On 23 March 2009, Treasury Secretary Geithner introduced his Public-Private Investment Program (PPIP) for helping to cleanse ‘toxic assets’ from banks’ balance sheets. A bank (with FDIC approval) may auction off troubled mortgages to ‘Public-Private Investment Funds’ (PPIF).  The PPIF’s are financed as follows:  85% through non-recourse debt from FDIC, 7.5% through equity from US Treasury, and 7.5% through equity from private investors. Under this structure, the most that private investors can lose is all of their equity investment but if there is net gain on the ultimate disposition of the troubled mortgages, the private investors share the net gain equally with Treasury.

Two decades ago, a famous former professor of mine (with one foot in academe and the other on Wall Street) said, ‘There is no regulation of financial markets that a smart investor cannot get around.’

I was reminded of this professor when I read Karl Denninger’s Open letter To The FDIC Ombudsman on the ‘Market Ticker’ blog. He poses a case of a bank which is carrying a mortgage at 80% of face value but could only sell it in the open market for 30% of face value. If the bank sold the mortgage at 30% of face value, it would have to recognize the loss in book value and would weaken its  equity for regulatory purposes. Suppose, says Denninger, that the bank offers this mortgage for auction under PPIP and then bids to buy its own mortgage for 75% of face value (clearly winning the auction). The hit to regulatory equity is minimal. In the event that the mortgage subsequently becomes worthless, all the bank then loses is 7.5% of the bid price on the mortgage (i.e., its equity investment in the PPIF); FDIC and Treasury absorb the remaining loss of 92.5% of the bid price.

I think we can safely assume that the FDIC will disallow such a transaction, especially after Denninger’s warning letter.

However, what if banks implicitly collude to buy each other’s troubled assets under PPIP? I can see my old professor smiling.