Following the surprise failure of the House of Representatives to pass a financial rescue package, the Senate on Wednesday responded to the request of the Secretary of the Treasury to authorize the purchase of troubled mortgage assets. The Emergency Economic Stabilization Act of 2008, as it is called, would provide up to $700 billion to the Treasury Secretary to buy mortgages and other assets with the goal of restoring liquidity and stability to the United States financial system. The Senate bill, which mirrors the bill that the House rejected, would provide the Treasury Secretary with the requested authority and establish a variety of oversight mechanisms to help ensure that the program is implemented in a manner that protects taxpayers and provides accountability. The Senate bill adds a temporary increase in deposit insurance and number of energy and tax-related provisions in an effort to make the legislation more attractive to those House Republicans who voted against the rescue package.

Troubled Assets Relief Program 

The primary feature of the Act is the creation of a Troubled Asset Relief Program (“TARP”) to purchase troubled assets from financial institutions. “Troubled assets” are defined to mean residential or commercial mortgages, or any securities that are based on such or related to such mortgages (such as mortgage-backed securities or collateralized mortgage obligations), that in each case was originated or issued on or before March 14, 2008. In addition, the Treasury Secretary can deem any other financial instrument a troubled asset after consultation with the Chairman of the Board of Governors of the Federal Reserve and communication of such determination to the appropriate committee of Congress.

The Act would establish an Office of Financial Stability within the Treasury Department to implement TARP and requires the Treasury Secretary to consult with the Federal Reserve Board, the FDIC, the OCC, the OTS and the Secretary of Housing and Urban Development in such implementation. The Treasury Secretary would be required to establish guidelines and policies to carry out the provisions of the Act, but would be given broad authority to take necessary actions to execute the program. The authority for TARP would expire on December 31, 2009, but may be extended by the Treasury Secretary to a date not later than two years from the date of the Act upon certification of need to Congress.

A second element of the relief package is a program to guarantee troubled assets of financial institutions through the creation of a Troubled Assets Insurance Financing Fund. The Treasury would establish risk-based premiums for such guarantees at a level calculated to create reserves sufficient to meet anticipated claims. 

The Act would give the Treasury Secretary total purchase authority of $700 billion, of which $250 billion would be available immediately. Upon a Presidential certification of need, the Treasury may access an additional $100 billion. The final $350 billion may be accessed if the President transmits a written report to Congress requesting such authority and Congress does not pass a joint resolution of disapproval within 15 days. The Treasury’s purchase authority is reduced by an amount equal to the difference between the total of all outstanding guaranteed obligations and the balance of the Troubled Assets Insurance Fund.

As a condition to selling troubled assets to the Treasury, a financial institution must issue to the Treasury either a warrant to purchase non-voting common stock or preferred stock (in the case of a publicly traded institution) or a senior debt instrument (in the case of all other institutions). Institutions that sell less than $100 million of troubled assets would be excluded from this requirement.

Government Oversight 

The Act would establish the Financial Stability Oversight Board for the purpose of reviewing and making recommendations regarding the exercise of authority granted under the Act. The Board would be comprised of the Federal Reserve Chairman, the Treasury Secretary, the Director of the Federal Home Finance Agency, the Chairman of the SEC and the Secretary of the Department of Housing and Urban Development. 

The Act would also establishes various reporting requirements, including monthly financial reports and detailed reports to Congress following the purchase of every $50 billion of assets. In addition, prior to April 30, 2009, the Treasury Secretary would be required to submit a report to Congress on the current state of the financial markets and the effectiveness of the financial regulatory system.

The Act would create several layers of oversight. The Comptroller General would be given oversight of TARP and would be required to report to Congress every 60 days and to perform an annual audit. The Act would create the Office of the Special Inspector General for the Troubled Asset Relief Program, with a Special Inspector General who will be appointed by the President. Finally, the Act would create a Congressional Oversight Panel to review the state of the financial markets, the regulatory system and the use of authority under TARP.

Temporary Increase in Deposit Insurance

The Act would temporarily increase federal deposit insurance from $100,000 to $250,000. Share insurance for federally insured credit unions would receive an identical increase. The temporary increase in deposit insurance would expire December 31, 2009.

Homeowner Assistance

For mortgages and mortgage-backed securities acquired through TARP, the Treasury Secretary must implement a plan to mitigate foreclosures and to encourage servicers of mortgages to modify loans through Hope for Homeowners and other programs. The Act would allow the Treasury Secretary to use loan guarantees and credit enhancements to avoid foreclosures. The Act also would require other federal entities that hold mortgages to take similar actions to minimize foreclosures and encourage loan modifications.

Executive Compensation and Corporate Governance

The Act would require the Treasury Secretary to promulgate executive compensation rules governing financial institutions that sell troubled assets through TARP. If the Treasury purchases troubled assets directly from an institution and receives a meaningful equity or debt position in the institution as a result of the transaction, the institution must meet certain compensation standards, which include limits on incentives that would encourage taking unnecessary and excessive risks, clawback provisions for bonuses or incentives that are based on financial statements that are later proven to be materially inaccurate, and prohibitions on making any golden parachute payment to senior executives while the Treasury holds an equity or debt position in the institution. The Treasury would have to define what a “meaningful” position would be for purposes of applying these restrictions on compensation.

When the Treasury purchases assets at auction, an institution that has sold more than $300 million of troubled assets will be prohibited from entering into any new employment agreement with a senior executive officer that provides a golden parachute in the event of an involuntary termination, bankruptcy filing, insolvency or receivership. This prohibition will apply for so long as TARP is in effect.

Interest on Reserves

In 2006, legislation was enacted that would permit the Federal Reserve to pay interest on reserves beginning October 1, 2011. The Act accelerates this date to October 1, 2008.

Authority to Suspend Mark-to-Market Accounting

The Act would authorize the SEC to suspend the application of the Financial Accounting Standards Board’s Statement No. 157, “Fair Value Measurements” for any issuer or with respect to any class or category of transaction. This accounting statement, which establishes a framework for measuring fair value under generally accepted accounting principles and expands disclosures about fair value measurements, has been blamed by many for substantial write-downs in assets that do not have quoted prices in active markets.

Reimbursement from Financial Institutions

The Act would require that, in five years, the President must submit to Congress a proposal that recoups from the financial industry any projected losses from TARP. This provision could ultimately lead to the imposition of an assessment on all financial institutions to recover the cost of TARP.

Tax Provisions

The Act would require that gain or loss from the sale of preferred stock issued by Fannie Mae or Freddie Mac by a financial institution be treated as ordinary income or loss, rather than a capital gain or loss. This provision would allow the many financial institutions that held preferred stock of these government sponsored enterprises to use the losses they have recognized to offset ordinary income. To be eligible for this special tax treatment, the financial institution must have held the preferred stock on September 6, 2008 or have sold the preferred stock on or after January 1, 2008 and before September 7, 2008.

Section 162(m) of the Internal Revenue Code imposes limits on the deductibility of executive compensation in excess of $1 million. Under the Act, compensation to covered executives in excess of $500,000 would not be deductible by any financial institution that sells more than $300 million of troubled assets to the Treasury, excluding amounts sold through direct purchases. The Act also would amend Section 280G with respect to the golden parachute rules.