After a stunning defeat on Monday and an equally stunning market reaction that saw the S&P 500 fall by the largest margin since the crash of 1987 and the Dow experience the largest intraday point decline in its history, proponents of a bill that authorizes the largest government rescue in U.S. history succeeded in obtaining Senate approval. The legislation, titled the Emergency Economic Stabilization Act of 2008 (the “EESA”), grants the U.S. Treasury Secretary (the “Secretary”) the authority to establish a program – to be known as the Troubled Asset Relief Program (or “TARP”) – to buy mortgage-related and other troubled assets in order to restore the capital base of financial institutions holding the troubled assets.

Having passed in the Senate, the bill now goes to the House of Representatives for a vote (currently anticipated on Friday). If passed, the bill then needs to be signed by the President to become law.

We set out below the principal features of TARP. Note that a number of the details of how TARP will work are to be set out separately in program guidelines (due within 45 days of enactment). Note also that the elements of TARP approved by the Senate are the same as those included in the House bill defeated on Monday. The difference between the two is that the legislative package submitted to the Senate also included a temporary increase in the maximum coverage of FDIC deposit insurance from $100,000 to $250,000 and extension or expansion of a range of tax relief programs.

In brief:

  • Up to $700 billion may be used to buy troubled assets from financial institutions. The money would be disbursed in tranches – $250 billion is to be available immediately, the next $100 billion is to be available upon certification by the President that it is needed, and the remaining $350 billion will become available (if needed) unless, within 15 days of the request, Congress objects through a joint resolution. 
  • Sellers of troubled assets (“participating institutions”) will be required, subject to a de minimis exception, to issue warrants to Treasury exercisable for nonvoting common or preferred shares, or voting shares as to which the Secretary will waive voting rights (or, in the case of participating institutions that are not listed in the United States, warrants for common or preferred shares or senior debt instruments).
  • Participating institutions selling more than $300 million of troubled assets in an auction would be subject to limitations on the ability to provide new “golden parachute” arrangements to certain senior executive officers. Those institutions selling troubled assets directly, where Treasury has a meaningful equity participation, would be subject to limitations on golden parachutes. They would also be subject to limitations on compensation that increases risk-taking and provisions for bonus recapture where earnings or other statements later prove to be materially inaccurate. Separately, participating institutions with sales of more than $300 million (excluding sales made directly, if any such institution only sells directly) would not be entitled to tax deductions for annual compensation payable to their CEO, CFO and their three other most highly compensated officers in excess of $500,000 per covered employee. 
  • Treasury is to create a federal insurance program, the premiums for which are to be paid by participating institutions. 
  • Oversight is to be provided by a newly established Financial Stability Oversight Board, consisting of the Chairman of the Fed, the Secretary, the Chairman of the SEC, the Director of the Federal Housing Finance Agency and the Secretary of Housing and Urban Development, as well as by an Office of the Special Inspector General for TARP and a Congressional Oversight Panel. 
  • Judicial review of Treasury decisions will be available. 
  • The SEC will have authority to suspend the application of the mark-to-market accounting standards in Statement of Financial Accounting Standards No. 157 (fair value measurements). The SEC is also directed to study the mark-to-market accounting standards and to report its findings to Congress within 90 days. 
  • In five years, if TARP has generated a shortfall, the President is to submit proposed legislation to recoup amounts from the financial industry to avoid adding to the deficit or national debt.

Another Week and a Half that Was

he approval capped a 10-day period of intense, and unprecedented, political activity, overshadowed only by the continued unprecedented turmoil in the financial markets, with the U.S. money market funds fleeing to safety, selling commercial paper, withdrawing funds from the interbank market and buying short-term government paper and the equity markets experiencing huge swings.

Since our last update on “the week that was” (September 14-20), the proponents of the Treasury plan went on the offensive in the halls of the Capitol and on the airwaves. Last Wednesday, President Bush, in the only address of his presidency devoted exclusively to the economy, appealed for support at a time of deep unease across the political spectrum and the country. Meanwhile, with the U.S. election only weeks away, the two presidential candidates weighed in on aspects of the proposal, adding to the political drama as Congressional staff and Treasury officials worked round the clock to finalize a legislative package before the scheduled recess of Federal lawmakers. An expected agreement failed to materialize last Thursday night, sending the markets into a further frenzy on Friday. Negotiations were complicated by a counter-proposal submitted by House Republicans based on an industry-funded insurance pool, in lieu of the taxpayer-funded Treasury proposal.

