The federal government’s efforts to stabilize the turbulent banking industry will undergo significant changes in the coming weeks. In a speech last Tuesday and in testimony last week before the Senate Banking, Housing and Urban Affairs Committee and the House Financial Services Committee, Secretary Geithner outlined a new approach, the Financial Stability Plan (the “Plan”), which includes five new or revised recovery programs. A few aspects of the Plan are addressed in the economic stimulus package, the American Recovery and Reinvestment Act (ARRA), that both the House of Representatives and the Senate approved last Friday, and that the President will sign today. We note the relevant ARRA provisions below.

This advisory briefly outlines the high points of each of the programs in the Plan, assesses the initial adverse reaction to the Plan, and describes the Plan programs in detail. We then explore several significant principles embedded in the Plan and their likely consequences — several of which may be counter-productive — and conclude with some observations about two core issues underlying the Plan.

The Plan

Five programs constitute the bulk of the Plan. All of the funding from Treasury for these programs will come out of the Troubled Asset Relief Program (TARP). Across all of the programs, Treasury has emphasized the themes of transparency and accountability, which may well affect a banking organization’s interest in participating in any one of the programs.

  • The Financial Stability Trust program (FST) contemplates heightened (but unspecified) supervision by the federal banking agencies, including a “stress test” for banks, provides for additional capital investments by Treasury (apparently separate from the existing Capital Purchase Program), and requires new and public reports. From the description of the FST, it is unclear whether an institution must pass a stress test — the underlying assumptions and measurements of which seem not to have been determined — to be eligible for the additional investments. Treasury has not placed a dollar figure on the amount of investments it is prepared to make.
  • The Public Private Investment Fund (PPIF) is heir to concepts that had circulated earlier about a “bad bank” or an “aggregator bank.” The PPIF is broadly comparable to these earlier proposals, in that the PPIF is intended to enable banking institutions to remove troubled assets from their balance sheets. No single “bank” or other entity, however, would make the purchases. Rather, the PPIF would help to finance purchases by private investors, up to at least $500 billion. To achieve the $500 billion level, it appears Treasury would have to commit about $100 billion to the fund.
  • The Consumer and Business Lending Initiative (CBLI) significantly expands the Federal Reserve’s existing Term Asset-Backed Securities Loan Facility (TALF) both quantitatively and with respect to the assets eligible for TALF. The enlarged program would entail an $80 billion investment from Treasury in addition to the $20 billion that Treasury already has committed.
  • The Affordable Housing Support and Foreclosure Prevention Plan (AHSFPP) will assist home purchasers and homeowners. The most concrete element of this program is the assignment of $50 billion of TARP funds to support loan modifications. President Obama is expected to announce further details about the AHSFPP during a speech tomorrow.
  • The Small Business and Community Lending Initiative (SBCLI) seeks to increase lending to small businesses by expanding the secondary market for these loans and loosening some of the eligibility requirements for loans insured by the Small Business Administration. There is not a dollar figure on this program.  

The Plan abandons certain proposals that had been discussed as possible programs for inclusion. The Plan does not contain a “guarantee” or “asset wrap” program that would support assets held to maturity by a banking organization. The Plan does not mention any bankruptcy cram-down concept that would allow bankruptcy judges to modify the terms of first-lien residential mortgage loans, nor does the Plan make any provision for assistance to monoline insurers in order to bolster the market for municipal bonds.1 The Temporary Liquidity Guaranty Program (TLGP) of the Federal Deposit Insurance Corporation (FDIC) also is not mentioned, although the FDIC could, of course, revise this program as it sees fit. The Plan draws on funds from Treasury and the Federal Reserve, but it does not attempt to tap the FDIC’s Deposit Insurance Fund.  

ARRA contains provisions on executive compensation and on the return of investments received under TARP that supersede portions of the Plan and that are important to potential participants in the Plan.  

The Reaction to the Plan

As presented, the Plan has met with unexpectedly negative reaction, both on Capitol Hill and in the markets. Secretary Geithner spent last Tuesday afternoon with the Senate Banking Committee and last Wednesday morning with the House Financial Services Committee. In both hearings, legislators from both parties complained about the lack of detail in the announced Plan. Stock prices fell dramatically in the 30 minutes during Secretary Geithner’s announcement. The Dow Jones industrial average dropped approximately 300 points in that half hour and was down approximately 4.6 percent for the day, while the Standard and Poor’s 500-stock index lost about 4.9 percent for the day.  

