U.S. Treasury Announces Public-Private Investment Program

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1 March 24, 2009 U.S. Treasury Announces Public-Private Investment Program On March 23, 2009, the United States Department of the Treasury (the Treasury ), in conjunction with the Federal Reserve and the Federal Deposit Insurance Corporation (the FDIC ), announced the Public-Private Investment Program ( P-PIP ), which is part of the US government s Financial Stability Plan. P-PIP is designed to raise new capital to purchase (i) loans and other assets (which have not yet been specified) currently held directly on the books of US banks and US savings associations ( Legacy Loans ), and (ii) securities originally issued before 2009 which are backed by loan portfolios ( Legacy Securities, and together with Legacy Loans, Legacy Assets ). Since the burst of the housing bubble and the onset of the current credit crisis, Legacy Assets held by banks, financial institutions and investors have become illiquid. As a result, such Legacy Assets have become difficult to value; mark-to-market valuations of them are virtually impossible. The illiquidity of these Legacy Assets, in turn, has further contributed to the tightening and the contraction of the credit markets. Summary of P-PIP Under P-PIP, the Treasury plans to use $75 to $100 billion in funds from the Troubled Asset Relief Program ( TARP ), in addition to funds from private investors, to generate $500 billion in purchasing power to buy Legacy Assets (with the potential of expanding the program to $1 trillion over time). P-PIP is composed of two parts, the Legacy Loans Program and the Legacy Securities Program. The Legacy Loans Program is intended to address those Legacy Loans on US banks and US savings associations balance sheets which, as noted above, have made it difficult for such banks and savings associations to access the private markets for new capital and which have limited their ability to lend to consumers. The Legacy Securities Program is intended to address Legacy Securities that are currently trading in the secondary markets, but that have become highly illiquid and, as a result, are trading, if at all, at seriously discounted values. These Legacy Securities are generally held by banks as well as by insurance companies, pension funds, mutual funds and funds held by individual retirement accounts. However, the materials provided to date by the Treasury provide conflicting information as to whether the Legacy Securities Program will permit investment in Legacy Securities purchased from institutions other than regulated financial institutions (as defined by the Emergency Economic Stabilization Act ( EESA )). 1 The Legacy Loans Program Under the Legacy Loans Program, the FDIC and the Treasury will create public-private investment funds ( P-PIFs, each a P-PIF ) that will purchase, through an auction process, eligible pooled portfolios of Legacy Loans ( Eligible Asset Pools ) from participating US banks 1

2 and US savings associations ( Participant Banks ). 2 The FDIC and the Treasury will attract private capital to invest in such P-PIFs through the provision of (i) debt for each P-PIF in an amount of up to 50% of such P-PIF s total equity investment (and, in some cases, up to 100%), debt which will be guaranteed by the FDIC and secured by the underlying Eligible Asset Pools of such P-PIF, and (ii) a co-investment of equity by the Treasury of 50% of the equity capital of each P-PIF (though private investors can choose to receive an equity commitment from the Treasury of less than 50%). Consistent with the EESA, the Treasury will also receive warrants in each P-PIF. The details of such warrants have not yet been disclosed by the Treasury. Oversight, Governance & Management The FDIC will oversee the formation, funding and operation of these newly formed P-PIFs. It will also be responsible for overseeing and managing its debt guarantees. In exchange for such oversight and management commitments, the FDIC will be entitled to receive a fee for facilitating and conducting the auction process. In addition, it will receive an ongoing administration fee for overseeing the P-PIF and a fee for providing debt guarantees of any P-PIFs. 3 While the Treasury will manage its investment, private investors will retain control of the asset management of the P-PIF subject to oversight by the FDIC. Finally, unless otherwise provided, each Participant Bank will continue to service the Eligible Asset Pools sold by such Participant Bank to each P-PIF. The governance and management structure of the Legacy Loans Program also requires that each P-PIF agree to waste, fraud and abuse protections to be defined by the Treasury and the FDIC; the P-PIF must also agree to make certain standard representations, warranties and covenants regarding the conduct of its business and its compliance with applicable laws. Each P-PIF will also be subject to certain inspection rights that include access, as needed, to information required by the Special Inspector General of TARP and by the Government Accountability Office. Participant Banks US banks and US savings associations that are interested in participating as Participant Banks in the Legacy Loans Program must work with their primary bank regulators to identify and evaluate the Eligible Asset Pools such Participant Banks wish to auction off and sell to a P- PIF. After identifying a pool of Legacy Loans to auction and sell, Participant Banks and regulators must then contact the FDIC to express their interest in participating in the Legacy Loans Program, and demonstrate to the satisfaction of the Treasury and FDIC that the contemplated Eligible Asset Pools qualify based upon the Treasury s and FDIC s agreed upon minimum requirements, which have yet to be provided. Auction Process, Winning Bids, Valuation, Investment & Fees Upon the determination of Eligible Asset Pools for sale by a Participant Bank, the FDIC will oversee initial due diligence of the Eligible Asset Pools and preparation of any required marketing materials; moreover, it will conduct the auction process. Participant Banks must cooperate with the FDIC to facilitate the auction process. The FDIC will then conduct the auction, review the bids and select the winning bid(s). Once the winning bid(s) is selected, the Participant Bank(s) will have the option to accept or reject the bid within a preestablished timeframe. 2

