Gaming the PPIP?

By James Kwak

A couple of weeks ago, Yves Smith picked up on the story that the TARP Special Inspector General is investigating suspicious trades in connection with the Public-Private Investment Program. When PPIP was announced almost a year ago, there was widespread speculation about how banks and other private investors could take advantage of the program to unload toxic securities onto taxpayers (technically speaking, onto investment funds containing some private money, some public money, and a lot of non-recourse financing from the government). That story more or less faded away because PPIP never really amounted to much; banks apparently decided they were better off sitting on their toxic assets, counting on favorable accounting rules and regulatory forbearance, instead of selling them.

Here’s the relevant section from the SIG-TARP report (p. 141):

“The PPIF management company in question operates both a PPIF and one or more non-PPIF funds that invest in similar securities (i.e., mortgage-backed securities (‘MBS’)). In the case of this fund management company, the same person is the portfolio manager for both the PPIF and the non-PPIF fund. In late October, the portfolio manager directed that a particular MBS from the non-PPIF fund be sold after the security — in this case a residential MBS — had been downgraded by a rating agency. According to the company, multiple bids were received, and a quantity of the security was sold to a dealer. Within minutes of the sale, however, the same portfolio manager purchased, for the PPIF, the same amount of the same security from the dealer at a slightly higher price. Later in the day, the portfolio manager bought more of the security for the PPIF from the dealer at the original price.

“The management company involved (the identity of which is not being disclosed at this time pending SIGTARP’s investigation) asserts that there was nothing inappropriate about these trades, and Treasury has concluded that the trades did not violate PPIF rules. The facts, however, give rise to difficult questions. Was the initial purchase really arm’s length, or was the dealer aware that the portfolio manager was prepared to repurchase the securities immediately? How can a manager conclude that it is wise to sell a security at one price but then almost simultaneously repurchase the same securities at a higher price? Were these trades designed to push the risk of this downgraded security from the private, non-PPIF fund onto the taxpayer-supported PPIF?”

I wouldn’t necessarily assume wrongdoing. For one thing, the fund manager is just a fund manager, meaning he makes fees (based on assets under management and performance) from both the PPIF and the private fund. So arguably, shifting losses from one fund to another doesn’t help him that much. Of course, there are various scenarios under which it would benefit him: the fees from the private fund could be higher; one fund could have profits from which he gets a cut while the other may not; he could have his money in the private fund but not in the PPIF; he could have a nudge-nudge wink-wink agreement with the private investors; and so on.

10 responses to “Gaming the PPIP?

  1. Good post. We know there will be people gaming the system. Of more concern is that gaming the system is 99.999% of the time without material negative consequence and 75% of the time (wild guess) is rewarded financially and with recognition for performance within the firm itself.

  2. This has panjandra, tax cheat little Timmy Geithner written all over it.

  3. We don’t know enough about the transaction to determine what benefits were accrued and to whom.

    The dealer obviously made money by the two-step process of the manager buying a portion higher and the rest at par. No doubt there were fees on top of that at both ends but there was still a premium paid over what the dealer paid on a portion.

    Which leads to second unknown and that is just how much did the dealer pay for the MBS security. Clearly this looks like a prearranged tri-party trade. The security was downgraded so the question is how much was the selling price to the dealer. I suspect it was above true market value if offered openly. How much above depends on what rating the security was downgraded from and what it was at the time of sale. Something that went from A to CCC would be effectively worthless for example.

    The other thing I would note is that it refers to a MBS security but no one should construe that to mean an entire MBS but likely just a single tranche or some portion thereof.

    7 of the 9 PPIP participants are active CDO managers. It would seem likely that this was a tranche or portion of a tranche of MBS that was part of the collateral assets of a CDO. Further, only a small portion of MBS tranche assets in CDOs are actually senior MBS tranches that have active principal payment flow.

    Upwards of 70 percent are usually Credit Support tranches. The underlying MBS may have both Mezzanine and Support tranches but having only one class of those is more common than having both. Those tranches, even this many years in, are not likely receiving principal payments and only interest payments. Though if the entire MBS has experience an event of default (this could be percent of prepayment or percent of delinquent or other such triggers) there could be acceleration going on and erosion of the actual principal balances of credit support tranches.

    So it is quite possible that what was purchased was an asset that may never receive its principal returned and thus the question is – how much was paid for that?

    Let’s say an MBS has M1, M2, M3, M4, and M5 support tranches. These typically have principal sizes at a declining scale with the M1 perhaps no more than 2% of the outstanding total MBS principal. The rest are lower. Under stress they erode quickly. Such that if the asset purchased was an M2 and the downgrade was because M5 was exhausted and M4 is well under way you are literally a few months (at best) before M2 is going to zero. And cash flow may be zero depending on distribution rules under events of default.

    It is therefore possible that an asset was purchased that has no cash flow and is about to be obliterated completely. Since 85% of the funding (or more) comes from loans via the Treasury and FDIC the only loss to the manager in this case is 15 cents on the dollar. But if they paid more than 15 cents on the dollar during the purchase – i.e. the dealer over-paid then they don’t lose anything in real terms and pocketed fees at both ends in current income.

    This is the sham that PPIP always was. It was also the sham the TARP was originally written to do. PPIP was only necessary because of the reporting requirements of TARP that would allow Congress (and perhaps eventually taxpayers) to see the transactions on a monthly basis. It will also be the same sham that comes in April with the FDIC and the new securitization rollout. The whole idea is to get all of the losses onto the taxpayers as quickly as possible.

  4. Gaming the PPIP. Isn’t that a tautology?

  5. I forgot to mention Geithner’s AIG bailout trickery.

  6. A dollar spent by a bureaucrat is a dollar spent but a dollar lent by a banker does not necessarily mean a dollar spent.

    I believe that allowing the banks to help out the economy by lowering their capital requirements now, even at the risk of more bailouts tomorrow, is much better than having government bureaucrats trying to do it directly.

  7. I know this is way, way, way off topic (that’s why I picked a low-reply post to broach the subject), but can someone please explain to me in no uncertain terms how and why snowboarding became an Olympic event?

    Aren’t these the same pimply-face, SlimJim-chomping pains-in-the-asses that crowd the sidewalks of every major metropolitan downtown central business district with their dopey skateboard antics, causing annoyance, and often times physical danger, to countless workaday pedestrians, not to mention damage to public and private building exteriors? Now I’ve got to stare at these baggy-pants douche bags for five hours every night as well?

    I just know those tea party jerkwads are championing this sport. Don’t ask me why, it just figures since their reasoning is so screwed up on every other issue.

    And, oh yeah, clearly the PPIP is just another Wall Street influenced Treasury and Fed scheme to bailout the bankers at the taxpayer’s expense. I wouldn’t put any shenanigans past the parties facilitating the trades.

  8. It’s probably being used what it was intended for: stealing from the public piggy bank. I was so worried they might disappoint us and not do it!

  9. You’re right, we don’t have enough information to draw a definitive conclusion. But as one who spent 26+ years in enforcement at the SEC, this deal stinks to high heaven. Obviously prearranged trading and to what purpose? It is seldom innocent.

    Oh yea, BDS. Is it a sport? Does it sell commercials? Exercise the buttons on your remote. Better yet, read a book. The hoopleheads took control a long time ago.

  10. It’s just about conceivable that the non-PPIP fund has a rating requirement in its mandate that the PPIP fund doesn’t. Maybe the fund manager likes the bond at the price but literally couldn’t hold it in the non-PPIP fund That’s the only way I can think of that this trade(s) would be justified, because otherwise it sounds pretty damn dodgy.