Portfolio manager Cale Smith on investing, Spoke Funds®, and Islamorada in the Florida Keys.

The Treasury Department’s long awaited Public-Private Investment Program, or PPIP, has finally launched. Here’s how I described the plan in my March letter to investors:

The basic idea is that if the big banks can sell off their bad assets, they can function again. The banks know this but can’t find any buyers. The government is bringing buyers to the table by sweetening the deal. In one part of the program, big investors can buy toxic assets “legacy loans” with some of their own money and a lot more of the government’s. In the other part, a handful of really big funds will be allowed to buy “legacy securities” – big bundles of repackaged loans – by putting up $500M each. The government will match that with $1 billion more through a special fund that has been closed to private firms until now. Some of that $1B would be non-recourse, meaning the funds are protected if they default. The funds get to cheaply buy just the best assets with borrowed money and no risk of imploding. So, they stand to make an absolute killing.

As pointed out in this New York Times article, the feds have “reached a deal to sell $1.3 billion in mortgages from Franklin Bank, a Houston-based lender that failed last November and was taken over by the F.D.I.C.”

Now if you’re asking yourself, “Why are taxpayers buying the toxic assets of a bank that is already dead?” you’re not alone. It’s one thing for Treasury to be providing large subsidies to private investors to buy toxic assets. That was a seemingly rational way to take toxic assets off the balance sheets of the country’s banks and help the banking system recover from the credit crisis.

But as pointed out in this post on The Baseline Scenario, these particular toxic assets at Franklin Bank already became property of the US government once the bank failed. At that point, the government owned 100% of the upside and 100% of the downside on those assets.

Until last week, that is, when the government through the PPIP program gave half of the potential upside to an investment fund – “Residential Credit Solutions of Fort Worth” – a company founded by a veteran of the subprime mortgage industry. As described above, that company bears no risk under the PPIP program when buying those assets.

In other words: the government gave half of the potential gains from those assets to a company started by an individual who may or may not have helped enable the crisis to begin with – and then kept all of the downside to itself.

Why are we subsidizing investors who are buying the assets of already dead banks? How does this help strengthen the banking system?

I have no idea.

Perhaps you can tell me.

Hat tip to FinanceGuy and RortyBomb, too.

My column in today’s Keys Weekly:

Q. What exactly is causing all these banks to fail?

A. Let’s review the business model of a bank. If you have a checking account or a car loan, you probably already know the basics.

A bank takes in money from one group of people, depositors, lends it to another group, borrowers, and profits from the difference. If a bank borrows money from a depositor at 3 percent and lends it out at 6 percent, the bank has earned a 3 percent spread, or net interest income.

Most banks also make money from fees and other services, typically called noninterest income, which when combined with net interest income comprises the bank’s net revenues.

Much more than other businesses, a bank’s revenue and profits are tied to its balance sheet. You’ll recall a balance sheet is the financial statement that summarizes a company’s assets, liabilities and equity at a specific point in time. The balance sheet shows what is owned, what is owed, and what is left over.

On the asset side of a bank’s balance sheet, you’ll find loans and investments, and on the liabilities side you’ll see deposits and borrowings. One important point to understand about a balance sheet is that while the value of assets may change, liabilities are fixed. Since the amount of assets is always equal to liabilities plus equity, any change in the bank’s assets will be reflected in its equity, too.

If the Bank of Margaritaville had $50 million in both assets and liabilities, but no equity, then a small decline in the value of those assets would mean that the bank could not meet its debts. The bank would become insolvent.

So a bank’s equity is a critical cushion for both depositors and bank shareholders.

What sorts of things would cause that equity cushion to disappear? Bad loans, which effectively reduce the amount of assets on a bank’s balance sheet and therefore its equity, too. A constant barrage of bad loans could eventually drain the equity right out of a bank – if the regulators don’t step in and seize the bank first.

Q. What books would you recommend to help learn about investing?

A. I’ve previously mentioned three books that are great for new investors. Those were The Little Book That Beats the Market by Joel Greenblatt, The Little Book That Builds Wealth by Pat Dorsey, and One Up On Wall Street by Peter Lynch. Here are five others that I would view as absolute must-reads for anyone who would like to become a better investor.

1 – The Intelligent Investor by Benjamin Graham. Graham is the father of modern stock analysis and the mentor to Warren Buffett. His writings are so densely packed with insight that it’s almost impossible to take notes. Here’s one of my favorite quotes: “You are neither right nor wrong because the crowd disagrees with you. You are right because your data and reasoning are right.”

2 – Beating the Street by Peter Lynch. The second book by one of the best mutual fund managers of all time contains dozens of mini case studies explaining why he bought certain stocks. It also contains the classic list of “Peter’s Principles,” including gems like, “Never invest in any idea you can’t illustrate with a crayon.”

3 – The Five Rules for Successful Stock Investing by Pat Dorsey. If you do nothing but stick to these five rules, you’ll be miles ahead of other investors. This is a great but still underappreciated book that covers a huge range of material exceptionally well.

4 – Common Stocks and Uncommon Profits by Phil Fisher. This classic explains how to pick stocks with low risk but high potential growth. As opposed to Graham’s numbers-based methods, Fisher advocates a qualitative approach to investing.

5 – The Essays of Warren Buffett, edited by Lawrence Cunningham. This collection of Buffett’s letters to shareholders over the years is unparalleled in terms of learning how to think independently about business, investing and Wall Street.

Finally, while I haven’t finished it yet, I can also strongly recommend Joe Ponzio’s F Wall Street. Joe, too, is a fan of Warren Buffett, and he does a superb job of explaining Buffett’s key concepts.