Special Inspector General Barofsky and his team make particular note of the lack of oversight in TARP, and also worry that hedge funds are even more opaque in other trillion dollar programs.
The SIGTARP team did its own survey and received reasonable, but uneven, reporting by banks eventhough Treasury said it would be too cumbersome.
Will Treasury and Congress respond in a positive manner?
Many aspects of PPIP could make it inherently vulnerable to fraud, waste, and abuse. First, PPIP deals with assets that have recently been illiquid, making valuation difficult, therefore raising the danger that the Government will overpay for the assets. Second, many of the participants in these markets, such as hedge funds, are substantially unregulated and the internal oversight and compliance capability at those institutions vary widely. Next, the interrelationships between the market participants can be extremely complex and difficult to anticipate: the same entity might buy and sell toxic assets for its own benefit and manage portfolios of toxic assets for others, all while holding or managing equity or debt securities of the banks and other institutions that have large positions in the same toxic assets. Finally, the sheer size of the program — up to a trillion dollars for the PPIFs and up to another trillion dollars for the expansion of TALF — is so large and the leverage being provided to the private equity participants so beneficial, that the taxpayer risk is many times that of the private parties, thereby potentially skewing the economic incentives.
After receiving initial briefi ngs from Treasury on PPIP and discussing the issue with law enforcement partners, SIGTARP has identifi ed three of the most significant areas of potential vulnerability to fraud and abuse applicable across the program. Because SIGTARP has not been provided with many of the specifi c details of the mechanics of the various programs, SIGTARP’s observations and recommendations are necessarily at a high level.
Conflicts of Interest
The first area of vulnerability is that the private parties managing the PPIFs might have a powerful incentive to make investment decisions that benefi t themselves at the expense of the taxpayer. By their nature and design, including the availability of significant leverage, the PPIF transactions in these frozen markets will have a significant impact on how any particular asset is priced in the market. As a result, the increase in the price of such an asset will greatly benefi t anyone who owns or manages the same asset, including the PPIF manager who is making the investment decisions.
As an extremely simplified example from the Legacy Securities Program, assume that the fund manager of the PPIF owns 1 million bonds of MBS X in its own account. MBS X is currently valued on the fund manager’s books at 20% of its original value, or $20 per bond, for a total of $20 million. The fund manager does an estimate and believes that, in a fully functioning market, MBS X is actually worth 30% of face value, or $30 per bond.
In the absence of a conflict of interest, the fund manager, using PPIF funds, might be willing to pay up to $30 per bond in the market. However, the fund manager realizes that it can make more money for itself if it drives the price even higher. It thus uses the funds it controls in the PPIF to buy 1 million MBS X bonds from someone else at $40 per bond, or $40 million. This transaction has the potential, in the current illiquid market, of setting the market price for that MBS X at $40, even though that price is far above what the MBS is actually worth.
As a result, the fund manager could sell the MBS on its own books and recognize a profit of $20 million. Over time, however, the price of MBS X declines to its actual value, $30 per bond, and results in a $10 million loss to the PPIF fund. This loss has no negative impact to the fund manager, however, because it did not have any of its own money invested in the fund. Indeed, the fund manager has made money on the PPIF, because it has received fees from both Treasury and the private investors based only on the total size of the PPIF. In other words, the confl ict results in an enormous profit for the fund manager at the expense of the taxpayer.