With all eyes on Washington, negotiations resumed Friday, continued through Saturday and well into the night, with agreed legislation posted late Sunday night. Among other things, a proposed “say on pay” provision, proposed authority to permit bankruptcy judges to modify mortgage obligations and a proposed diversion of 20% of asset sale profits for affordable housing were dropped. The alternative insurance plan proposed by House Republicans was folded into the purchase-based TARP, and the inclusion of a shortfall recovery provision (from the industry, after five years) appeared to have sealed the deal.

On Monday, the legislation was submitted to the House, and in an outcome that stunned the nation, the proposal was defeated. The markets reacted instantly, with heavy selling pressure on large investment banks and regional banks. The Dow closed down 777 points, a slide of 7%, and the S&P lost 8.8%. Investors fled to the safety of government securities. During the day, in response to continued strain in the credit markets (spreads on interbank lending rates hit new highs), the Fed injected further liquidity into the system and expanded its temporary reciprocal lending arrangements by $330 billion. The next day, Asian markets plunged, with bank stocks hit the hardest, while the U.S. market closed up.

To win support from lawmakers who voted against the bill on Monday, the backers of TARP added a package of additional measures, which expand and/or extend a variety of individual and business tax breaks, including tax credits for the production and use of renewable energy sources, such as solar energy and wind power, business tax credits for research and development and the child tax credit. The additional measures also cancel the alternative minimum tax for millions of families and provide tax relief to victims of recent floods, tornados and severe storms. A summary of the key elements of the EESA and TARP is set forth below.

The legislation is expected to proceed to a vote in the House of Representatives tomorrow.

Key Elements of the EESA/TARP

The bill approved by the Senate has the following key elements:

Authority. The Secretary is authorized to purchase “troubled assets” from “financial institutions.”

Term. Authority in respect of TARP terminates on December 31, 2009, subject to extension until the second anniversary of enactment of the EESA. The authority to hold troubled assets is not subject to these termination dates.

“Troubled Assets.” Troubled assets are defined as residential and commercial mortgages and other securities, obligations and instruments based on or related to such mortgages, in any case originated or issued before March 14, 2008. The Secretary may treat other financial instruments as “troubled assets” if the purchase of the assets would promote financial market stability. In making such a determination, the Secretary would be required to consult with the Chairman of the Fed and provide notification to Congress.

“Financial Institution.” The term “financial institution” may also be interpreted broadly. The term includes any institution, including, but not limited to, any bank, saving association, credit union, securities broker or dealer, or insurance company “established” and regulated under the laws of the United States and that has significant operations in the United States. It excludes non-U.S. central banks. The use of the phrase “but not limited to” appears to permit the Secretary to include other types of institutions not specifically listed. In light of some of the other requirements of the EESA, such as the limitations on compensation and the obligation to provide equity participations, non-U.S. institutions will have additional issues to consider as they weigh the consequences of participation. The replacement of “organized” with “established” (from prior drafts) reflects input from the perspective of non-U.S. institutions, though the use of the term “licensed” may have been clearer.

Mechanisms. The EESA does not mandate how TARP will operate. Instead, the Secretary is to issue program guidelines no later than 45 days after enactment of the EESA or, if earlier, the end of the second business day after the first purchase under TARP. The guidelines are to address the mechanisms for asset purchases, the methods for pricing and valuing assets, procedures for the selection of asset managers and the criteria for identifying troubled assets for purchase. TARP is to ensure that assets are not purchased at a price higher than that initially paid for them by the selling institution.

The Secretary may hold assets to maturity or for resale, and may sell assets at prices to maximize the government’s return. The Secretary may also enter into securities loans, repurchase transactions or other transactions in respect of purchased troubled assets. Revenues and proceeds of sale, as well as from sale, exercise or surrender of warrants or senior debt received under TARP (see below), are to be applied to reduce the public debt.

The Secretary is to “encourage” private sector participation in purchases of troubled assets and in investment in financial institutions.

In making purchases, the Secretary is to purchase assets at the “lowest” price consistent with the purposes of the EESA. The Secretary may use auctions or reverse auctions and, where such mechanisms are deemed not feasible or not appropriate, may purchase troubled assets directly (using appropriate pricing measures). In determining whether to engage in direct purchases, the Secretary is to consider the long-term viability of the institutions in question.

Oversight. Oversight is to be provided by the newly established Financial Stability Oversight Board. The EESA also establishes an Office of the Special Inspector General for the Troubled Assets Relief Program and a Congressional Oversight Panel.

Insurance Program. If the Secretary uses the TARP authority to purchase troubled assets, the Secretary is required to establish a program to guarantee troubled assets issued or originated prior to March 14, 2008. Upon the request of a financial institution, the Secretary would guarantee principal and interest on troubled assets. Financial institutions that participate in the insurance program would pay premiums into a newly established Troubled Assets Insurance Financing Fund. Premiums could be based on credit risk of the assets being guaranteed. The Secretary is to publish the methodology for setting premiums by asset class.

