2009-03 Ppip Save The Day

GORELICK BROTHERS CAPITAL Market Update Will “PPIP” Save the Day? Christopher Skardon March 25, 2009 Investors interested in the details of the Government’s Public-Private Investment Program (“PPIP”) announced Monday will find the Government’s announcement, proposal summaries and other information at www.financialstability.gov. News coverage of the program has been extensive. Rather than re-summarizing, we have elected to comment briefly on three questions essential to program’s success. • • •

Is $100 billion of Government participation enough? Which investors and asset managers will participate? Will the banks sell the assets?

Is $100 Billion Enough?

Government equity makes the difference…

In our last market update, “Distressed Mortgage Demand and the Public-Private Partnership,” we concluded that up to $200 billion of private capital might be available to partner with Government to buy up to $1,200 billion of residential and commercial mortgage backed securities (“RMBS” and “CMBS”) and residential whole loans (“WLs”). In our view, the prospect of actually raising $200 billion in private capital was extremely optimistic. The Treasury Department has now pledged up to $100 billion as equity and mezzanine funding to match private investor capital. Thus, private investors (and public pensions) need contribute only $100 billion, a goal we regard as reasonable.

Which Investors and Asset Managers will Participate?

Attracting retail investment through large PPIF’s is very positive…

Legacy Securities We have argued that broad investor participation is essential to the success of a Public-Private Investment Program, so we are heartened by Treasury’s effort to attract retail investors. It will do so by partnering with five large investment managers to create Legacy Securities Public-Private Investment Funds open to mutual funds and similar vehicles.1 Retail participation will have two important benefits: First, we did not consider retail investors as a potential source of private capital in our prior analysis, but we believe their contribution could be meaningful, likely drawing significant capital away from money market accounts. Second, “democratizing” access to generous, Government-subsidized returns, is politically astute, serving to insulate the program from charges of unfairness or elitism. Like index funds, the new vehicles will offer broad access to the “Beta” trade with relatively low fees

1

Statements from PIMCO and BlackRock just a day after PPIP’s release about launching PPIF participating mutual funds did not surprise us. Public comments have been extensive. See, for example, http://latimesblogs.latimes.com/money_co/2009/03/geithner-bank-m.html. For further information please contact Michael Davis, Director of Investor Relations, [email protected] Gorelick Brothers Capital, LLC ● 4064 Colony Road, Suite 340 ● Charlotte, NC 28211 ● (704) 442-1094

Large investors to invest through TALF-eligible hedge funds and private equity funds…

Early investors (finally) might be rewarded…

and liberal liquidity. At the same time, the complexity and heterogeneity of the asset class, however, makes it likely that more selective peers will offer better performance. Indeed, Treasury has apparently recognized that large institutional investors require more than five, large-scale, investment options. Both institutional investors and taxpayers will look for managers to have significant “skin in the game” and the ability to deliver “Alpha.” The expansion of the Federal Reserve’s TALF program to finance RMBS and CMBS addresses those concerns. While details are in short supply, we think that the Fed will offer appropriate loan terms and attractive leverage to accommodate legacy assets, and we believe TALF will be the primary financing mechanism for pension, endowment/foundation, sovereign wealth and high net worth capital, most of which will be channeled through hedge funds and private equity funds. Currently, the Fed offers generous leverage to buyers of certain consumer asset backed securities through TALF, roughly on the order of 15x to 20x. We suspect haircuts will be somewhat higher for real estate securities, especially in light of their longer term. Nonetheless, even at lower gearing, returns will almost certainly be high enough to attract interest from virtually all types of allocators.2 This market will develop of its own accord, but one likely scenario would see the five “Beta” funds bidding with sufficient size and frequency to stabilize pricing, in time fostering confidence and comfort among the smaller “Alpha” funds. Lacking the “Beta” sponsors’ brand recognition, the smaller players will need more time to raise capital, but eventually, confidence will combine with capital to rebuild a working market for these assets. Until now, we have regarded patience as the better part of valor for distressed mortgage investment strategies. Months and years of opportunity await, but assuming still missing details emerge as expected, we now see a possibility that early investors in some securities strategies will fetch the highest rewards.