3 A third-party valuation firm will work with the FDIC to assist the FDIC and the Participant Bank to determine the valuation of the Eligible Asset Pools. Moreover, the valuation firm will provide the FDIC with its views on the appropriate leverage of such Eligible Asset Pools to be provided to the P-PIF with the winning bid, and with any other information that it may have on the structure and the value of the bids. However, Eligible Asset Pools will be purchased from Participant Banks at prices determined through the auction process (not based on the independent valuation of a third-party). The price received from the private capital component will be used to calculate the cash equivalent price of the total Eligible Asset Pool by using the framework provided by each P-PIFs capital structure and leverage (i.e., an Eligible Asset Pool that receives a high bid of $91, and has a debt-to-leverage ratio of six to one, will require each equity investor (the private investor and the Treasury) to provide equity capital in the amount of $6.50 and will require the FDIC to guarantee debt provided by the P-PIF to the bank in the amount of $78). The leverage provided to the P-PIF will be in the form of debt guaranteed by the FDIC and backed by the Eligible Asset Pools purchased by the P-PIF. Such leverage amounts will be determined on a pool-by-pool basis at the FDIC s sole discretion, but in no case will such leverage exceed a debt-to-leverage ratio of six to one. The terms of any debt financing will be set forth in the FDIC Guaranteed Secured Debt for the P-PIF Term Sheet, which has not yet been provided by the FDIC or the Treasury. However, the Treasury has stated that the P- PIF will be required to maintain a debt service coverage account to ensure that the working capital for each P-PIF is sufficient to meet anticipated debt servicing obligations, interest expenses and operating expenses. In addition, a portion of cash proceeds from the sale of Eligible Asset Pools of a particular P-PIF must be retained until cash flow from Eligible Asset Pools has fully funded the debt service coverage account, at which point the escrowed cash will be released to the Participant Bank. Private Investors & Refundable 5% Deposit Private investors who participate in the Legacy Loans Program are expected to include individual investors, pension plans, insurance companies and other long-term investors. Such investors will be allowed to submit joint bids, but will not be able to do so once the auction process begins. According to the Treasury, passive private investors in the Legacy Loans Program will not be subject to the executive compensation restrictions under the EESA. However, the Treasury has not yet provided any specific qualifications for a passive private investor. Potential private investors will be pre-qualified by the FDIC to participate in an auction to purchase Eligible Asset Pools. For a private investor s bid to be considered in the auction process, the bid must be accompanied by a refundable cash deposit ( Deposit ) for 5% of the bid value. In the event the bid is rejected or unsuccessful, the Deposit will be refunded in full to the bidder. Private investors may not, however, participate in any P-PIF that purchases assets from Participant Banks that are affiliates of such investor or that represent 10% or more of the aggregate private capital in the P-PIF. 3

4 The Legacy Securities Program The Legacy Securities Program is aimed at reinvigorating the secondary market for Legacy Securities by providing a combination of debt and equity financing to dedicated funds purchasing such Legacy Securities. The Treasury intends to accomplish this goal by: expanding the Term Asset-Backed Securities Loan Facility ( TALF ) to create a lending program that will allow eligible borrowers to receive non-recourse loans to fund purchases of eligible Legacy Securities; and having the Treasury participate as an equity investor alongside private investors in legacy securities investment funds ( Legacy Securities Funds ). Expansion of TALF The Treasury intends to expand TALF to include loans to purchase certain non-agency residential mortgage-backed securities that were originally rated AAA and outstanding commercial mortgage-backed securities and asset-backed securities that are rated AAA. Borrowers will have to meet the criteria set out under TALF in order to qualify for these TALF loans. The minimum capital investment that an eligible borrower will be required to make to receive such TALF loans (which will be based on the risk profile of the underlying assets) and the lending rates, minimum loans sizes and loan durations under TALF for this newly expanded class of asset-backed securities have yet to be determined by the Treasury. However, the Federal Reserve is working to ensure that the duration of these TALF loans take into account the duration of the underlying assets securing them. Legacy Securities Funds The Treasury also intends to accomplish its goals under the Legacy Securities Program by participating as an equity investor alongside private investors in Legacy Securities Funds specifically targeted at Legacy Securities (which will initially include securities backed by mortgages of residential and commercial properties). The Treasury will approve up to five asset managers (and perhaps more) with, among other things, (i) a demonstrated track record of purchasing Legacy Securities; (ii) a demonstrated capacity to raise at least $500 million of private capital; (iii) a minimum of $10 billion of Legacy Securities under management; (iv) a demonstrated operational capacity to manage the Legacy Securities Funds in a manner consistent with the Treasury s stated objectives; and (v) their headquarters in the US. Such asset managers must submit an application, as provided by the Treasury, to the Treasury no later than April 10, 2009, to be pre-qualified to raise capital to invest along side with the Treasury in a Legacy Securities Fund. The Treasury currently contemplates informing applicants of its preliminary approval on or prior to May 1, Role of the Asset Managers, Capital Raising & Debt Financing. Once approved by the Treasury, asset managers will have a limited period of time to raise at least $500 million of private capital to purchase Legacy Securities designated by the asset manager in its application, and to demonstrate committed capital prior to receiving final approval from the Treasury. Under P-PIP, approved asset managers will receive funds from the Treasury in an amount equal to the private capital raised by such asset manager. Any capital received by an asset manager from the Treasury will be invested one-for-one on a fully side-by-side basis with private investor funds for a term no greater than ten years, unless otherwise extended with the Treasury s consent. 4

