On Monday, the U.K. Treasury announced a financial sector rescue that included a government-led recapitalization of the banking sector and a new government program to guarantee inter-bank borrowings. As early as this evening, Treasury Secretary Paulson may announce a plan to use his authority under the Emergency Economic Stabilization Act of 2008 (EESA) to invest directly in financial institutions by purchasing newly issued equity securities directly from the issuing financial institutions. As the credit markets remain frozen, a recapitalization through direct government capital injection in return for an equity stake may offer more immediate relief by giving banks sufficient capital to continue warehousing non-performing assets while also resuming lending. Yesterday, White House Press Secretary Dana Perino stated that "It was a part of the rescue package that the President supported, and it gives the Treasury Secretary a range of possibilities, and investing in banks directly was one of those authorities."
Secretary Paulson may also announce a plan to implement some form of governmental support to stimulate inter-bank lending, although the Federal Reserve already appears to be using everything in its ample Section 13(3) toolkit to accomplish that goal. Also reportedly under consideration is a further expansion of federal deposit insurance coverage (which was temporarily increased in EESA from $100,000 to $250,000 for individual accounts).
While EESA's use of the term "troubled asset" might imply to the casual reader that the Treasury Department may only purchase an instrument that is already an "asset" on the balance sheet of a financial institution, that is not, in fact, the case. Under EESA, Treasury's authority to purchase "troubled assets" specifically includes "any other financial instrument that the Secretary of the Treasury, after consultation with the Board of Governors of the Federal Reserve System, determines the purchase of which is necessary to promote financial market stability...." This language is broad enough for Treasury to justify treating capital stock of financial institutions as "troubled assets" if the Secretary concludes that purchases are "necessary to promote financial stability."
However, there are a number of critical questions that Treasury will have to answer:
What criteria will be used to determine which banks will be eligible to receive government investment?
Will the program be voluntary? May banks refuse to participate in the plan, whether to avoid shareholder dilution or for fear of being stigmatized?
What form will the investments take? Cumulative vs. non-cumulative and perpetual vs. limited life preferred (each has important regulatory capital implications)? Convertible vs. non-convertible preferred or debt securities? If the Treasury acquires non-convertible preferred or debt security, must it also receive warrants or similar equity participation rights, as it must with most purchases of "regular" troubled assets?
How will the security be priced (both purchase price and dividend rate, if any), if the security is not already traded on a national securities exchange?
What executive compensation limitations will Treasury require as a condition of the investment, in light of the requirements of Section 111 of EESA?