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Monday, 23 March 2009

Does your flesh crawl at the words public-private?

The long suffering US tax payer is about to be gang-raped by investment banks and fund managers because of the US government’s reliance on private sector firms to set the pricing. They can’t price the assets themselves so they think that by matching the funding provided by a third party fund manager, but as sure as water flows downhill the investment banks and fund managers will tilt the tables so the money will all slide to their end, and this is how it will probably work:

The U.S. government has said this is how the program will work:

Step 1: Treasury will launch the application process for managers interested in the Legacy Securities Program.
Step 2: A fund manager submits a proposal and is pre-qualified to raise private capital to participate in joint investment programs with Treasury.
Step 3: The Government agrees to provide a one-for-one match for every dollar of private capital that the fund manager raises and to provide fund-level leverage for the proposed Public-Private Investment Fund.
Step 4: The fund manager commences the sales process for the investment fund and is able to raise $100 of private capital for the fund. Treasury provides $100 equity co-investment on a side-by-side basis with private capital and will provide a $100 loan to the Public-Private Investment Fund. Treasury will also consider requests from the fund manager for an additional loan of up to $100 to the fund.
Step 5: As a result, the fund manager has $300 (or, in some cases, up to $400) in total capital and commences a purchase program for targeted securities.
Step 6: The fund manager has full discretion in investment decisions, although it will predominately follow a long-term buy-and-hold strategy. The Public-Private Investment Fund, if the fund manager so determines, would also be eligible to take advantage of the expanded TALF program for legacy securities when it is launched.

OK, so what does any sensible fund manager do when he passes pre-qualification in step 2? That’s right, he goes out to find investors for say $100m. Probably banks who already have distressed assets, or funds under their management or something similar so it is not so obvious. The Treasury matches the funding with $100m and $200m of debt funding.

The fund manager then goes off to bid for impaired debt. Now let’s say that the bank we mentioned in the last paragraph has toxic assets in a nice little package with a face value of $500m, and a current book value after write-downs of $400m, but which the bank really thinks is worth no more than $300m. The fund manager comes along to bid for the package and maybe he is the only bidder, maybe he has competition, but he pays $400m for the loans. So the bank has contributed $100m to the fiund which it has received back from the fund manager together with the $300m that it thought the loans were worth from the government.

So the bank has recovered all the money it ever thought it was going to get, but it still has a 50% interest in the loans, so if those loans are indeed worth $300m, the bank has made 50% of $400-300m = $50m on the deal instead of writing off $100m (although the bank has already written off $100m).

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