Introduction
The US Treasury Department recently announced two programs as part of its Financial Stability Plan designed to foster the purchasing of two types of “legacy assets”: (1) portfolios of mortgage loans held by banks (legacy loans); and (2) distressed mortgage backed securities (legacy securities). The vehicle for private participation in each program will be the investment in and management of a public-private investment fund (PPIF). The Legacy Loans Program will establish PPIFs in which private investors and the Treasury will invest capital. These PPIFs will obtain financing, guaranteed by the FDIC, from non-Treasury sources (either from the sellers of loans acquired by the PPIF or from other lenders). The Legacy Securities Program provides for joint equity participation in PPIFs by Treasury and private investors. Treasury will provide financing directly for these PPIFs.

Legacy Loans Program
The Legacy Loans Program is designed to create a market for mortgage loans owned by banks that need to be sold to enhance lending by these banks. The mechanisms for creating a market are (i) significant government participation to limit private equity’s risks and (ii) the organizing of a bidding process for such assets.

The FDIC will be responsible for administering this program. Banks will be invited to present loan portfolios to the FDIC. The FDIC will conduct due diligence and underwriting, with the assistance of third-party contractors, to determine the acceptable leverage ratio for each portfolio. FDIC will then administer an auction process pursuant to which investors will bid for the right to participate in the PPIFs which will own the loan portfolio.

The winning bidder will contribute up to one-half of the equity into the PPIF for the portfolio, with the remainder of the PPIF’s equity being contributed by Treasury. A PPIF’s debt-to-equity ratio must be no greater than 6:1 in all cases. Bids must be accompanied by a refundable cash deposit equal to five percent of the bid value. Once a bid is selected, the owner of the loan portfolio will have the option to accept or reject the bid within a pre-established timeframe. Contributions of equity from Treasury and from private investors, and funding of FDIC-guaranteed debt to the PPIF, will occur at closing of the purchase of the loan portfolio by the PPIF.

The FDIC guaranty will be secured by the purchased assets, and the FDIC will receive an annual guaranty fee from the PPIF, based on the outstanding debt balances of the PPIF-owned assets. The FDIC’s rights with respect to the collateral will be senior to the rights of equity investors to those assets. Profits and losses will be shared by Treasury and the private investors, in proportion to their respective equity investments.

The private investor will retain control of asset management within each PPIF, subject to FDIC oversight, pursuant to requirements established by FDIC and Treasury regarding management, financial and operational reporting requirements, exit timing and exit options. Servicing of PPIF-owned loan portfolios will either be retained by the selling banks or be assumed by the PPIF or another entity.

Treasury anticipates that individual investors, pension plans, insurance companies and other long-term investors will participate in the program. Private investor groups must be approved by the FDIC, and are expected to include an array of different investors such as financial institutions, individuals, insurance companies, mutual funds, publicly managed investment funds and pension funds. Currently there is no limitation on the number of PPIFs that may be formed, nor is there a limitation on the ability of private investors to form funds through which to syndicate investments in PPIFs and to bid on loan portfolios.

Private investors may not participate in any PPIF that purchases assets from sellers that are affiliates of such investors, or that represent 10 percent or more of the aggregate private capital in the PPIF. Cooperation between private investor groups will be prohibited once the auction process begins.

Loans will be purchased only from FDIC-insured depository institutions, and only US banks or savings associations are eligible to participate in the program. Participant banks must demonstrate to the satisfaction of Treasury and the FDIC that the contemplated loan pools qualify based upon Treasury and FDIC minimum requirements. Any collateral supporting eligible assets must be located predominantly in the United States.

Additional details of the program will be subject to notice and comment rulemaking (in contrast to the Federal Reserve’s Term Asset-Backed Securities Loan Facility, with respect to which the Fed has statutory authority to implement, and change, the rules at any time and without comment or notice). The comment process will provide market participants with an opportunity to influence the direction and specific terms of this program. The following questions are examples of questions raised, but not answered, by the materials released on the program to date:

1. What are the underwriting requirements that will be applied in evaluating loan pools to be acquired (i.e., how “toxic” can they be)?
2. What will be the qualification criteria for investors?
3. How do investors apply for and obtain pre-qualification to invest in PPIFs?
4. While Treasury guidelines clarify that passive investors will not be subject to executive compensation restrictions, will fund managers be subject to such restrictions?
5. Is the five percent (5%) deposit required upon submission of a bid calculated against the bidder’s proposed equity stake, or on the basis of the total bid?
6. What will be the minimum equity investment that a private investor can make in a PPIF?
7. What are the limitations and requirements regarding lending sources that may provide the FDIC-guaranteed debt (if that financing is not provided by the selling bank itself)?
8. If servicing of PPIF-owned loans is retained by the selling banks, how much may those banks charge in servicing fees? If not, how will the servicer be selected?
9. May PPIFs issue any debt that is not guaranteed by FDIC?
10. From what source of funds (i.e., PPIF funds or separate Treasury funds) will FDIC be reimbursed for its oversight functions?

