Distressed Real Estate and Investment
Management Alert
March 2009
Authors:
Anthony R.G. Nolan
anthony.nolan@klgates.com
+1.212.536.4843
Daniel F. C. Crowley
dan.crowley@klgates.com
+1.202.778.9447
Gordon F. Peery
gordon.peery@klgates.com
+1.617.261.3269
David H. Jones
david.jones@klgates.com
Public-Private Investment Partnerships to
Tackle Legacy Toxic Assets
On Monday, March 23, 2009, the U.S. Department of Treasury (“Treasury”)
announced the expansion of the Troubled Assets Relief Program (“TARP”) to
facilitate removal of “distressed real estate-related assets” from the balance sheets of
financial institutions. The announcement described the framework for two publicprivate investment programs (collectively, “PPIP”) under which the United States
will make equity co-investments in, and provide leverage to, investment vehicles that
will be established to acquire from financial institutions existing whole loans,
commercial mortgage-backed securities (“CMBS”) and private-label residential
mortgage-backed securities (“RMBS”). For background information on programs
related to TARP and the Economic Stabilization Act of 2008 (“EESA”), please see
the K&L Gates Global Financial Markets Newsstand.
+1.704.331.7481
Anthony J. Barwick
tony.barwick@klgates.com
+1.919.743.7340
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The latest announcement by the Treasury sets broad guidelines for how the PPIP will
operate to provide an opportunity for private investors to participate in the purchase
of real estate loans as well as CMBS and RMBS assets. As described below, the
PPIP will combine additional capital from federal sources with capital from private
investors and will add federally provided or guaranteed debt to provide financing for
the PPIP vehicles’ purchases.
Among the details that Treasury made available, an applicant that wishes to be a
“Fund Manager” under the Legacy Securities Program (discussed in detail below)
must apply no later than April 10, 2009, with preliminary approval from Treasury
expected on or prior to May 1, 2009. Also due on April 10, 2009 are comments to
the Federal Deposit Insurance Corporation (“FDIC”), which solicited public
comments on the Legacy Loans Program (also described below in greater detail).
Background
When the TARP program was first announced in the fall of 2008, it was envisioned
as a program that would use Treasury funds to purchase illiquid mortgage-related
securities from banks. Critics pointed out several flaws in the plan. First, the
original TARP plan did not provide a clear mechanism for determining the prices at
which toxic assets would be sold. If the Treasury were to overpay for assets, the
U.S. taxpayers would bear the risk of nonperformance. On the other hand, if the
Treasury were to pay a price that reflected market valuations of such assets, the
purchases would not contribute enough capital to recapitalize the banking system. In
addition, many financial institutions were concerned that Treasury purchases at
distressed prices would create observable inputs that would lead other institutions to
mark down similar assets to a benchmark based on the price for which the Treasury
acquired assets, further depleting their capital. Consequently, in November 2008 the
Treasury changed direction by instituting a program of capital infusions known as
the Capital Purchase Program and by instituting the Term Asset-Backed Securities
Loan Facility (“TALF”) program, which was designed to resuscitate the
securitization markets as a source of liquidity not only for financial institutions but
Distressed Real Estate and Investment Management Alert
for consumers and small businesses whose
borrowing needs had traditionally been beyond the
capacity of the traditional banking system. The first
TALF funding occurred on March 25, 2009, with
K&L Gates representing a sponsor in one of the first
TALF-eligible securitizations.
With TALF now underway, the announcement of
the PPIP marks Treasury’s return to the effort to
remove toxic assets from banks’ balance sheets.
However, the basis of this effort is quite different
from that which was originally conceived. With the
PPIP providing for private investors to invest sideby-side with the Treasury and also providing an
auction process with respect to real estate loans, the
PPIP creates a market clearing price for at least
some of these assets. To the extent that performance
losses exceed expectations, the taxpayers’ risk will
be mitigated because private equity investors will
share those losses pro rata with the Treasury’s
equity position and because most Treasury funding
will be in the form of debt that bears losses after the
equity. To the extent that the market price is too low
to provide significant capital for a viable selling
institution, the Treasury’s previously announced
plan to stress-test banks will provide additional
government-funded equity as needed.
A Summary of How It Works: Two
Programs for Two Asset Classes
A cornerstone of the PPIP program is the formation
of joint ventures between government and private
capital providers. These public-private joint venture
entities are designed to help provide a market
mechanism for valuing distressed assets and
acquiring those assets from their current owners
through attractive leveraged acquisition financing of
those assets.
The Legacy Loans Program: Under the Legacy
Loans Program, the FDIC and the Treasury will
provide oversight for the formation, funding and
operation of public-private investment funds
(“PPIFs”) that will purchase distressed loans on a
pool-by-pool basis from insured federal- and statechartered banks and thrifts that are not under foreign
ownership or control and that elect to sell assets to a
PPIF (“Participant Banks”). Potential private
investors in a PPIF will need to be pre-qualified by
the FDIC in order to participate in the Legacy Loans
Program.
