This afternoon, Treasury announced the terms of its previously announced Capital Assistance Program (CAP), a key element of Treasury’s Financial Stability Plan announced on February 10. Also today, the Federal Reserve, FDIC, OCC and OTS announced that they would be jointly conducting “forward-looking economic assessments” (popularly referred to as stress tests) of 19 large U.S. banking organizations “to estimate the range of possible future losses and the resources to absorb such losses over a two-year period.” If that assessment leads an institution’s regulators to conclude that the institution needs additional capital, it “will enter into a commitment to issue a CAP convertible preferred security to the U.S. Treasury in an amount sufficient to meet the capital requirement determined through the supervisory assessment,” although the institution will be given six months to seek to raise private capital instead.
Treasury has issued a “white paper” setting forth its rationale and goals for the CAP, a public term sheet setting forth the terms on which eligible publicly traded financial institutions may participate in the CAP, a set of FAQs for the CAP, and application guidelines and a form of application for CAP participation. Following are key terms of the CAP:
- Qualifying financial institutions (QFIs) – as with the Capital Purchase Program (CPP), QFIs generally include any U.S. bank, savings association, bank holding company, and savings and loan holding company that is not controlled by a foreign bank or company. As was the case under the CPP, for purposes of CAP eligibility, the deadline for approval of any holding company application is January 15, 2009. All QFIs are eligible to participate, whether or not they participated in the CP and even if they are not required to undergo the stress tests required of the largest QFIs. Only publicly traded QFIs are eligible to participate at this time. Treasury states that it intends to issue CAP terms for non-publicly traded QFIs, S corporations and mutuals.
- Participation – QFIs must apply to participate before 5:00 p.m. EST on May 25, 2009, and, as with the CPP, application is made through the organization’s primary federal regulator, rather than directly to Treasury. QFIs required to undergo a stress test need not await the results of that assessment before applying.
- Closing – QFIs “will have up to six months after receiving preliminary approval to close the transaction.” During that time period, QFIs have the opportunity to seek private capital to replace the CAP capital.
- Security Purchased – Treasury will purchase preferred stock that is mandatorily convertible to common stock. As with the CPP preferred stock, the convertible preferred stock will be senior to common and junior preferred stock and pari passu with any existing senior preferred stock, including any CPP preferred stock or preferred stock issued under the Targeted Investment Program (TIP).
- Amount of Funding – Each QFI may issue an amount of convertible preferred equal to between 1% and 2% of its risk-weighted assets plus any additional amount so long as the proceeds of the additional amount are used to redeem preferred shares issued to Treasury under the CPP or TIP. The issuance of convertible preferred to Treasury will be treated as a “Qualified Equity Offering” under the CPP to the extent its proceeds are used to redeem CPP preferred stock (effectively exchanging CPP preferred stock for CAP convertible preferred) and the proceeds so used will also count towards the Qualified Equity Offering proceeds that are required to be raised in order to reduce the number of shares of common stock underlying the Treasury’s CPP warrant.
Any QFI that seeks to issue convertible preferred in excess of these amounts will require the approval of its primary federal regulator and will be regarded as having received “exceptional assistance,” with all of the implications that go with that designation (including compliance with stringent executive compensation restrictions).
- Conversion to Common Stock – The convertible preferred will be convertible into shares of common stock at a conversion price equal to 90% of the average closing price for the common stock for the 20 trading day period ending February 9, 2009, subject to customary anti-dilution adjustments and subject to possible additional reductions if required stockholder approvals are not obtained on a timely basis. The convertible preferred will convert as follows:
- automatically after 7 years from issuance;
- at the option of the holder, “upon specified corporate events, including certain sales, mergers or changes of control of the QFI”;
- at any time at the option of the QFI, subject to regulatory approval. (Note: Treasury’s white paper states that the QFI can convert the preferred, with regulatory approval, “if needed to preserve lending in worse-than-expected economic environment.”)
Upon conversion, the QFI must pay any accrued and unpaid dividends, but has the option of paying in either cash or additional shares of common stock (valued for this purpose at the closing price on the second preceding trading day, rather than the conversion price).
- Redemption – The convertible preferred may be redeemed only with regulatory approval and only with the proceeds of issuances of common stock for cash totaling at least 25% of the issue price of the convertible preferred or from additions to retained earnings. Subject to those conditions, the convertible preferred can be redeemed during the first two years at par, plus accrued but unpaid dividends, and after two years, at the greater of par plus accrued and unpaid dividends and the as-converted value of the preferred. Following the conversion of the convertible preferred into common stock, the QFI may, subject to regulatory approval, repurchase any shares of common stock held by Treasury at a price equal to the greater of the conversion price and the market price of the common stock on the date of repurchase (calculated based on the average closing price during the 20 trading day period beginning on the day after notice of repurchase is given), so long as the repurchase if funded from the proceeds of an issuance of common stock for cash or from additions to retained earnings.
