Critics have pummelled the US treasury department’s Public Private Investment Program (PPIP), which is to buy distressed assets from banks, for seeming to benefit Wall Street at US taxpayers’ expense. But it doesn’t have to be that way. With some revisions, treasury could deliver a plan that makes private investors’ goals the same as taxpayers. The US has done it before.
During the savings and loan (S&L) crisis of the 1990s, entities called aligned interest partnerships disposed of the toxic assets of S&Ls managed by the US government’s Resolution Trust Corporation. Here’s how it worked: The government contributed assets to a partnership that was financed by a private investor. The investor managed the partnership, and both sides shared the proceeds. Thus the government maintained a financial interest in the success of the partnership. This is a sharp contrast to PPIP, where the selling bank disposes of the asset outright, with no chance of future profits.
The partnership model worked. When all was said and done, private investors recovered more than 125% of the assets’ initial estimated value. But taxpayers were the ultimate winners. Compared with similar assets sold outright, the government got up to 45% higher returns using the partnership structure.
Several factors contributed to the success of the aligned interest partnerships. First, the investors received no fee for managing the assets. This reduced the temptation to sit on assets just to maintain a stream of easy payments from the government. The chief executive was paid entirely out of the investors’ share of overall proceeds. The private investors were free to manage the assets as they chose, with no daily oversight. Instead, investors provided monthly documentation that they were obeying the partnership’s rules. But since the private investors got paid only on net receipts, they had a strong incentive to operate efficiently.
Perhaps most important, partnership investors started to see equity returns much earlier than their counterparts in the treasury plan. Private investors would receive just enough early on to keep them actively engaged. The big payoff came when most or all of the assets were sold.
With the treasury plan, on the other hand, it seems that private partners start getting a return on their equity investment only after net receipts were large enough to pay off all of the initial debt. This raises a dangerously high bar. Once investors realize how hard it will be to pay back the taxpayer-financed debt in full, they could lose motivation entirely.
As we try to improve on the current treasury plan, there is much to learn from aligned interest partnerships. The same principles that worked for the Resolution Trust Corporation could be adapted for bank loans seized by the Federal Deposit Insurance Corporation, foreclosed properties owned by Fannie Mae or Freddie Mac, and even for toxic mortgage-backed securities that require loan modifications. In the case of the mortgage-backed securities, for example, it would be much better for the selling banks to keep an interest in the performance of the asset pools, meaning that they can still reap the benefits of further profits. This would provide an incentive to hand over toxic asset portfolios to third-party investors that will focus on increasing value.
The aligned interest partnerships offer other lessons as well. Treasury should not insist on full debt repayment before providing a return on equity. Most important, those revising the plan should ask themselves how each proposed change will affect investors’ incentives to pay taxpayers as much as they can.
©2009/THE NEW YORK TIMES
Edited excerpts. Cyrus Gardner is the chairman of an investment banking firm and a former adviser to the Resolution Trust Corporation. Comments are welcome at email@example.com