Legacy Loans

FDIC financing will likely be compelling…

As we discussed last week, legacy residential whole loans will demand the greatest amount of Government support, likely between half and two-thirds of Treasury’s available capital. Whole loans are by far the largest of the legacy asset classes (approximately $4 trillion notional) and require the most intensive management. Successful investment depends on controlling servicing, whereby investors maximize profit by modifying and refinancing purchased loans. While the Legacy Loan Plan specifies that selling banks may continue to provide servicing, most skilled investors will call for direct control by purchasers, as existing bank servicers generally lack the profit motive, culture and skill set to maximize performance of deteriorating loan portfolios. We therefore see captive or dedicated servicing and origination capabilities as a prerequisite for managers of whole loan investment strategies. Such capabilities are in short supply. Furthermore, even when investors control servicing, we suspect FDIC will impose its own modification and refinancing standards on anyone accepting its financing offer. Most investors will bear this limitation in exchange for the generous term leverage available. We regard the FDIC deal of up to 6x leverage as extremely compelling. At those levels, cash flows from loan payments would allow participants to recoup invested capital in just two to three years (see Table below).

2

The TALF and Legacy Securities programs pose a number of thorny implementation issues, among them the mechanism for determining how much leverage is appropriate for various securities. We would note, for example, that distressed RMBS originally rated AAA trades at prices which range from less than $0.10 to $0.65. Will the same degree of non-recourse leverage be offered at both ends of that very broad price spectrum? Another difficult issue relates to how securities will be valued. Legacy securities are eligible for Government financing only if purchased from a recipient of TARP funds. Yet, the same CUSIP may be held by institutions which received TARP support and those that did not. Prices will necessarily be higher for financing-eligible purchases. Will noneligible holders be able to mark up values based on these purchase prices? In the case of the subsequent sale at a lower price by a non-eligible seller, will the security then need to be marked down? Will TARP recipients be allowed to exploit their position, arbitraging this difference by making markets for non-TARP recipients? (How ironic!)

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PPIP--Legacy Whole Loan Opportunity*

WL Tsy Example WL Current Mkt WL Mid Mkt

Price $ 84 60 72

Loan Amt $ 72 51 62

Equity Amt $ 12 9 10

Equity / Price 14% 15% 14%

Leverage 6 6 6

Coupon 7% 7% 7%

Yield 11% 20% 15%

Curr Yield 8% 12% 10%

Leverage Cost 2.5% 2.5% 2.5%

Excess Yield 6% 9% 7%

Levered Yield 43% 88% 63%

Levered Current Yield 29% 46% 36%

Years To Equity Defeasance 2.45 1.64 1.92

*Assumes performing WLs, 5 year average life, not loss-adjusted Source: Gorelick Brothers Capital, LLC

Will the Banks Sell? Our simple answer: Yes. Some will be forced to do so by regulators. Some will fail, and the FDIC will do it for them. Others will sell voluntarily as prices climb.

Forced Selling and Failures

Little doubt regulators will force selling…

On the theory that institutions holding depreciating assets against fixed liabilities can neither raise capital nor deploy it with confidence, political leaders and regulators have repeatedly and explicitly stated that a primary goal of the Financial Stability Plan is to cleanse bank balance sheets of troubled assets. The details announced this week are part of a broader plan including evaluations of the nation’s 19 largest banks under stress scenarios positing continued home price depreciation and climbing unemployment. The breadth, scale, speed and comprehensiveness of Government action leaves little doubt regulators will demand that banks sell. Stress test results will determine which assets and how much for each institution. Later this year, armed with knowledge and experience gained in this first cleanup round, regulators may well turn to mid-size and smaller banks, incorporating similar approaches in their routine examinations of those institutions. Along the way, many Banks will fail, and additional assets may find their way into private investor hands through the programs detailed this week.3