The PPIFs will purchase distressed loan assets from
Participant Banks with either cash or a combination
of cash and FDIC-guaranteed debt issued by the
PPIP. The debt issued by the PPIF will be nonrecourse. The FDIC guarantee of the debt will be
collateralized by the purchased assets, also on a
non-recourse basis. Leverage limits will be
determined on a pool-by-pool basis in the FDIC’s
discretion as part of the auction process for each
pool of Legacy Loans, with debt-to-equity ratios up
to 6-to-1 for each PPIF. Neither the FDIC nor the
Treasury has provided further information on any
other key terms applicable to the FDIC-guaranteed
debt or on the exact requirements for qualification
by participants in the program.
Pricing mechanics and key financing terms for
purchasers of Legacy Loans (e.g., applicable
LIBOR margins, guarantee fees, administrative fees,
minimum loan size, loan-to-value discounts, etc.)
will be determined in connection with the auction
process for Legacy Loans. To start the auction
process, a Participant Bank will identify a pool of
loans it would like to sell. The FDIC will oversee
initial due diligence and preparation of required
marketing materials and will conduct each auction
process with the assistance of a third party valuation
firm. Prior to the auction date, the FDIC will
conduct a separate analysis to determine the amount
of acquisition debt for the applicable pool that it is
willing to guarantee. Final eligibility of assets for
purchase will be determined by the relevant
Participant Bank, its primary regulator, the FDIC
and Treasury. Bids from the qualified private
bidders will be based on the amount of equity each
bidder is willing to invest in acquiring the pool
being auctioned, with the winner being the bidder
who proposes to fund the largest amount of equity.
The Treasury will agree to invest equity side-byside with the private equity to create the public
component of the winning PPIF, although the public
component will in all cases represent no more than
50% of the total equity in a PPIF. A Participant
Bank may elect either to accept or to reject the bid
once the auction is complete.
March 2009
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Distressed Real Estate and Investment Management Alert
Participant Banks of all sizes will be eligible to sell
their assets. Once the assets have been acquired by
the PPIF from one or more Participant Banks, the
private partner will have the responsibility for asset
management. The Participant Bank may continue to
service the Legacy Loans, unless otherwise agreed
and subject to the control and direction of the PPIF.
The PPIF will be subject to additional governance
procedures, management, financial and operational
reporting requirements as may be established by the
FDIC and Treasury.
The FDIC has invited public comment on the
Legacy Loans Program. Given the lack of detail,
comments from parties with experience in this
market may have a material impact on how this
program evolves. As noted above, the comment
period for market participants to respond to the
FDIC concerning the existing outlines of the
Legacy Loans Program expires on April 10, 2009.
Instructions for making comments can be found at
http://www.fdic.gov/llp/progdesc.html. For further
discussion of how the Legacy Loans Program is
expected to operate, including a range of potential
issues yet to be addressed, please see the K&L Gates
Mortgage Banking and Consumer Credit Alert Legacy Loans Program: The Government Offers
Bridge Over Troubled Assets, which is being issued
contemporaneously with
this Alert.
Legacy Securities Program: Under the Legacy
Securities Program, private asset managers (“Fund
Managers”) will be authorized to raise private
capital to invest in joint investment funds (“Legacy
Securities Funds”) with Treasury on a dollar-fordollar basis, with profits and losses shared on a pro
rata basis. The Fund Manager will control and
manage the Legacy Securities Fund and will have
responsibility and control over the acquisition,
disposition and liquidation of the assets in the Fund.
The private investors will contribute capital through
an investment vehicle also controlled by the Fund
Manager (a “Private Vehicle”). Fund Managers
must be headquartered in the United States and will
be pre-qualified based upon criteria that are
anticipated to include the following:
(1) demonstrated capacity to raise at least $500
million of private capital; (2) demonstrated
experience investing in CMBS and RMBS; (3) a
minimum of $10 billion (market value) of
securitized assets under management; and
(4) demonstrated operational capacity to manage
Funds in achieving attractive long-term
opportunistic investment returns following a
predominantly long-term buy-and-hold strategy.
The deadline for applications for loans from
Treasury under this program is April 10, 2009, and
preliminary application approval from Treasury is
expected on or prior to May 1, 2009. Applicants
will have a limited time after approval to raise at
least $500 million. The Treasury expects to approve
approximately five (5) Fund Managers, but this
number may be increased depending on the quality
of applications received. Eligibility to invest in a
Legacy Securities Fund is designed to be open to a
broad array of investors. The Treasury is
particularly encouraging participation by individual
retail investors, pension plans, insurance companies
and other long-term investors.
