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PIPP, PIPP, POORAY? Not so fast. 1

The (PIPP) Public, Private Investment Plan – Will it work?

If successful, PIPP will be remembered and studied by future generations as one of the defining moments of American perseverance and ingenuity. Though still in its infancy, in all likelihood the Obama presidency will be singularly defined by its handling of the current crisis.

Unveiled in detail for the first time by Treasury secretary Geithner on Monday, March 23, PIPP is the center-piece of the government’s adopted strategy following its inauguration in January. The market ceremoniously welcomed it as the DOW rallied 496 points (7%) on the news; but whether the plan is a panacea in restoring circulation to the troubled assets (thereby creating the necessary catalyst for a general recovery) remains to be seen.

The success of the plan boils down to the question of whether, in the aftermath of the crisis outbreak, the need to reduce risk “triggered a wide-scale deleveraging” that ultimately led to “fire sale” prices; that is, if the declines in the troubled assets are indeed overdone, then the owning institutions are stressed more due to an ‘irrational despondency’ than any inherent loss; if they’re not, and the prices are trading fairly, then the institutions (that hold sufficient amounts) are insolvent.

With this policy, the government has taken the former view and believes that the troubled asset declines are overdone. By encouraging private investment to participate (with handsomely advantageous terms), the government hopes to rejuvenate the market’s ability to establish an effective price discovery mechanism.

Geithner also commented that while there is no doubt that the U.S. government is taking risk with the PIPP, the taxpayer stands to make substantial returns on the investments.

But what’s clear is that the “socialization of losses, privatization of gains” mantra that marked the public’s initial protest with the earlier bailouts passed under the Bush administration (TARP) continues to taint PIPP in much the same way. For instance, private firms bidding on these assets are required to commit to a non-refundable deposit (5-10%) – the rest is insured by the Fed and the FDIC via guaranteed bond insurance.

The initial deposit is all that’s at stake for the private bidder: their potential for profit is unlimited while their total potential loss is finite and managed. The tax-payer, on the other hand, assumes responsibility for the entire amount (minus the initial deposit by the private investor) for any loses seen; through Treasury’s $75-100B TARP co-investment, they’re also granted the privilege of participating in 50% of the upside alongside the private bids.

In the absence of strict enforcement to prevent bidders from either directly or indirectly bidding on their own-assets, banks are free to “game” the system by offloading much of their current losses.

Whether fraudulent claims along these will be made remains to be seen.

But in anticipation of the loopholes seen in the legislation, banks have already begun to load up on more troubled assets. According to the New York Post, Citi and Bank of America have been aggressively buying up Alt-A and ARM mortgage backed securities (troubled assets), paying more than the going rate of around 30 cents on the dollar at times.

Previously these securities were traded for approx. 30 cents on the dollar, with most buyers being hedge funds acting opportunistically on a bet that prices will rise over time. With Citi and B of A’s unique ability to participate in PIPP, they are now in a position to trump those bids and potentially profit handsomely from offloading them to PIPP.

The loopholes don’t stop there. Bloggers have been quick to catalogue others:

Scam #1: Karl Denninger worries about banks bidding themselves (directly or indirectly) on their own assets (covered above).
Scam #2: Zero hedge worries about incentives for private partners to massively overpay.
Scam #3: Naked Capitalism worries about private partners betting against themselves, to the tax-payer’s detriment.
Scam #4: Steve Waldman worries about bank bondholders bidding as private partners, and thus bailing themselves out.

That it’s actionable and decisive in moving the issue forward seems to be enough to garner some support – but many still remain doubtful.

Either the plan will go down in history as the trillion-dollar ‘Hail Mary’ that won it, or loopholes will force the government’s hands in resuming the banks’ march towards nationalization.

Interestingly, in the absence of the scathing “socialist” rebukes that dampen the political will, nationalization (“privatization of losses and gains”) as a first-approach would likely cost less in the long run.

Edit (March 30, 2009): There is a well cited rumour in circulation this morning suggesting that much of the “profitability” reported by the banks in January and February of this year was as a result of “gifted.. trades” issued by AIG, acting as a proxy for tax-payer money funnelling into banks without direct involvement from the Treasury; and without the need to publically acknowledge the need for an on-going stimulus to this group. If indeed the government does internally acknowledge the inadequacy of PIPP in curbing systemic issues, then the plan itself may simply be a smoke-screen used to reveal market pricing on the hold-to-maturity value of these assets (to bolster transparency) before the plan is abandoned and the inevitable nationalization track resumed.

  • Crankyputz

    You seem to have a really good grasp on this whole situation, I admit that despite all my reading, I sometimes sit and stare and them in wonder, banking these days seems to have a fairy tale air to it…