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Treasury Releases Details of Public-Private Partnership to Purchase Toxic Assets

Financial Services Task Force Update James D. Friedman

On March 23, 2009, the United States Department of the Treasury (the "Treasury") unveiled the Public-Private Partnership Investment Program (the "Program"), which is designed to restore banks' abilities to lend by facilitating the removal of "legacy assets" from financial institutions' balance sheets. Legacy assets are real estate loans held by banks ("legacy loans") and the securities backed by pools of real estate loans ("legacy securities"). The Treasury intends to utilize between $75 and $100 billion in Troubled Asset Relief Program ("TARP") funds to encourage private investors to purchase legacy assets. By seeking private investors, the Treasury hopes to divide the risk of the legacy assets equally among taxpayers and the private investors. The Program has two parts: the Legacy Loans Program (the "LLP") and the Legacy Securities Program (the "LSP"). The provisions of each program are discussed below.

The Legacy Loans Program

All insured U.S. banks and U.S. savings associations are eligible to participate in the LLP. Banks or savings associations that are owned or controlled by foreign banks or companies are not eligible. There is no institutional size requirement for participants.

To begin the process, eligible institutions must confer with their primary regulator, the Federal Deposit Insurance Corporation ("FDIC"), and the Treasury to determine which assets may be sold. The Treasury has not disclosed a list of eligible assets for the LLP, but it has prohibited any legacy assets, and any collateral supporting them, that are predominantly situated outside of the United States. In general, the eligible institutions will be allowed to sell pools of loans.

After the bank approaches the FDIC, the FDIC will select a third-party independent valuation firm to offer valuation advice on the eligible asset pool. Using this valuation, the FDIC will determine how much leverage it is willing to provide for the purchase of the asset pool. Ultimately, the FDIC will auction off the pool of loans to private investors who will finance the transaction through the issuance of debt guaranteed by the FDIC. At most, the FDIC will allow leverage equal to a six-to-one debt-to-equity ratio. The level of leverage is dependent upon the independent valuation of the asset pool, which serves as collateral for the FDIC-guaranteed loans. The FDIC will also use the independent valuation to assess the merits of submitted bids.

As auctioneer, the FDIC must select the winning bid. For the FDIC to even consider a bid, the private investors must submit a refundable cash deposit of five percent (5%) of the bid value and agree to provide access to information requested by the Special Inspector General of the TARP and the Government Accountability Office. Once the FDIC selects a bid, the bank selling the asset pools has the right to reject the proposal. If a bid is unsuccessful or rejected by the bank, the deposit is returned. If a bank accepts a bid, then the private investor must establish a Public-Private Investment Fund ("PPIF") to purchase the asset pools. The private investor also gains access to the Program, through which the Treasury supplies up to fifty percent (50%) of the equity requirement of the purchase. While the private investor may take less than fifty percent (50%) of the equity requirement from the Treasury, there is likely to be a minimum level of Treasury equity required in any purchase. That amount has not yet been set. As mentioned above, the remainder of the purchase is financed through the issuance of FDIC-guaranteed debt by the PPIF. In exchange for the FDIC guarantee, the FDIC will charge an annual fee based on outstanding debt balances. For its role in the Program, the Treasury will receive warrants pursuant to the Emergency Economic Stabilization Act of 2008 ("EESA").

After the purchase has been made, the PPIF will be managed and controlled by a private fund manager whose primary goal is to liquidate all assets in the pool. Despite the PPIF's private control, the FDIC will provide strict oversight of the PPIF's activities. In addition, the PPIF will be required to maintain a Debt Service Coverage Account to ensure that each PPIF has sufficient working capital to cover its debt servicing obligations, interest expenses and operating expenses.

