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U.S. to Invite The Wealthy To Invest in The Bailout

By David Cho
Washington Post Staff Writer
Friday, March 6, 2009

The government is seeking to resuscitate the nation's crippled financial system by forging an alliance with the very outfits that most benefited from the bonanza preceding the collapse of the credit markets: hedge funds and private-equity firms.

The initiative to revive the consumer lending business, outlined by officials this week, offers these wealthy investors a new chance to make sizable profits -- but, thanks to the government, without the risk of massive losses.

The idea is to entice them to put their huge cash piles to work to stimulate the financial system. They would be invited to buy up recently issued, highly rated securities. These securities finance consumer lending, such as credit cards and student and auto loans.

The program, which could involve the government lending nearly $1 trillion to these investors, exceeds the size of every other federal effort to address the crisis so far. The initiative's approach could be the model for future federal efforts to aid the credit markets, sources familiar with government planning said. Officials call this strategy a "public-private partnership," but in essence the government is offering good deals to private investors to draw them into its rescue efforts.

Architects of this initiative have long been sensitive to the political challenges of teaming up with hedge fund managers and private-equity firms. But officials see these private investors as among the few who have ample cash available. In public statements, officials have sought to focus attention on the ultimate goal of freeing up credit for consumers.

The Treasury Department and Federal Reserve will continue to lean on these private investors as officials expand their aid to more segments of the lending markets each month, moving from consumer credit possibly on to commercial mortgages and financial derivatives, the sources said. But there is vigorous debate between the Treasury and the Fed and within them over how the program should evolve and at what speed.

This approach will culminate in a separate program that aims to relieve banks of toxic assets, backed by distressed loans, that are clogging the firms' balance sheets, sources said. This second initiative, which officials are hoping to unveil in the coming weeks, is also expected to reach at least $1 trillion. It may create multiple investment funds, financed by wealthy investors with matching dollars from the Treasury and loans from the Fed, to buy toxic assets, sources said.

These two programs, focused on reviving consumer credit and clearing troubled assets, each exceed the size of the other elements in the financial rescue package being developed by Treasury Secretary Timothy F. Geithner. These also include a $75 billion effort to aid homeowners and an effort to inject capital into banks, which has already involved hundreds of billions of dollars in public funds.

In the past, hedge funds and private-equity firms have not been major buyers of the securities that provide financing for credit cards and other consumer loans.

But the government is turning to these investors in part because traditional buyers, such as retirement funds, mutual funds and university endowments, have fled the markets. Many are deep in the red and reeling from past forays into buying complicated debt securities. Moreover, many pension funds have rules that ban them from borrowing money to make investments, which is an essential ingredient in the government's program. So many pension funds will not be able to participate.

Federal officials, however, have not given up on the traditional investors and are considering setting up investment entities that would allow pension funds to get a piece of the profits. Officials said pension officials have expressed strong interest in this idea.

The consumer credit revival program, formally known as the Term Asset-Backed Securities Loan Facility, or TALF, has been welcomed by a range of hedge funds and private-equity firms as well as some lenders who issue assets that finance consumer loans.

"Our members have significant interest," said Richard Baker, president of the Managed Funds Association, the leading association for hedge funds. "The plan recognizes that our industry can bring significant resources to bear."

Here's how a typical TALF deal would work: A hedge fund uses $1 million of its own money and gets a $9 million loan from the Fed, payable after three years, to buy a $10 million asset-backed security, which finances consumer loans. Hoping that the market for these assets recovers, the hedge fund would hold the asset for three years.

If the security rises in value to $11 million, the investor would keep the profit, essentially doubling the initial investment. The government, meanwhile, would consider the deal a success because consumer lending was spurred.

If the value fell below $9 million, the hedge fund would lose its down payment but nothing more. The Treasury, using bailout funds approved by Congress, would cover the next set of losses, with the Fed ultimately on the hook for anything more.

Steven Schwartzman, chief executive of private-equity giant Blackstone, said the program is "highly attractive" because of the government financing.

The TALF's primary aim is to get the "shadow banking system" running again. A vast portion of the financing for loans issued in the United States comes not from traditional banks but from other enterprises.

Some firms that issue consumer credit questioned the program's limitations. Executives at one leading bank said restricting the program to securities backed by only the highest-quality loans would be too constraining.

For example, many loans taken out by auto dealerships to stock their inventory do not have the highest ratings. Government officials, who want to make sure dealers can get these loans, are considering expanding the TALF to slightly lower-quality assets, sources said.

Some officials are concerned there may not be enough highly rated loans that can be combined into securities to sell to investors.

Another matter of discussion among federal officials is whether to lengthen the term of the financing extended by the government to investors, sources said. With securities backed by auto loans, for example, a relatively short period was deemed appropriate because these loans mostly carry three-year terms. But when the TALF expands in the coming months to aid other segments of the credit market, such as commercial real estate loans, the Fed may have to lengthen the time because such loans carry 10-year terms or longer.

If Fed and Treasury officials decide to extend the TALF model to the purchase of toxic assets, this would require expanding the approach from recently issued loans to those that are years old.

Each step away from the original target of the TALF -- recently issued, highest-quality assets -- may force the government to protect itself, which would involve offering less to private investors, officials said. But if the government goes too far in shielding itself, it may fail to generate interest by private investors. Striking the right balance -- among lenders who issue loans, investors who buy them and taxpayers who are facilitating the transactions -- has been one of the greatest challenges in developing the program, officials said.

Staff writers Neil Irwin and Binyamin Appelbaum contributed to this report.

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