How to Make the Bank Asset Plan Work

Four legal concerns to address.

MICHAEL PEREIRA

The government has finally figured out how to get us out of a credit crisis caused by leverage and securitization: more leverage and securitization.

Under the Public Private Investment Program (PPIP) unveiled last month, the Treasury plans to partner with private investors to purchase "legacy" (formerly known as "toxic") loans and securities from banks, with leverage guaranteed by the FDIC (for loan purchases) or provided by the Federal Reserve or Treasury (for securities purchases).

The aim of the PPIP is to put a price on illiquid assets, which will enable banks to sell those assets, make new loans, and raise new capital. Once that occurs, the spigots of securitization will be reopened and consumer credit will be expanded. PPIP, in short, aims to conscript private money into public service.

It's a combustible combination, and it will only work if, for investors, the anticipated financial rewards outweigh the potential legal risks. Do they?

On the financial side, a valuation riddle has dogged efforts to jump-start credit markets since passage of the Troubled Asset Relief Program last year. Selling legacy assets at too low a price would only wipe out needed bank capital. But selling those assets at too high a price would force taxpayers to pay more than they should.

The PPIP aims to solve this riddle by focusing on leverage rather than prices. Leverage allows investors to earn a higher rate of return on an asset than they might have otherwise. Or in this case, to earn the same return on higher-priced assets with leverage as they earn on lower-priced assets without leverage.

For example, with leverage an investor can get the same return on a loan he buys at 60 cents on the dollar as he does on a loan he buys without leverage for 40 cents on the dollar. Moreover, under PPIP the leverage will be nonrecourse, so an investor's loss will be limited to his investment. PPIP, therefore, appears to offer a compelling financial opportunity.

But the legal picture is more complicated. Private fund managers and government agencies have fundamentally different purposes, obligations and constituencies. Fund managers have a fiduciary duty to their funds and investors; government agencies generally exist to serve the public interest. If PPIP is to succeed it needs to effectively reconcile these divergent purposes.

Specifically, hedge-fund managers and other investors have at least four legal concerns that must be addressed.

First, they are concerned about the consistency and reliability of the government as an investment partner. The Treasury announced the PPIP on March 23. A few days later, Treasury Secretary Timothy Geithner outlined new proposed regulations for hedge funds. The Treasury also noted that it will manage PPIP investments "in the public interest." Both unnerved fund managers who are worried about conflicts between public and private interests.

Second, in the wake of the bonus flap and resulting congressional proposals to tax Wall Street bonuses at punitive rates, investors are concerned that any gains they get from the PPIP will be stripped away via taxation.

Third, the FDIC has promised to maintain "rigorous oversight" of the formation, funding and operation of Public-Private Investment Funds (PPIFs). Investors need to know whether the FDIC's oversight role will compromise their decision-making autonomy.

Finally, there are tax considerations. Domestic investors worry that Treasury will require PPIFs to be structured as tax-inefficient vehicles. Non-U.S. investors worry that the activities of PPIFs -- especially loan servicing -- will be construed as a U.S. trade or business, thus subjecting them to U.S. taxation.

By addressing these concerns, the Treasury, the FDIC and the Fed can calm the worries of investors, enhance participation and increase the likelihood of success of the PPIP.

Specifically, with respect to the first two issues, the government can offer participating funds reasonable exemptions from any future regulation or tax that would otherwise hit them because of their participation in the PPIP. On the third issue, the FDIC can soothe concerns by issuing detailed and binding guidance on its oversight rights. And on the fourth issue, the Treasury can permit PPIFs to be structured as pass-through entities, and the IRS can confirm that the activities of PPIFs will not be considered a U.S. trade or business. This will encourage offshore investors to pour money into PPIFs without fear that doing so will subject them to U.S. taxes.

The PPIP is not perfect -- no government program is. But it is the most financially plausible proposal to date for resolving the legacy asset problem. To increase the likelihood of participation by private investors, the government should leverage its demonstrated financial creativity by providing additional legal certainty.

Mr. Pereira is the publisher of the Hedge Fund Law Report.