Legacy Securities Program
The Legacy Securities Program is designed to create a market for the purchase of mortgage backed securities (MBS) issued prior to 2009. The method for stimulating the market will be the creation of five (or more) significantly capitalized PPIFs which will compete with one another to purchase these securities. Criteria for approval of fund managers for these PPIFs include: (1) ability to raise private capital of at least $500 million; (2) experience investing successfully in eligible MBS; and (3) a minimum of $10 billion (market value) of eligible MBS under management at the time of the application. Treasury initially expects to approve approximately five fund managers, but additional fund managers may be considered if the quality of applications and the market warrant additional fund managers.

Securities eligible for investment by PPIFs under the Legacy Securities Program will initially include commercial MBS and non-agency residential MBS issued prior to 2009 that originally had a AAA or equivalent rating from two or more nationally-recognized statistical rating organizations. The MBS need not have that rating at the time they are purchased by the PPIF. The intent of the program is generally that PPIFs hold MBS as a long-term investment, but Treasury will consider proposals involving “limited trading.” The expected maximum term of PPIFs is 10 years, but Treasury may approve longer terms in its discretion.

Approved fund managers will be obligated to raise capital for investment in PPIFs, and that capital would be invested on a dollar-for-dollar basis with Treasury funds. Treasury equity contributions and debt fundings will occur periodically as the PPIF makes purchases of eligible MBS, and in proportion to the private capital contributed by the fund manager upon each purchase. Similarly, Treasury will divest in the same proportion and at the same time as private investors each time the PPIF sells MBS assets. Treasury will retain the right to cease funding of its committed but undrawn equity capital and debt financing, in its sole discretion.

A PPIF will have the ability to borrow from Treasury in an amount of up to 50 percent (or in certain cases up to 100 percent) of the PPIF’s total equity capital. Enhanced restrictions on asset level leverage, redemption rights, disposition priorities, and other factors that Treasury deems appropriate will impact Treasury’s decision to lend more than the 50 percent. The Treasury loans will be non-recourse and will be secured by the MBS owned by the PPIF. Funds may also finance the purchase of eligible securities through TALF, any other UST program or debt financing raised from private sources.

A PPIF may not purchase MBS from a seller that is affiliated with the PPIF’s fund manager or with the fund manager of any other PPIF, or from any private investor that has committed 10 percent or more of the capital raised by the PPIF’s fund manager. The assets underlying any eligible security must be located predominantly in the United States.

Fund managers may collect fees from private investors, in the managers’ discretion; provided that Treasury will consider the fees proposed to be charged to private investors as a factor when evaluating applications by private asset managers to become fund managers approved for PPIFs. Treasury will receive a management fee, also to be proposed by asset managers in their applications for fund manager approval, as a percentage of Treasury’s equity contribution.

Asset managers must submit applications for Treasury approval no later than April 10, 2009, and Treasury expects to grant preliminary approvals no later than May 1, 2009. After preliminary approval by Treasury, private asset managers will be required to raise at least $500 million in order to receive final approval as a fund manager. There will be no universal deadline within which each fund manager must raise those funds, but Treasury indicates it will pay close attention to whether each applicant meets its forecasted fundraising timeline.

Expansion of TALF
In addition to the PPIF structure, the Legacy Securities Program includes a broadening of the Federal Reserve’s Term Asset-Backed Securities Loan Facility program (TALF), which was established to foster the market in high-quality Asset Backed Securities across a wide range of underlying asset types. The first round of TALF subscriptions was $4.7 billion in requested loan funds, with $2.8 billion attributable to credit card loan ABS and the remainder attributable to auto loan ABS. TALF initially did not include MBS, but was recently broadened to include residential MBS that meet TALF’s credit-rating requirements. The expansion of TALF announced as part of the Legacy Securities Program would involve a loosening of the credit-rating requirement under TALF (at least as it applies to MBS) and the broadening of TALF-eligible mortgage assets to include commercial MBS.

For more information about these programs, please contact:

David Dubrow
dubrow.david@arentfox.com
212.484.3957

Mark Katz
katz.mark@arentfox.com
202.857.6260

Daniel Lopez
lopez.daniel@arentfox.com
202.857.6240