The Legacy Securities Program

The goal of the LSP is to restart the market for legacy securities, which the Treasury hopes will allow financial institutions to free up capital and lead to the extension of new credit. The LSP aims to do this by both expanding the assets eligible under the Term Asset-Backed Securities Loan Facility ("TALF") to include legacy assets and by combining government funds and private investment into PPIFs that will purchase legacy securities. For the purposes of the LSP, eligible assets are defined to include securities backed by mortgages on residential and commercial properties that were issued prior to 2009 and were originally rated AAA or its equivalent by two or more nationally recognized ratings agencies. In addition, the assets must be secured directly by the actual mortgage loans, leases or other assets and not by other securities, and the loans and underlying assets of such securities must be situated in the United States.

The Treasury begins the process by selecting qualified private fund managers to manage the PPIFs. Private fund managers interested in applying must fill out the application available on www.FinancialStability.gov and submit it to the Treasury by April 10, 2009. The application has questions regarding the fund manager's history, proposed fund structure and proposed fund strategy. In selecting managers, the Treasury will look for several key characteristics: (1) a demonstrated capacity to raise at least $500 million in private capital, (2) a track record of investing in eligible assets, (3) a minimum of $10 billion of eligible assets under management, (4) a demonstrated operational capacity to manage the funds according to the Treasury's long-term strategy and (5) headquarters in the United States. The Treasury intends to select up to five managers, although it may increase this number in the future. By May 1, 2009, the Treasury will notify selected fund managers if they have received preliminary approval. After notification, fund managers will have a short period of time in which to raise at least $500 million of private capital before the Treasury grants final approval of their applications.

As with the LLP, PPIFs in the LSP will be funded by both private investors and the Treasury. The Treasury will match private investment dollar for dollar, providing the PPIF with additional equity. In addition, on behalf of the PPIF, fund managers may subscribe for senior debt from the Treasury, so long as the PPIF does not grant private investors voluntary withdrawal rights. The Treasury will allow the PPIF to take out secured non-recourse loans in the amount of fifty percent (50%) of the total equity capital of the fund. Essentially, these loans allow the fund manager to double the Treasury's contribution to the PPIF. In some instances, the Treasury may even consider loaning up to one hundred percent (100%) of the total equity capital of the fund, although this extra loan amount will likely lead to additional restrictions on asset level leverage, redemption rights, disposition priorities and other factors that the Treasury believes to be important. The loans will accrue annual interest at a rate to be determined by the Treasury and will be payable in full at the end of the term of the PPIF, which cannot exceed 10 years. If additional funding is still needed, the PPIF may seek funding through the expanded TALF program.

Once the PPIF is funded, the fund manager will begin to purchase legacy securities at his or her discretion. In general, the Treasury is likely to select fund managers with a buy-and-hold strategy. The Treasury will also impose numerous conditions and restrictions on the fund manager and the operation of the PPIF. For example, the fund manager must: (1) submit monthly reports to the Treasury on legacy assets purchased and disposed of, the current valuation of legacy assets and the profits and losses of the legacy assets in the manager's PPIF; (2) track prices of legacy assets using third party sources and annual audited valuations by a nationally recognized accounting firm; (3) not purchase legacy assets from affiliates of the fund manager, other fund managers, affiliates of other fund managers or any private investor that has committed at least ten percent (10%) of the aggregate private capital raised by the fund manager and (4) provide access to books and records of the PPIF for the Treasury, the Special Inspector General of the TARP, the Government Accountability Office and their representatives and advisors. Furthermore, private investors may be given voluntary withdrawal rights from the private vehicle that is used to fund the private portion of the PPIF, but no private investor may withdraw for three years following the private vehicle's initial investment in the PPIF.

The Treasury does permit fund managers to charge fees to private investors and to the Treasury. However, the Treasury fee must be a fixed fee that applies as a percentage of equity capital contributions by the Treasury. In addition, executive compensation restrictions do not apply to passive private investors in legacy securities PPIFs.

All proceeds from the PPIF will be split between the private investors and the Treasury, depending on the total equity contributions of each. As required by EESA, the Treasury will take warrants, the terms of which are as yet undetermined.

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For more details, or if you have any questions, please contact Jim Friedman at 414-277-5735 / jim.friedman@quarles.com or your Quarles & Brady LLP attorney.