This reaction suggests at least two infirmities in the Plan as articulated. First, the announcement contained few details about the programs in the Plan, thus failing to dispel the uncertainty about the future of most banking organizations and about reasonable investment opportunities.  

Second, the total cost of the Plan remains unclear but makes commitments that easily could exceed the remaining $350 billion in TARP. The dollar figures stated in or inferable from the Plan would total $230 billion for three programs: the PPIF, the CBLI, and the AHSFPP. This result leaves $120 billion for the FST and the SBLCI.2 The capital support element in the FST appears to contemplate substantial investments in banking organizations, particularly the largest ones. Treasury’s first investments in the nine largest financial institutions totaled $125 billion. If the FST investments are comparable in amount, then the TARP funds would be exhausted. Further, if the PPIF is expanded to $1 trillion, another $100 billion contribution by Treasury would be required.  

The broad and intense reaction to the Plan is likely to complicate Treasury’s efforts to flesh out the details of and to implement the programs in the Plan. Public and congressional interest in the elements of the programs is likely to increase as the principles and consequences outlined above become more fully understood.  

Components of the Plan

Financial Stability Trust

The FST program is intended to restore confidence in banking institutions through enhanced supervisory and reporting requirements, as well as a new Treasury-funded capital investment program.

Supervisory Requirements. On the supervisory side, the FST program calls for more stringent supervision and analysis of the credit and other exposures on a banking organization’s balance sheet — an approach that is intended to be more forward-looking. The federal banking agencies have in recent years attempted to address some of these issues, particularly for “large and complex” institutions. Clearly more guidance will be forthcoming, but the substance is difficult to predict. Moreover, any broad agency guidance can always be modified for institutions on a case-by-case basis.  

The Plan also requires a “stress test” for “major institutions,” — i.e., those with assets in excess of $100 billion — to determine whether they have sufficient capital “to continue lending and to absorb the potential losses that could result form a more severe decline in the economy than projected.” The Plan is unclear what consequences will flow from “passing” or “failing” the test, although “failing” institutions certainly would undergo more intensive examination and supervision. However, since these largest institutions may each present some form of systemic risk, each of them probably will continue to be eligible for further capital investments from Treasury, and the stress test results would factor into the decision on the amount any of one investment. (The nature of these investments is discussed below.)  

Capital Assistance Program. The capital support element of the FST is the Capital Assistance Program (CAP), which is described as providing a “capital buffer” for banking institutions and as a bridge to additional private investment. It would appear that the largest banking organizations are eligible for CAP investments, regardless of how they perform on the stress test. Institutions with less than $100 billion in assets also are eligible with specific supervisory approval. The stress test also is a requirement for these institutions, but performance may not be determinative.  

The underlying assumptions and the metrics of the stress test have yet to be specified. The concept of the stress test is not entirely new; it is widely rumored that organizations with bank subsidiaries rated “3” (or worse) must, in order to receive Capital Purchase Plan (CPP) investments, demonstrate their ability to remain wellcapitalized during the current crisis, even without Treasury assistance. These demonstrations can include projections based on negative assumptions.

The application of the stress test to organizations with less than $100 billion in assets is not completely clear. Any bank’s federal regulator could require that any of its supervised institutions undergo the stress test — and indeed we expect that many institutions, both large and small, already must examine their financial performance under some kind of stress test.3 Although the Plan does not appear to apply the stress test to banking institutions across the board, any institution with less than $100 billion in assets that seeks additional capital from Treasury must undergo the test.  

The CAP investments appear to be along the lines of the current CPP investments. The CAP investments would be in the form of a preferred security instrument — presumably one that would qualify as Tier 1 capital — that is convertible into common stock. The conversion would be at the option of the recipient institution, although this decision probably would be substantially informed by its regulator “if needed to preserve lending in a worse-than-expected economic environment.” The dividend on the instrument has not been determined, and it may or may not include a dividend step-up as the CPP now requires. The exact conversion price also will be determined later, although the Plan states that the price will be at a modest discount from the prevailing market price of the common stock as of February 9, 2009. Whether the $120 billion that remains in TARP after other commitments in the Plan are accounted for will be sufficient for this purpose is uncertain. The instruments that Treasury receives under the CAP will be placed in the FST, a separate legal entity that will manage federal investments in U.S. banking institutions.  