5 Asset managers may charge management and incentive fees in their discretion, as such asset managers propose in their respective applications to the Treasury. Asset managers will also have the ability, if their investment fund structures meet certain guidelines, to subscribe for senior secured non-recourse loans for their Legacy Securities Funds from the Treasury in the amount of up to 50% of total equity capital of such Legacy Securities Funds (and the Treasury will consider requests for senior debt of up to 100% of such Legacy Securities Funds total equity subject to certain restrictions, including restrictions on asset level leverage, withdrawal rights, and disposition priorities) ( Treasury Debt Financing ). 4 Any Treasury Debt Financing provided to purchase Legacy Securities for a Legacy Securities Fund will be secured by the assets underlying the Legacy Securities. The asset managers may, however, finance the purchase of Legacy Securities through qualified TALF loans, or debt financing from private sources so long as the equity capital of the Treasury and the private investors is leveraged proportionately from such private debt financing sources. Eligible Assets & Control of Asset Purchases and Dispositions. The Legacy Securities that will initially qualify under P-PIP are commercial and residential mortgage-backed securities issued prior to 2009 that were originally rated AAA (or its equivalent) by two or more nationally recognized statistical rating organizations and that are secured directly by actual mortgage loans, leases or other assets and that are not secured by other securities, unless otherwise provided by the Treasury. Moreover, the loans and any other assets underlying the eligible Legacy Securities must be situated predominantly in the US. Finally, Legacy Securities must be purchased solely from financial institutions from which the Secretary of the Treasury may purchase assets pursuant to Section 101(a)(1) of the EESA. Governance & Management. Despite the various restriction on eligible Legacy Securities under P-PIP, asset managers can control the process of asset selection and pricing, as well as asset liquidation, trading and disposition. The Treasury, however, retains the right to cease funding of committed but undrawn equity capital of the Treasury and Treasury Debt Financing in its sole discretion. Asset managers will have certain obligations under the Legacy Securities Program, which include (i) presenting monthly reports to the Treasury on the eligible Legacy Securities purchased and disposed of by the asset manager, as well as the valuations of such eligible Legacy Securities and any profits or losses on such eligible Legacy Securities included in the Legacy Securities Funds 5 ; (ii) purchasing those eligible Legacy Securities only from sellers that are not (a) affiliates of such asset managers, any other asset manager or its or their respective affiliates or (b) private investors that have committed at least 10% of the aggregate private capital raised by such asset manager; (iii) agreeing to waste, fraud and abuse protections for the Legacy Securities Funds (which have not yet been provided by the Treasury); and (iv) providing access to relevant books and records of the Legacy Securities Funds for the Treasury, the Special Inspector General of the TARP, the Government Accountability Office and their respective advisors and representatives. * * * The information thus far provided by the Treasury is still preliminary. The Treasury currently expects to inform asset managers that submit timely applications to participate in the Legacy Securities Program of their preliminary qualification on or prior to May 1, However, the 5

6 timeframe for the Legacy Loans Program has not yet been provided by the Treasury. If you should have any questions about this memo or about participating in P-PIP, you should get in touch with your contact at Weil, Gotshal & Manges LLP, or John J. Dedyo at , Doug Warner at , or Germaine N. Gurr at , 1 The Public-Private Investment Program Fact Sheet indicates that the Legacy Loan program will provide financing for purchases of Legacy Securities held by institutions other than regulated financial institutions. However, the Legacy Securities Public-Private Investment Funds Term Sheet indicates that eligible Legacy Security must be purchased solely from financial institutions from which the Secretary of the Treasury may purchase assets pursuant to Section 101(a) of the EESA. 2 Eligible Legacy Loans and any collateral supporting such loans must be situated predominantly in the US. 3 The fee received by the FDIC for its debt guarantee will be calculated based on the outstanding debt balances of each P-PIF and will be payable to the FDIC annually upon the anniversary date of the transaction closing date for such P-PIF. A portion of the fee will be allocated to the Deposit Insurance Fund. 4 Treasury Debt Financing will not be available to any Legacy Securities Fund that provides private investors with voluntary withdrawal rights. 5 For reporting purposes, all prices of eligible Legacy Securities must be based on third party sources and annual audited valuations by nationally recognized accounting firms Weil, Gotshal & Manges LLP, 767 Fifth Avenue, New York, NY 10153, (212) , All rights reserved. Quotation with attribution is permitted. This publication provides general information and should not be used or taken as legal advice for specific situations, which depend on the evaluation of precise factual circumstances. The views expressed in this publication reflect those of the authors and not necessarily the views of Weil, 6

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