Limits on Executive Compensation. The EESA imposes limits on executive compensation for financial institutions that participate in TARP. Institutions that sell assets directly rather than through an auction process would be subject to the following limitations:

  • no compensation incentives for senior executive officers to pursue business strategies that pose excessive risk to the institution;
  • a right on the part of the institution to recover bonuses and other incentives paid to senior executive officers based on reported results that subsequently prove to be materially inaccurate; and 
  • no golden parachute payments (undefined, but presumably include those described below) for senior executive officers while the Secretary holds an equity or debt position in the institution.

For purposes of these rules, covered officers are the CEO, CFO and three other highest paid executive officers, as presented in an SEC proxy statement (or its counterpart in the case of a private company).

Institutions that participate in auctions of troubled assets resulting in purchases (directly or through auctions) of more than $300 million would be barred from entering into new golden parachute arrangements for senior executive officers that would pay out on involuntary termination or insolvency events.

The EESA also provides for amendments to Section 162(m) of the Internal Revenue Code that, in effect, will limit participating institutions that sell assets in aggregate exceeding $300 million from deducting as an expense any compensation above $500,000 for each of the CEO, CFO and any of the three other highest paid officers in the institution. (Those that sell directly only would not count their sales towards the $300 million threshold.) Unlike the current Section 162(m) rules, the $500,000 deduction limit has no performance compensation exception.

Receipt of Equity/Debt Interests. The Secretary is directed, as a condition to buying troubled assets, to receive from participating institutions that are publicly traded in the United States, warrants for nonvoting common or preferred shares in the institution (or voting shares, as to which the Secretary would waive voting rights). With respect to participating institutions that are not publicly traded in the United States, the Secretary is to receive warrants for common or preferred shares or senior debt. The participation is to provide gains on sale and interest income for the benefit of taxpayers, as well as downside protection for asset sales. The Secretary can apply a de minimis exception (not to exceed $100 million) and such other exceptions/alternate arrangements where an institution cannot, as a legal matter, issue the securities in question.

Recoupment of Shortfall. Five years after the date of enactment of the EESA, the President must submit to Congress a proposal for recouping any losses incurred under TARP from the “financial industry” (prior drafts called for the burden to fall on participating institutions).

Next Steps

The next step is a vote in the House of Representatives, anticipated on Friday.

Assuming the EESA becomes law, many of the details of TARP will need to be worked out. And, as with any legislation that is rushed through against the backdrop of significant political pressure to “do something” and hardened positions, it remains to be seen whether in the short term confidence returns to the capital markets and whether the grip on market liquidity begins to loosen. (Keep an eye on the money market funds and the commercial paper market.)

Over the medium term, understanding and clarifying the details of implementation will be paramount. How troubled assets are priced, particularly in a housing market where prices remain in free-fall, can have a substantial impact on the market as well as on balance sheets. Over the longer term, questions of cost and ultimate success will keep economists, analysts and regulators busy for years.

In the meantime, attention will be focused on:

  • the program guidelines; 
  • the mismatch embedded in the definition of financial institution – some provisions of the EESA apply to a seller of the troubled assets, while others apply to the parent holding company; 
  • whether Treasury will also purchase Tier I preferred or similar instruments, as was done this week to rescue Fortis as well as historically in Japan and Sweden in response to their respective banking crises; and 
  • the implications of the equity participation requirement, and how the combination of the troubled assets and equity participations will be priced relative to the cash provided by Treasury: Will both be sold for fair value, or would Treasury have been better off getting a more readily saleable senior debt instrument? Will Treasury be able to overpay for assets and get the warrants as well? Or are the warrants the equivalent of a penalty, with the assets and warrants expected to exceed the amount of the purchase price?

And in Other Developments

Short sales. The SEC issued guidance on its emergency short sales prohibitions and issued additional guidance regarding the sale of loaned but recalled stock. Last night, citing the pending efforts in Congress to pass the EESA, the SEC extended its September 17 and 18 emergency relief as follows:

  • the short sale prohibitions in respect of the specified institutions (on the list initially of 799 financial institutions, but since enlarged) are extended to 11:59 p.m. ET on the third business days after enactment of the EESA (but in any case not beyond October 17); 
  • the Form SH reporting requirements are extended to 11:59 p.m. ET on October 17, but the SEC has indicated that these requirements will continue after that date in the form of an interim final order, pending a comment period and final rulemaking; 
  • the relief for issuer repurchases (under Rule 10b-18) is extended to 11:59 p.m. ET on October 17; and 
  • the hard T+3 close-out requirements for naked short selling are extended to 11:59 p.m. ET on October 17, but the SEC has indicated that these requirements will continue after that date in the form of an interim final order, pending a comment period and final rulemaking.