Many important questions about investments under CAP remain unanswered. As a threshold matter, it is unclear whether, at least for institutions with less than $100 billion in assets, CAP targets healthy organizations or unstable institutions. The CAP investments are described as a “capital buffer” to preserve (or increase) lending ability in a worse-than-expected economic downturn. If a Treasury investment is necessary in order to ensure an adequate capital position, then it seems unlikely that a recipient institution would have demonstrated sufficient capitalization under the scenarios in the stress test. Also unresolved is the total amount available under the CAP. As noted above, Treasury will have no more than $120 billion available for CAP without an additional appropriation. The original CPP investments in the nine largest banking organizations totaled $125 billion.  

A provision of the ARRA allows a CAP recipient or any other TARP recipient to return the funds received. Until now, a recipient could return the funds only if it had raised replacement Tier 1 capital. A potentially significant prerequisite applies, however: The institution’s primary federal regulator must approve the return of funds. In the current economic circumstances, such approval may be difficult to obtain.  

Reporting. The FST program contemplates more detailed and public reports from banking organizations, regardless of whether an institution has received Treasury assistance or not. Treasury will work with the banking agencies, the SEC and accounting standard setters to “improve” public disclosures by banking organizations. The new reports will include “measures to improve the disclosure of the exposures on bank balance sheets.” The new requirements clearly will apply to publicly traded institutions; the Plan does not discuss application to privately held institutions.

Other Conditions. Institutions participating in CAP (or those that receive “extraordinary assistance” in the future) will be subject to several possibly onerous conditions, some of which already exist but in softened form.  

  • Reports on the Use of Plan Funds to Support Lending. Recipients of CAP investments or other “exceptional assistance” will have to document in various ways how the assistance they have received will expand lending. Specifically, in applying for CAP or extraordinary assistance funds, an institution must submit a plan that explains how it will use the funds to preserve and strengthen lending. Treasury will make these plans public.  

Additionally, each institution will have to make a detailed monthly report to Treasury, including new loans to businesses and consumers and the quantity of asset-backed securities (ABS) and mortgage-backed securities (MBS) purchased. The monthly report also must include a description of the lending environment in the communities and markets that the institution serves and a comparison with the institution’s most rigorous estimate of what its lending would have been in the absence of government support. While these monthly reports apparently will not be made public, there will be two significant public components. Publicly traded institutions will be required to include “similar reports” in a form 8-K filed simultaneously with their forms 10-Q or 10-K. Treasury also will use the reports to publish the key metrics showing the impact of the Plan on credit markets.

  • Foreclosure Mitigation. Participants must adhere to the foreclosure mitigation guidance that Treasury will issue.
  • Dividends, Stock Repurchases and Acquisitions. The FST program imposes three sets of restrictions:
    • First, as to dividends, “extraordinary assistance” recipients must reduce common dividend payments to $0.01 quarterly until the government investment is repaid. Other capital recipients — i.e., CAP participants — may pay higher dividends if Treasury and the recipient’s primary federal regulator agree that the higher dividends are consistent with the institution’s achievement of its capital planning goals.
    • Second, recipients may not repurchase any shares held by stockholders other than Treasury until Treasury’s investment has been repaid. A recipient may seek approval from both Treasury and its primary federal regulator to make repurchases before repayment to Treasury.
    • Third, both “exceptional assistance” and CAP recipients may not make cash acquisitions of healthy firms. Restructuring plans are not subject to this prohibition if the primary federal regulator agrees. The Plan does not attempt to distinguish between a healthy and an unhealthy institution.
  • Electronic Publication of Assistance Transactions. The publication feature is not strictly an obligation of assistance recipients but rather is an element of how Treasury will implement the FST. Recipients nevertheless should be aware that their participation will receive some publicity and will not be confidential. Treasury will post all contracts under the Plan on a website, FinancialStability.gov, within five to 10 business days of completion. The postings for capital investments will detail the value of the investment, the quantity and strike price of any warrants, the schedule of required payments to the government and when the government is being paid back. Terms and conditions, including pricing, of the new investments will be compared to the terms and conditions of recent market transactions, if possible.

Public-Private Investment Fund

Often compared to the “bad bank” concept, the PPIF is intended to spur private purchases of troubled assets from banking institutions in order to “cleanse” the balance sheets of those institutions. To do so, the PPIF will provide public financing in order to “leverage” private capital to produce $500 billion in financing for these purchases. Treasury may expand the program up to $1 trillion, although the funds necessary for such expansion is likely to exceed the funds remaining in TARP. According to some analysts, using a somewhat conservative leverage ratio of 4:1, Treasury would be able to generate the $500 billion with a $100 billion contribution. The prices of asset purchases financed by the CAP will be determined solely by negotiations between buyers and sellers; Treasury will have no role in this matter.