- Dividends – The convertible preferred will bear cumulative dividends of 9%, payable quarterly, until converted or redeemed (subject to increase if shareholder approval is not obtained on a timely basis). So long as the preferred stock is outstanding, the QFI may not pay other dividends or repurchase or redeem shares, unless it is current on the payment of dividends on the convertible preferred. In addition, so long as Treasury holds any convertible preferred or common stock issued under the CAP , dividends on the common may not exceed $.01 per share per quarter, without Treasury approval, and Treasury’s consent is required for any repurchases of equity securities or trust preferred securities, subject to exceptions similar to those under the CPP.
- Voting Rights – As with the CPP preferred stock, the convertible preferred will be non-voting, except on class-specific matters on which preferred stock typically votes (including the right to elect two directors if dividends are unpaid for six dividend periods). Treasury will be entitled to exercise all voting rights in the common stock after conversion of the preferred, but Treasury will “publish a set of principles governing its use of these rights prior to closing any transactions.”
- Transfer of Shares – Treasury may transfer shares to any third party at any time, and will receive registration rights to facilitate transfers. In addition, after the mandatory conversion date, Treasury will make reasonable efforts to sell on an annual basis an amount of common stock equal to at least 20% of the total common stock owned by Treasury on the mandatory conversion date until Treasury owns no shares of common stock.
- Warrants – To comply with EESA requirements that Treasury obtain warrants or other contingent consideration when purchasing troubled assets, Treasury will receive warrants to purchase common stock with an aggregate exercise price equal to 20% of the senior preferred investment. The warrants will have a ten-year term and a per share exercise price equal to the conversion price of the convertible preferred, subject to typical anti-dilution provisions (and subject to possible further reduction if required stockholder approvals are not obtained on a timely basis). Unlike the common stock issued on conversion of convertible preferred, Treasury will not exercise voting rights on shares used on exercise of the warrant. Following redemption of all of the convertible preferred and common stock resulting from conversion of convertible preferred held by Treasury, the QFI may repurchase the warrant and any common stock issued upon its exercise then held by Treasury at fair market value.
The forward-looking economic assessments, or stress tests, are required for institutions with more than $100 billion of assets, which “comprise the core of the US banking system representing roughly two-thirds of aggregate U.S. Bank Holding Company assets.” As stated in the FAQs accompanying the joint announcement, the purpose of the assessment is “to estimate the range of possible future losses and the resources to absorb such losses over a two-year period … under two economic scenarios: a baseline and a more adverse scenario.” If an institution’s primary regulator concludes that the institution needs additional capital, the institution “will enter into a commitment to issue a CAP convertible preferred security to the U.S. Treasury in an amount sufficient to meet the capital requirement determined through the supervisory assessment,” subject to the six month opportunity to raise private capital instead.
The assessment will cover two economic scenarios: a baseline scenario and a more adverse scenario. The assumptions for real GDP growth and the unemployment rate for 2009 and 2010 in the baseline scenario “equal the average of the projections published by Consensus Forecasts, the Blue Chip survey, and the Survey of Professional Forecasters in February,” which were real GDP growth of (2.0)% for 2009 and 2.1% in 2010 and unemployment of 8.4% in 2009 and 8.8% in 2010. The housing assumptions in the baseline scenario are “consistent with the house price path implied by futures prices for the Case-Shiller 10-City Composite index and the average response to a special question on house prices in the latest Blue Chip survey,” which were a 14% year-over-year decline in house prices in 2009 and further 4% decline in 2010. The alternative “more adverse” scenario assumes real GDP growth of (3.3)% in 2009 and 0.5% in 2010, unemployment of 8.9% in 2009 and 10.3% in 2010, and a 22% year-over-year housing price decline in 2009 and a further 7% decline in 2010.Each institution will “analyze potential firm-wide losses, including in its loan and securities portfolios, as well as from any off-balance sheet commitments and contingent liabilities/exposures” under these two scenarios, and also “forecast internal resources available to absorb losses, including pre-provision net revenue and the allowance for loan losses.”
The regulators will review the analyses (particularly to “ensure they are appropriate, consistent with the firm’s underlying portfolio performance and reflective of each entity’s particular business activities and risk profile”) and discuss the analyses with the institution. Based on those discussions, the regulators will “determine whether the institution has a sufficient capital buffer necessary to ensure each institution has the amount and quality of capital necessary to perform their vital role in the economy.” In the end, the “assessment of the firm’s capital and the size of any potential needed additions to capital will be determined by the supervisors.”