Stimulus

Public Private Partnerships and the Free Will Problem

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Who killed the Public Private Investment Program?

The so-called Bad Bank was designed as a way for the government to get so-called Toxic Assets off the balance sheets of banks. As I noted last week (when the Treasury Department was reportedly getting ready to announce a preliminary roster of private-sector participants in the program), the PPIP has been vastly diminished from its original conception. The preliminary roster didn't even come last week, and now financial geniuses like Ezra Klein are in pursuit of the PPIP killer. Klein's excogitation:

[The] PPIP plan fell apart not because the Treasury Department decided it was unnecessary but because the banks, which were suddenly flush with fresh capital, refused to participate in it. And that was probably a smart bet from their perspective: The government has made clear that it will not allow them to fail. If the economy sags again, their capital dries up and they prove unable to hold the assets to maturity, the PPIP, or some other federal program, will always be available to help them out of their bind.

This thinking is bass-ackwards. Banks holding bad assets are not the ones with wiggle room in PPIP decisions: They are in the same position as underwater mortgagees without savings and facing a short sale. If they have to sell their toxic assets at too low a price, they will have to take a loss they can't afford to take. And nobody out there is offering a high enough price.

The question isn't why Treasury can't motivate sellers of toxic assets: It could do that easily, and without the fig leaf of bringing in private players, just by buying the bad loan portfolios directly from the banks — at higher prices (in most or all cases) than they're worth. The problem here is on the demand side, not the supply side.

So why isn't anybody out there looking to buy distressed MBS assets? After all, the vast majority of Americans are still servicing their mortgages, and while that might not be enough to keep a bank afloat, it could certainly be a good investment for an experienced vulture investor who can buy at an attractive price.

Jeremiah S. Buckley, partner at the law firm BuckleySandler, LLP (which represents banks), explains why potential PPIP partners have been hard to find. "The way the PPIP was originally structured," Buckley said in an interview, "if the seller didn't get an acceptable bid, it could withdraw the offer. So if I'm a potential buyer of these assets, I could spend a lot of money on due diligence, then find out, hey, I haven't gotten anything."

That needs a bit of gazing up into the clouds and thinking about the meaning of it all: Even with capital infusions from the government, even with a government backstop against losses, even though everybody knows that the assets will continue to generate some level of return for their owners, you still can't get a price low enough to satisfy capital market investors? Are these buyers too greedy or too cheap?

Neither: They're too smart to overpay now for something they'll be able to pick up cheaper in the future, when the FDIC is liquidating these assets on behalf of failed banks. The default rate in residential mortgages continues to rise, with no indication that we're reaching the top (or bottom) of the trouble. The rate of commercial real estate defaults has not yet begun to explode. In the first half of this year, 52 banks have failed. No amount of stress test grade inflation can stop the avalanche.

There are other disincentives to the PPIP for capital firms. Harold P. Reichwald, a corporate and finance attorney at Manatt, Phelps & Phillips, LLP, in an interview, listed TARP-style interference at the firm level, executive compensation limitations, and concern that "the very fact that you make a profit by government assistance somehow puts you in bad boy category. I don't think entrepreneurs want to feel like whipping boy," he said.

The PPIP has been an instructive lesson in the doubly bogus bogosity of public-private ventures. Because the Treasury doesn't want to be seen as giving a gift outright to crapola banks, it creates a Rube Goldberg structure that ignores actual human decision-making and makes the original TARP idea (simply buy bad assets, in the tradition of the Resolution Trust Corporation) look like a model of rationality by comparison.

And now it is taking steps that will further reduce the incentive of private capital to come in and help the banks. The Federal Deposit Insurance Corporation last week introduced new regs for investors buying troubled assets. The proposals include capital support requirements; cross guarantees over  commonly owned banks; transaction limits; guarantees on continuity of ownership; "clear limits" on secrecy law jurisdiction vehicles (overseas banks); and other limitations as well as strict disclosure commitments. (Good news: colonoscopies are not mandatory, yet.) If you're already having trouble attracting customers, this seems like an odd way to solve the problem.

That's the problem with governments trying to play in markets. In this weird "private sector," it turns out people are still free to say no to a bad deal.