The form and terms of Treasury financing remain unclear, however. It may provide funds directly to support purchases, or it could provide certain guarantees or loss-sharing arrangements. Conceivably, sources of federal financing other than TARP funds could be used for PPIF, including loans from the Federal Reserve or the proceeds of FDIC-guaranteed bonds.

The central question about the PPIF is whether it will work. The critical fact that will answer this question is whether it will somehow cause the currently wide bid-ask spreads on troubled assets to narrow so that clearing

prices can be set and sales can occur. Indirectly, the availability of a presumably cheap source of credit to purchasers from Treasury could cause the purchasers to offer slightly higher prices; whether they will do so remains to be seen. Assuming that clearing prices are set, there could be significant effects on the capital positions of the selling banking organizations and even on those of non-selling institutions that must look to clearing prices to mark assets on their books.

Commercial and Business Lending Initiative

The CBLI represents a five-fold increase in the size of the TALF that has been developed (but not yet put in operation) by the Federal Reserve.4 As originally proposed in November 2008, TALF would lend money to holders of AAA-rated asset-backed securities on a non-recourse basis but secured by such securities (subject to a haircut). Securities qualify for TALF only if backed by newly and recently originated auto loans, credit card loans, student loans and SBA-guaranteed small business loans. Treasury planned to capitalize the facility with $20 billion to leverage $200 billion in lending by the Federal Reserve.

According to the Fact Sheet, the new CBLI would perform essentially the same function, but with $100 billion in capital from Treasury to leverage $1 trillion in lending. The categories of assets backing securities eligible for the program would be expanded to include small business loans and commercial MBS. A press release on last Tuesday from the Federal Reserve advised that private-label residential MBS also would be eligible and that assets collateralized by corporate debt may be included, but no decision has yet been made. The CBLI will continue to be limited to AAA-rated securities.

The CBLI will be put in place promptly, but presumably the now fully-developed TALF program will go into operation at the end of this month as previously planned. The Federal Reserve released guidance on the TALF program on February 6.

Affordable Housing Support and Foreclosure Prevention Plan

Treasury deliberately made the AHSFPP general in nature and was explicit that a comprehensive plan would be forthcoming later. Some additional information may emerge from President Obama’s speech tomorrow. Even as outlined on Tuesday, however, the AHSFPP contains several key points:5

  • Mortgage Rates. Treasury remains committed to driving down rates on residential mortgage loans, although the Federal Reserve currently is taking the lead by purchasing up to $500 billion in residential MBS issued by the government-sponsored enterprises (GSEs) and up to $100 billion in direct obligations of the GSEs. (Both purchase programs were announced in November 2008.) Treasury has some power to influence actions by Fannie Mae and Freddie Mac that would help lower interest rates, but these actions are not discussed in the Plan.
  • Avoidable Foreclosures. Treasury will devote up to $50 billion to induce reductions in monthly payments on mortgages financing owner-occupied middle class homes and thereby avoid foreclosures. Presumably the program will be designed to support modifications where the borrower can afford the reduced payments. The mechanics of this loan modification program will be announced later. One interesting question is whether the program will be similar to the FDIC proposal from last November, which suggested a $25 billion program that did not provide direct assistance to lenders or borrowers but represented a loss-sharing arrangement with purchasers of modified loans. The Treasury Department under Secretary Paulson estimated that the FDIC proposal would in fact cost $75 billion, so the Plan at least adopts a middle approach in dollar terms. Lenders, servicers and investors should also look for a targeted debt-to-income ratio in the forthcoming comprehensive plan, since existing modification programs range from 31 percent to 38 percent.  

In connection with this part of the Plan, the Office of Thrift Supervision (OTS) last Thursday urged the thrift institutions it regulates to hold off on home foreclosures until the modification program is finalized.6 The other federal banking regulators have not yet made similar recommendations. Last Friday, Fannie Mae, Freddie Mac, Bank of America, JPMorgan Chase and Morgan Stanley announced a freeze on foreclosures through March 6. Citigroup said that it would cease foreclosures through March 12, unless the details of the modification program are announced before then. The various moratoria are limited to mortgage loans on owner-occupied homes.  

