The U.S. Federal Deposit Insurance Corp launched the first test of its Legacy Loans Program that could eventually help banks rid their balance sheets of toxic assets so they can raise new capital and increase lending, the agency said on Friday.

Officials at the FDIC, which insures the deposits of U.S. banks and acts as the receiver for failed institutions, said they will take final bids in late August or early September and declined to say which bank's toxic assets were involved in the test.

In the test transaction, a receivership will transfer a portfolio of residential mortgage loans to a limited liability company in exchange for an ownership interest in that entity, the agency said in a statement.

FDIC spokesman Andrew Gray declined to comment on the size of the asset pool. He said bidders must sign a confidentiality agreement in order to participate.

Royal Bank of Scotland and Deutsche Bank AG are the advisers to the FDIC on the program.

In its early stages, the pilot program is soliciting interest for the transaction and potential bidders are going through a qualification process, officials said.

No open and operating institutions are currently participating, FDIC officials said.

Accredited investors will be offered an equity interest in the limited liability company under two options.

The first is an all-cash basis, which is how the FDIC has recently sold receivership assets, with an equity split of 20 percent to the investor and 80 percent to the FDIC. The other option is a sale with leverage, under which the equity split will be 50-50 between the investor and the FDIC.

The FDIC said it will be protected against losses by the limits on leverage amount, the mortgage loans collateralizing the guarantee, and the guarantee fee.

The FDIC will analyze the results of this sale to see how the Legacy Loans Program can best further the removal of troubled assets from bank balance sheets, and in turn spur lending to further support the credit needs of the economy, the agency said.

FDIC officials did not rule out additional sales.

The test pilot differs from previous receiverships sales due to the inclusion of a leverage aspect that hasn't been utilized since the era of the Resolution Trust Corporation, a government trust that liquidated assets in the 1980s and 1990s during the savings and loans crisis.

The FDIC is also offering two leverage ratios for investors -- 6-1, which comes with certain performance strings attached, and 4-1, which has no strings attached.

For example with a 6-1 leverage, if the transaction price is $700 million, a note will be issued for $600 million and the remaining $100 million will be split evenly between the investor and the FDIC.

An investor who opts into the 6-1 leverage ratio will be required to meet certain performance thresholds and redirect some cash flows to lower the note in order to protect the lender, which is the FDIC.

For an all cash transaction, the investor would be liable for 20 percent, or $140 million, based on a $700 million price.

Investors might find the 6-1 leverage option too onerous, said University of Louisiana finance professor Linus Wilson, who questioned why investors would want to partner up with the government and put up a 20 percent stake equity without cheap leverage.

Thus, 4 to 1 leverage may be the more popular choice, Wilson said.

Officials said the note could be structured so that it is marketable instrument, similar to a mortgage-based security.

If the test proves successful, open and operating institutions will be able to shed troubled loans as long as the manager follows certain loan-servicing requirements under either the Home Affordable Modification Program guidelines or FDIC's loan modification program.

The Legacy Loans Program is part of the government framework called the Public-Private Investment Program, which also includes a separate program under the Treasury Department to sop up troubled securities.

The Treasury unveiled PPIP last year with the goal of enticing private equity firms who were sitting on the sidelines awaiting rules on when and how they could participate.

(Reporting by John Poirier and Julie Vorman; editing by John Wallace, Leslie Gevirtz and Bernard Orr)

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