Voluntary Selling

Prices are bound to rise…

The question of whether banks will sell voluntarily has plagued TARP since its inception under Secretary Paulson last fall. Banks have already taken mark-to-market losses on securities and might not sell voluntarily unless they receive prices in excess of their marks. Theoretically those marks reflect the likelihood and degree of future value deterioration, but Bank executives argue prices also reflect a severe and unbearable liquidity discount.4 So,

3

FDIC’s official watch list counted 252 banks at risk as of 12/31/08 (http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aCOhsHEaFe6g). Sources close to FDIC tell us 200 banks would be closed tomorrow if FDIC had sufficient staff to do so. 4 Within the last few weeks, FASB (the accounting standards setters) succumbed to intense political pressure and published new guidance clarifying (relaxing) the application of mark-to-market valuation methods in respect of illiquid assets.

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Transaction driven transparency creates selling pressure…

with some exceptions, higher prices are a necessary inducement.5 Recently rallying prices for TALF-eligible credit card and auto loan securities support the notion that a Government financing program drives prices higher. Over time, greater demand for legacy real estate securities should reduce liquidity premiums further. As that occurs, at the very least, we think increased trading activity will foster greater transparency, reducing the amount of “model-marked” securities on bank balance sheets and putting some pressure on holders to sell. For whole loans, PPIP explicitly gives Banks “the option of accepting or rejecting the bid…” tendered through the FDIC auction process. Because whole loans are the most sizeable troubled asset afflicting bank balance sheets, we think banks’ primary “option” will be to sell. We also note that the FDIC will be employing a “Third Party Valuation Firm” to value whole loan pools and determine available leverage in advance of sale. Market participants will quickly discover the template for loan valuation, and we think it will become very difficult for banks to reject bids as unreasonable. Just as increased trading activity in securities will clarify securities valuation, so will this process bring transparency to whole loan pricing. The selling pressure may come to bear in short order. We recall that only two transactions were responsible for the speed and cheapness (or so it seemed at the time) of the Government sponsored sale of Wachovia.6

Conclusions

A full house usually wins the day…

The Financial Stability Plan’s Public-Private Investment Program is the most coherent attempt by the “something most be done” crowd to solve the crisis afflicting our financial institutions and our economy. The plan is a significant improvement over previous ad hoc solutions, such as the Bear Stearns rescue, Lehman Brothers abandonment, TARP 1 turnabout and the forced marriage of Bank of America and Merrill Lynch, some of which combined the worst elements of free-market principles and Government intervention. Unlike last fall, most large U.S. financial institutions now exist and function solely by virtue of Government support. PPIP is the Government’s final alternative to nationalization, and the banks’ last chance to remain ostensibly independent while working through the crisis. Through PPIP, Government has transformed taxpayers into a large passive lender and invited retail and private capital to participate as investors. There is no question that private capital will do best in this environment, but at least Government will be able to say that taxpayers and retail investors can benefit as well. In the poker game they have been playing with banks, private capital and taxpayers, the Government now holds a full house—a popular President, bank ownership, regulatory coordination, taxpayer funding and a coercive Congress. While not always the best hand, a full house usually wins the day.

5

In some situations, accounting rules may prevent institutions from marking up securities to higher values based on market prices, instead requiring any appreciation to be recognized over the remaining life of the asset. In those cases, selling now will result in an immediate, perhaps irresistible, gain. 6 The seizure of IndyMac gave FDIC first-hand knowledge of the risks associated Alt-A and Option Arm mortgages, prompting its takeover of Washington Mutual. The subsequent sale of Washington Mutual informed potential buyers that the market value of Wachovia’s Option-Arm mortgage portfolio was over $20 billion less than stated.

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Legal Notice The forecasts and opinions contained herein are for illustrative purposes only and are not to be relied upon as advice or interpreted as a recommendation. Some information herein reflects proprietary research based upon various data sources and some information has been taken from third-party sources. Such sources are believed to be reliable but have not been independently verified for accuracy or completeness. The information provided is intended for informational discussion purposes only, and does not constitute an offer to sell or a solicitation of an offer to buy any securities and does not constitute investment advice. An offer to invest may be made only through the applicable confidential offering memorandum. No information contained herein either in whole or in part may be reproduced or redistributed without our express written consent.

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