After weeks of historic events in the financial sector, Congress passed, and President Bush signed into law, the “Emergency Economic Stabilization Act of 2008” (the “Act”). Despite media hype, the Act is not really a “bank bailout” but rather a significant and controversial federal initiative to provide a vehicle for financial institutions with certain types of problem debt to (a) sell that debt to a government entity or (b) secure a federal guarantee of collection of that debt for the lender. In either instance, it is an attempt to provide liquidity, stability, and confidence to a system that has become frozen in its tracks due to pressures arising from the complex combination of a comprehensive credit crunch and election year politics.
Unlike the ’80’s, the current situation is largely a liquidity-based crisis which, for most of the banking institutions that have failed, resulted from adverse publicity and the classic “bank run” triggered by media coverage and the self-fulfilling prophecy that ensued.
The Act establishes a “Troubled Asset Relief Program” and a “Troubled Asset Relief Fund” that will be used to facilitate the purposes of the Act. Programs will be implemented by Treasury to purchase “troubled assets,” or to guaranty collection of troubled assets in certain circumstances, subject to the terms of the Act and rules yet to be adopted. Treasury will implement its responsibilities primarily through a new “Office of Financial Stability,” which will exercise its authority in conjunction with the federal banking regulators as well as HUD.
The Act contains a number of conditions to participation that institutions (and their boards) will need to carefully consider and weigh in determining whether to participate. As always, the devil is in the details. Each institution will need to review and analyze potential participation based on its own specific needs and strategic plans.
The following are certain highlights of the Act which may be of interest to institutional lenders.
Eligible Lenders and Eligible Debt
Eligible lenders include banks, S&L’s, credit unions, securities broker/dealers, and insurance companies. Eligible debt includes all “mortgagerelated assets” originated or issued before March 14, 2008, which encompasses residential mortgages as well as commercial real estate debt and any related securities, obligations, or other instruments. The Act enables the Treasury to purchase or to guaranty troubled assets, subject to payment of a premium by the impacted institution in the case of a guaranty. Guidelines are required to be published by Treasury within 45 days to explain the method for identifying, valuing, pricing, and purchasing eligible “troubled assets.”
Consequences of Participation
The “bailout” comes with strings attached. Equity warrants or subordinated debt will be required to be provided by some institutions that participate in the process, and there are significant restrictions on executive compensation which may adversely impact executive retention for troubled institutions at the very time it may be most important to attract and retain key executives. Executive compensation programs will be scrutinized for terms that encourage unnecessary and excessive risk taking, and there are clawback provisions as well as restrictions on “golden parachutes” for executives of participating lenders.
Warrants or debt may not be required, however, participation by an institution is less than $100 million in the aggregate. As a result, most community banks will likely not need to be concerned with this issue if they choose to participate. The potentially dilutive impact of such debt or equity issuance in any event is uncertain, and may be a significant deterrent to participation.
Lenders will also need to pay premiums related to the referenced “guaranty” participation. Participation will also entail significant public reporting and disclosure obligations for Treasury that may well translate to important reputation risk considerations for participants.
Many of the mechanics of the program, including how the sale and guaranty process will be conducted, relevant cost, and by whom at the federal level, remain to be determined. Treasury has already issued a request for indications of interest by potential “financial agents”, i.e. private contractors to assist Treasury in implementation of the loan purchase program.
Increased FDIC Deposit Coverage
The Act includes a temporary (October 3, 2008 through December 31, 2009) increase in FDIC deposit coverage from $100k to $250k. The “temporary” nature of the increase raises a number of issues, including whether termination of the increase at the end of 2009 would result in uncertainty and deposit runs at that time, and it is likely that the “temporary” increase may become permanent. The FDIC may not take the temporary increase into account in setting deposit assessments, however FDIC premiums are likely to increase anyway. Whether the increased deposit coverage will result in increased (or at least stabilized) deposit levels remains to be seen.
The Act directs the SEC and the Federal Reserve to study and analyze mark-to-market accounting issues and standards. Whether further actions in that regard will be forthcoming from Congress or the regulatory agencies is unfortunately unclear.
Fannie/Freddie Investment: Tax Assistance
The Act provides some level of tax assistance in that certain banks selling Fannie Mae and Freddie Mac stock can treat losses as offsetting ordinary income, which should help institutions suffering losses from Fannie and Freddie investments.
The troubled asset purchase program may serve indirectly to assist and facilitate potential financial institution M&A activities by providing a ready vehicle to purchase troubled assets from participant balance sheets. Likewise, other aspects of the Act, including mark-to-market opportunities, when combined with recent Federal Reserve and IRS initiatives (relating to enhanced opportunities for private equity and merger treatment of problem loans), may serve to enhance M&A opportunities in the financial services sector.
The Act also provides for a federal “override” of certain “standstill” and other restrictive contractual terms that may be contained in M&A agreements for troubled institutions (institutions receiving FDIC assistance or that have been seized by the FDIC) in order to facilitate a broader range of potential M&A opportunities for those institutions. The impact of those changes on potential transactions remains to be seen.
Again, the devil is in the details and implementation issues abound. Whether it will ultimately be in the best interests of institutions to participate in the process will need to be addressed by each institution on a case-by-case basis.