Legacy Securities Funds may borrow from the
Federal Reserve Bank of New York (“New York
Fed”) under the TALF program. The Legacy
Securities Program expands the TALF program by
relaxing two important eligibility criteria for CMBS
and RMBS. While TALF-eligible securities
generally must have been issued after January 1,
2009 and must be rated “AAA” at the time of the
TALF financing, CMBS and private-label RMBS
issued before 2009 will be eligible for TALF. There
seems to be a discrepancy, however, in the
Treasury’s statements on the rating requirements for
CMBS to be eligible for TALF financing. RMBS
are eligible for both purchase by a Legacy Securities
Fund and TALF financing as long as they were
originally rated “AAA.” However, the March 23,
2009 Treasury announcement seems to provide that
while CMBS that were originally rated “AAA” may
be purchased by a Legacy Securities Fund, that
CMBS must be currently rated “AAA” in order to
be eligible for TALF financing. In other words, it is
not clear whether CMBS that were rated “AAA” at
the time of issuance but have since been
downgraded will be eligible for purchase under the
Legacy Securities Program but not eligible for
TALF financing. Additionally, it remains to be seen
whether the New York Fed will relax the origination
March 2009
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Distressed Real Estate and Investment Management Alert
date restriction to permit eligible CMBS and RMBS
to be backed by significant concentrations of
mortgage loans that were originated prior to October
1, 2007.
The Legacy Securities Program also goes beyond the
previously announced TALF program in that the
Treasury will provide matching equity capital on a
dollar-for-dollar basis to be used for the purchase of
these asset types. Each Fund Manager will have the
option to obtain secured non-recourse loans from the
Treasury (“Treasury Debt Financing”) in an
aggregate amount equal to between 50% to 100% of
the Legacy Securities Fund’s total equity capital, so
long as the private investors in the fund do not have
voluntary withdrawal rights. Any Treasury funding
at a level over 50% leverage of total equity capital
would subject the Legacy Securities Fund to further
restrictions on asset level leverage, disposition
priorities and other factors that Treasury may deem
relevant. In addition to fund level leverage that may
be provided by the Treasury Debt Financing, the
Fund Managers may borrow from the New York Fed
under the TALF to finance the purchase of these
assets, subject to TALF haircuts that could be
financed by Treasury Debt Financing as described
above. Any Treasury Debt Financing to a PPIP that
borrowed under the TALF program would be
structurally subordinated to any TALF loans made
by the New York Fed to that PPIP. The terms and
conditions of any TALF asset acquisition financing
will be determined at a later date after discussions
with market participants.
Importantly, Treasury may cancel any loan or equity
commitment not previously funded at any time in
the Treasury’s discretion. Funds may also be
financed through private sources, provided that
Treasury capital and Private Vehicle capital must be
leveraged proportionately from such private debt
financing sources. The Treasury will be given
warrants as required by the EESA to protect the
interests of taxpayers. The terms and amount of
such warrants will be determined based on the
amount of Treasury Debt Financing taken.
Because PPIP will depend on private investor
participation, it may be some time before it is clear
whether this approach will work to stabilize and
revitalize the credit markets for commercial and
private real estate assets. Unfortunately, Treasury’s
March 23, 2009 announcement did not provide
many details regarding key terms that private
investors will need to know prior to entering into a
formal agreement for the purchase of legacy assets
under either program. For example, the Treasury, in
its announcement, made it clear that the executive
compensation restrictions of the EESA would not
apply to passive investors, the implication being that
the restriction may apply to Fund Managers under
the Legacy Securities Program and to the persons
responsible for managing PPIFs participating in the
Legacy Loans Program (possibly including
Participant Banks). How these restrictions are
interpreted in this context is yet to be known.
Likewise, no details regarding the Treasury’s rights
as a warrant holder have been revealed. There are
also questions regarding the mechanics of the
auction, transferability of equity interests, and the
extent to which investors may be subject to
oversight or disclosure obligations. We will
continue to monitor these details as they are
announced and evolve for the benefit of our clients.
The financing that the U.S. government will make
available has the potential to significantly magnify,
via leverage, private investor returns. Questions
which remain unanswered include the extent of
these enhanced returns, whether they will be enough
to stimulate private demand for the distressed assets,
and whether financial institutions will be willing to
part with these distressed assets at the prices
determined by the private market. There are doubts
especially as to the willingness of financial
institutions to sell Legacy Loans that are not
currently marked to market and therefore not
necessarily subject to embedded liquidity discounts.
In addition, sponsors of private equity funds that
may be established to make equity investments in
PPIFs or joint venture feeders will have to consider
a wide range of legal issues, including under the
Investment Company Act and the Internal Revenue
Code. In particular, offshore funds or those with
foreign investors that invest in a PPIF under the
Legacy Loans Program would have to consider
structuring investments in order to minimize
negative tax attributes associated with having
income that is effectively connected to the conduct
March 2009
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Distressed Real Estate and Investment Management Alert
of a trade or business in the United States. Another
open question for potential sellers, investors and
managers is the extent to which participation in
either program could subject them to enhanced
legislative or regulatory scrutiny or changing terms
as the programs evolve.
experienced over the course of a decade after a
similar financial crisis, private investors will have to
work closely with the Treasury, the FDIC and the
New York Fed to establish a viable partnership and
make many compromises to meet each of their
needs under this program.
For PPIPs to stimulate bank lending and avoid the
stagnation in the financial sector that Japan recently
If you have questions with respect to any of the
foregoing, please contact the authors of this Alert.
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©2009 K&L Gates LLP. All Rights Reserved.
March 2009
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