losses in excess of equity were to be borne by the Treasury or third-party lenders.

Governance and Oversight

The Treasury was responsible for administering the program, while the Special Inspector General for TARP and the Government Accountability Office monitored the program in an oversight role. The Treasury also hired the Bank of New York Mellon (BNY) to serve as “the administrative agent, custodian, and valuation agent” of the program. In this role, BNY maintained important documentation, filed financial reports to the Treasury on behalf of the PPIFs, and provided an independent estimate of the value of PPIF investment portfolios (SIGTARP Report, Q4 2009).

With fund managers having near-total control over the use of public dollars, the Treasury put in place a number of rules to ensure that its funding would not be exploited, and hired PricewaterhouseCoopers (PWC) to supervise PPIFs with respect to them. PPIFs also were required to adhere to certain transparency guidelines. These included having to submit reports to the Treasury on a monthly, quarterly, and annual basis, as well as undergoing “continuous testing of their solvency and liquidity” (SIGTARP Report, Q3 2009).

The stock market responded positively to the announcement of PPIP on March 23, 2009; the S&P 500 and Dow Jones Industrial Average both had gains of nearly 7% that day. However, as the Treasury spent several months assessing the pool of applicants, the market appeared to lose interest in the proposal as financial market conditions improved more generally (Geithner 2014; Financial Crisis Manual).

As a result, the Treasury was forced to abandon its plan of committing up to $100 billion in funding for PPIP’s implementation (including the Legacy Loans Program). By July 8, 2009, the Treasury’s commitment for the Legacy Securities Program—which by then had become the centerpiece of PPIP—had been reduced to just $30 billion (Joint Statement 7/8/2009).

On July 8, the Treasury also announced its choice of nine private sector fund managers, each of whom was charged with operating a PPIF created under the Legacy Securities Program. These included (1) AllianceBernstein; (2) Angelo, Gordon & Co. and GE Capital Real Estate; (3) BlackRock; (4) Invesco; (5) Marathon Asset Management; (6) Oaktree Capital Management; (7) RLJ Western Asset Management; (8) the TCW Group; and (9) Wellington Management Company (Joint Statement 7/8/2009). Despite a reduction in funding available for the program, the appointment of nine fund managers represented an operational expansion of it, as the Treasury originally anticipated choosing only five firms with which to partner.

Following their selection, the nine fund managers worked to solidify the capital structure of their individual PPIFs and ultimately raised a total of $7.4 billion in private equity, all of which was matched by the Treasury. In addition, each fund manager accepted Treasury debt worth as much as its aggregate capital base.^FNPPIFs took on debt exclusively from Treasury without ever tapping into funding from TALF (i.e., all PPIFs opted for full turn financing). A potential reason for this is that fund managers could fund purchases of some legacy CMBS through TALF, but not legacy RMBS—which constituted a vast majority of their investments. Equipped with this combination of public and private funding, the PPIFs had access to $29.4 billion in total funding.^FNThese figures and Figure 2 do not include the TCW Group, which received more than $300 million in government funding. In January 2010, TCW wound down its PPIF, exiting the program after the head of its PPIF left the firm. It ultimately repaid the government in full.

Source: SIGTARP Report, Fourth Quarter 2013

By late 2009, as they continued to raise private capital, the PPIFs also began to invest in legacy securities. By the end of 2012, eight PPIFs had invested approximately $24.4 billion of available funding—$6.1 billion in private capital and $18.3 billion in TARP equity and debt (SIGTARP Report, Q4 2013).

PPIFs predominantly invested in non-agency RMBS but also invested in CMBS.^FNAll PPIFs were allowed to invest in both RMBS and CMBS except for Oaktree Capital Management, which—per its contract with Treasury—could invest only in CMBS (SIGTARP Report, Q4 2013). As Figure 3 shows, PPIFs gradually expanded their investment portfolios from fourth quarter 2009 to the end of 2010. The value of their investments peaked during first quarter 2011, when PPIFs held approximately $22.1 billion in legacy securities, and hovered in the range of $20 billion until third quarter 2012, when they started to reduce their portfolios. By June 2013, each PPIF had completely unwound its investments.

At the program’s peak, 34% of total RMBS holdings were prime, 47% were Alt-A, 11% were subprime, and 8% were option-ARM. As for CMBS, 13.5% were super senior, 39.0% were AM (a “mezzanine-level originally rated AAA bond”), and 26.7% AJ (the lowest tranche of CMBS to receive a AAA rating). The remaining 20.5% were classified as “other CMBS” by the Treasury (PPIP Quarterly Report, March 31, 2011).

The Treasury never released transaction-level data on PPIP, thus making it difficult to know which kinds of financial institutions predominantly sold assets to PPIFs under the program. In the end, each PPIF generated a positive net internal rate of return (IRR), ranging from 18.2% to 26.3%. The Treasury incurred no losses on total disbursements of $18.6 billion and, overall, netted a positive return of $3.9 billion from dividends, interest, and other income (SIGTARP Report Q4 2013).