Rejection of the standalone model. Goldman Sachs and Morgan Stanley received approval from the Federal Reserve to become bank holding companies, subjecting them to regulation and oversight by the Federal Reserve.

Money market funds. The Treasury Department clarified that its guaranty program for money market funds would include taxable as well as tax-exempt funds and that coverage would apply to investments in funds as of the close of business on September 19. Further details are to be forthcoming shortly.

Further casualties. After its credit ratings were downgraded to below investment grade, a drastic fall in its stock price and a massive outflow of deposits, Washington Mutual was seized by U.S. government regulators and its deposit assets were sold to JPMorgan Chase. The FDIC was appointed receiver. “Qualified Financial Contracts,” which include swaps, options, futures, forwards and repurchase agreements, were also transferred to JPMorgan Chase.

There were press reports that the Federal Bureau of Investigation had begun an investigation of various financial institutions and individuals.

Meanwhile in Europe, the weekend saw a flurry of activity around Bradford & Bingley Plc (in the UK), Fortis (a Dutch/Belgian banking and insurance group) and Hypo Real Estate Holding AG (in Germany). Bradford & Binlgey was nationalized, while the governments of Belgium, Holland and Luxembourg moved to rescue Fortis. Germany guaranteed loans to Hypo Real Estate. The following day, Belgium rescued Dexia with a capital injection, and Ireland agreed to provide guarantees in respect of deposits and liabilities at six Irish banks. The rescues raise questions as to whether there will be further casualties in Europe and whether European regulators will be able to act in a coordinated fashion in light of the regime of national legislation in place in the EU. At this time, regulators appear unwilling to consider an EU bailout should one or more become necessary, while the unilateral actions taken by Ireland have been criticized as undermining efforts of the EU to develop a coordinated response.

Back in the United States, the FDIC announced that “Citigroup Inc. will acquire the banking operations of Wachovia … in a transaction facilitated by the [FDIC].”

Credit default swaps. Last week, the SEC Chairman, following the lead of New York State, turned his attention to credit default swaps (“CDS”) and other credit derivatives and urged Congress to provide the SEC with the authority to regulate these instruments. The Governor of New York announced that New York State would regulate CDS, at least to the extent that the buyer of the CDS protection owns the underlying reference security. In these cases, the seller of the protection would be deemed to be selling insurance and required to be licensed in the State of New York under the New York State Insurance Law. These requirements would not apply where the buyer, at the time the swap is entered into, does not hold, or reasonably expect to hold, a “material interest” in the reference obligation (as contemplated by guidelines issued by the New York State Department of Insurance in Circular No. 19 (“Best practices for financial guaranty insurers”)).

Minority investments in banks. In another sign of the times, the Federal Reserve issued a policy statement on equity investments in banks and bank holding companies, which sets forth its views on the general question of when a minority investor (holding 10.0% - 24.9% of voting stock) in a bank or bank holding company would become subject, by reason of the investment, to supervision, regulation and other requirements applicable to bank holding companies under the Bank Holding Company Act and related regulations. However, the Fed left for another day application of its views on control to a group of multiple investors making a contemporaneous investment in a bank or bank holding company. The principal concern of minority investors has not been triggering the bright line tests (control over, or the power to vote, 25% of voting securities or controlling the election of a majority of the board), but rather on the limits of the third prong: a determination that an investor exercises a “controlling influence” over management or policies. The policy statement addresses board representation, total equity ownership, consultation with management, business relationships and covenant protection.

Elimination of the CSE program. On Friday, the SEC announced the elimination of the Consolidated Supervised Entities (“CSE”) program, which was established in 2004 as a way for global investment banks to avoid regulation abroad by voluntarily submitting to SEC oversight. Under the program, the SEC had responsibility for the oversight of capital, leverage and liquidity levels at investment bank holding companies like Goldman Sachs, Morgan Stanley, Merrill Lynch, Lehman Brothers and Bear Stearns – authority that went far beyond the agency’s traditional regulation of broker-dealers. The decision to eliminate the CSE program was a tacit concession that the SEC does not have the expertise or the resources to regulate these financial institutions on an entity-wide level. Going forward, in the newly reconstituted landscape of U.S. financial institutions, all of the surviving investment banks that were part of the CSE program will be subject to statutory supervision by the Federal Reserve under the Bank Holding Company Act.

Mark-to-Market Accounting. In the face of significant criticism of the mark-to-market accounting rules (SFAS 157 – fair value adjustment) and calls from some quarters to suspend them, the SEC and the FASB issued a clarification on mark-to-market accounting, ahead of release by the FASB of further guidance.