Let’s say RIP to PPIP
Remember PPIP? The Public-Private Investment Program was to provide cheap government financing to encourage investors to overbid for banks’ toxic assets.
Investors would overbid, it was thought, because they were being offered a free put option. If the toxic assets they bought fell further in value, taxpayers would be left holding the bag.
The program has been largely left for dead, but the FDIC still sees some life in its part of the plan. Last week, the agency had a pilot sale, offering loans out of the estate of failed Franklin Bank, whose assets are in FDIC receivership.
Sure enough, the winning bidder elected nearly the maximum available amount of non-recourse leverage, resulting in a 22 percent premium for the assets over bids that didn’t take advantage of leverage.
On the surface, this seems like a good thing for taxpayers, since the higher purchase price accrues to the FDIC’s Deposit Insurance Fund.
But in a new paper, Linus Wilson of the University of Louisiana at Lafayette argues that while the auction prices are increased by leverage, the increase is offset by the loan guarantee the FDIC makes as part of the deal.
So at best it’s a wash and at worst the “subsidized leverage discourages the winning bidder from maximizing the value of loan portfolios.”
If true, this last part is problematic. The point of getting assets back into private hands is that private investors are supposed to be better than the FDIC at managing them. But if the structure of the sale discourages investors from maximizing value, then FDIC may be short-changing itself in the long run.
At least in this case, the 22 percent purchase premium was captured by the Deposit Insurance Fund, since the pilot sale was for assets already in FDIC receivership.
But FDIC conducted the test with an eye toward using it on living banks. If it does so, shareholders and creditors of those banks will capture any increased value that results from government leverage, while taxpayers will be left holding most of the risk.
Another potential problem according to Wilson: Inflated prices from PPIP auctions may give other banks an excuse to mark up their own assets, reducing their incentive to raise necessary capital.
A better idea is to let asset prices fall to levels that don’t require government support. Shareholders and bank creditors should eat those losses. Such a recapitalization will put the financial system on firm footing again, providing a strong foundation for sustainable growth.