This Week’s Sign the Lunatics Are Running the Asylum

The Treasury Department’s long awaited Public-Private Investment Program, or PPIP, has finally launched. Here’s how I described the plan in my March letter to investors:

The basic idea is that if the big banks can sell off their bad assets, they can function again. The banks know this but can’t find any buyers. The government is bringing buyers to the table by sweetening the deal. In one part of the program, big investors can buy toxic assets “legacy loans” with some of their own money and a lot more of the government’s. In the other part, a handful of really big funds will be allowed to buy “legacy securities” – big bundles of repackaged loans – by putting up $500M each. The government will match that with $1 billion more through a special fund that has been closed to private firms until now. Some of that $1B would be non-recourse, meaning the funds are protected if they default. The funds get to cheaply buy just the best assets with borrowed money and no risk of imploding. So, they stand to make an absolute killing.

As pointed out in this New York Times article, the feds have “reached a deal to sell $1.3 billion in mortgages from Franklin Bank, a Houston-based lender that failed last November and was taken over by the F.D.I.C.”

Now if you’re asking yourself, “Why are taxpayers buying the toxic assets of a bank that is already dead?” you’re not alone. It’s one thing for Treasury to be providing large subsidies to private investors to buy toxic assets. That was a seemingly rational way to take toxic assets off the balance sheets of the country’s banks and help the banking system recover from the credit crisis.

But as pointed out in this post on The Baseline Scenario, these particular toxic assets at Franklin Bank already became property of the US government once the bank failed. At that point, the government owned 100% of the upside and 100% of the downside on those assets.

Until last week, that is, when the government through the PPIP program gave half of the potential upside to an investment fund – “Residential Credit Solutions of Fort Worth” – a company founded by a veteran of the subprime mortgage industry. As described above, that company bears no risk under the PPIP program when buying those assets.

In other words: the government gave half of the potential gains from those assets to a company started by an individual who may or may not have helped enable the crisis to begin with – and then kept all of the downside to itself.

Why are we subsidizing investors who are buying the assets of already dead banks? How does this help strengthen the banking system?

I have no idea.

Perhaps you can tell me.

Hat tip to FinanceGuy and RortyBomb, too.

Cale Smith

About Cale Smith

Portfolio Manager at Islamorada Investment Management.

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