Public Pensions and Private Partners

A profitable role in curing the toxic asset problem?
April 9, 2009 AT 3:00 AM
Girard Miller
By Girard Miller  |  Finance Columnist
The finance columnist for Governing.

The financial markets loved Treasury Secretary Tim Geithner's proposal to craft a public-private investment partnership (PPIP) between the U.S. Government and private investors to buy out legacy (toxic) assets from banks. It's a necessary step to the ultimate long-term liquification of the financial system. By providing the financial resources to enable private investors to bid at fair market values for underwater mortgage securities now held by crippled financial institutions, the government would share 50-50 in the profits -- while knowing that somebody with real expertise puts a real-world market price on these assets. The banks will get relief from further downside risk in their shaky portfolios but not a direct subsidy. It's a well-reasoned approach to a sticky problem.

Some critics don't like the risk-reward ratio for the federal government. They believe private investors stand to gain half of the profits but only risk 8 to 10 percent of the cost. That's because government funds will provide them cheap, non-recourse financing for their ownership shares. Before the plan clears Congress, we can expect to see more gnashing of teeth over that detail, and perhaps the ratio will change.

My view is that the secretary's plan is a good starting point, and it's OK to allow a reasonable level of extra profitability as incentives to the "first movers" who plunge into the cold waters of an untested marketplace. After a few of these auctions are completed, the risk-reward ratio can be changed, and the government can demand stiffer terms on its loans.

In fact, there might be a case for requiring the private investors to bear a little more risk on the low-interest loans that the government will give them for their 50 percent stake. After all, these are mortgage securities selling at deep discounts already, so it makes sense to require the private capitalists to put a little more skin in the game, perhaps through a bidding process on that aspect as well.

The public pension angle. There is one class of investors for whom a solid case could be made for getting the most favorable terms possible from the federal government in these deals: the nation's public pension funds. They control a pool of long-term, patient capital that can take a prudent amount of market risk on mortgage securities pools, and hold them to maturity at above-market rates of return commensurate with the risks. If anybody should be considered for the lowest-rate financing from the Treasury, without recourse in the event of default, it would be the public pension funds.

Public officials in 15 states have reportedly met with federal officials regarding the possibility of investing pension fund assets. So it looks like this idea is already being taken seriously.

A Public/Private/Public-Pension Partnership structure. I would urge the pension associations and especially the larger plans that already work with sophisticated private equity investors and money managers to put their heads together to make a case with Secretary Geithner's office that public pension funds do not represent the same kind of "boondoogle" publicity risk to the Administration and the taxpayers as self-interested capitalists. How about a plan that would allow this kind of discount financing to public pension plans, with partnering private money managers taking a smaller stake -- say, something like a partnership that's 50 percent federal, 25 percent pension fund, 25 percent private equity?

Another alternative is to provide lowest-cost financing to the pension funds and let them simply pay a money manager a performance fee based on the success of their investments. Unlike the outrageous fees charged by hedge funds, these arrangements could be priced competitively and transparently as a federal requirement for obtaining the low-cost funding.

A better bet than a pension guarantee bill. As I noted in a previous column, only about 5 percent or $100 billion of the $2 trillion sitting in public pension fund portfolios could be invested in a program like this. Remember however, that the funds' capital can be leveraged at least 2:1 on a prudent basis, so that the actual face value of the investments would be significantly higher. Thus, they have enough seed capital available to make a significant difference, especially in the early days of these programs. Although public pension funds cannot rescue the economy single-handedly, they certainly could occupy a vital seat at the table.

Strength in numbers. In a column last September, I suggested that the time would eventually come for public pension funds to tip-toe into the mortgage market for long-term investment returns. This federal program presents the first viable opportunity to put that strategy into play on an organized basis. Hopefully, the professional associations, lobbying groups and investment community will figure out that this is a viable opportunity for state and local pension fund participation in the cure of our nation's economic malaise. If they can't get their act together, I won't be surprised to see at least one or two major funds find a partner and do this on their own. By working together, however, the plans and their associations could provide a better and safer platform for all the funds, including the smaller ones.

Girard Miller
Girard Miller | Finance Columnist |