  • National Standards for Loan Modifications. The ASHFPP also indicates that Treasury will promote uniform standards for loan modifications. The results of this effort will be noteworthy, since the many federal programs now operating (including the FDIC’s programs in connection with failed institutions) differ in some important respects. The latest models for modifications are the FDIC’s “Mod in a Box” program and the Federal Reserve’s modification requirements with respect to residential mortgage loans held, owned, or controlled by a Federal Reserve Bank.
  • Participation in Foreclosure Mitigation Plans. Treasury will require all recipients of financial support under the Plan to participate in foreclosure mitigation plans. As a practical matter, all FST program recipients will have to participate. Purchasers under the PPIF that buy mortgage-related assets will have to adhere to Treasury’s foreclosure mitigation guidance. Participants in the CBLI may be covered, if the securities they offer as collateral are residential MBS.7 The SBCLI by definition does not include residential mortgage-related assets, so purchasers in that program should not be subject to this participation requirement.  

On a point related to foreclosures, ARRA increases funding for the Neighborhood Stabilization Program (a program created last year under the Housing and Economic Recovery Act), which assists state and local governments in purchasing and rehabilitating vacant houses in areas with high levels of foreclosure.  

  • Additional Flexibility for Hope for Homeowners and FHA. These two loan modifications currently have provisions that have deterred participation. Treasury will revise — or urge the revision of — some of these requirements in order to induce greater participation. The House Financial Services Committee has approved draft legislation along these lines.  

Small Business and Community Lending Initiative

Small business owners have had considerable difficulty obtaining commercial credit over the last several months, even where the Small Business Administration is able to provide credit enhancement. Accordingly, under the Plan, Treasury will finance the purchase of AAA-rated SBA loans, seek legislation to increase the guarantee of SBA loans to 75-90 percent,8 and reduce fees for SBA loan-related fees and expedite processing at the SBA. According to Treasury, it and the SBA will launch the program in the next several days. The cost to Treasury of this initiative has not been specified.  

Broad Compliance Issues

The Plan sets forth several conditions for participation in the Plan. Many of the conditions apply to specific programs, particularly the FST, and these have been described above. The restrictions described below apply across the board. Some of the earlier recovery programs have included similar but less onerous conditions.  

  • Executive Compensation. Treasury previously announced on February 4 new restrictions on executive compensation in firms receiving government assistance. The enactment of ARRA will supersede many of the limitations in the Plan. For reference, however, the Plan confirms the February 4 restrictions, which, in very general terms, encompass a cap of $500,000 on compensation of the 25 most senior executives (plus restricted stock payable as government assistance is repaid) and shareholder votes on compensation.

ARRA follows the concept of limitations on compensation but differs in significant respects from the Plan. Retroactivity is perhaps the most significant feature. The compensation restrictions in ARRA apply both going forward to institutions that will receive CAP or other TARP funds and retroactively to institutions that have received TARP funds. The retroactivity provision, which was opposed by the Obama administration,9 would enable Treasury to amend its TARP agreements unilaterally, a power that the agreements give to Treasury if compelled by statutory changes.  

In very rough terms,10 ARRA restrictions bar compensation based on “unnecessary and excessive risks” and claw back compensation based on materially inaccurate earnings statements, and prohibit “golden parachute payments,” which are defined to include any severance payments other than payments for services performed or benefits accrued. Additionally, compensation, other than base salary11 may take the form only of long-term restricted stock, which does not fully vest until TARP funds have been repaid and which may not constitute more than one-third of total compensation. (In other words, the value of the restricted stock, in rough terms, may not exceed 50 percent of salary.) These number of employees subject to the restrictions varies based on the particular restriction. For example, the restriction on parachute payments applies to the top 10 most highly compensated employees. The number of individuals subject to the restriction on compensation other than base salary varies based on a sliding scale by reference to the amount of TARP funds received. ARRA requires certifications of compliance from the chief executive officer and the chief financial officer of each recipient institution, apparently on an annual basis, and imposes certain requirements on the compensation committees of the boards of recipient institutions. TARP recipients must allow shareholders to have a non-binding vote approving all executive compensation.  

ARRA does not contain the salary cap proposed by the Obama administration with respect to certain institutions that receive assistance. However, ARRA also gives the administration the authority to impose restrictions in addition to those enumerated in the statute. Thus, it is possible that this restriction may resurface.  

Obama administration officials continued this past weekend continued to criticize the executive compensation limitations, but this objection will not preclude the President’s signing of the bill. What actions, if any, Treasury may take to mitigate the effects of the ARRA limitations remain to be seen.  

  • Expenditures. Under ARRA, the board of each recipient institution must adopt a company-wide policy regarding such “excessive or luxury” expenditures as Treasury may identify. ARRA suggests, but does not require, that such expenditures be defined to include entertainment, office renovations and aviation or other transportation services.
  • Lobbying. The Plan confirms previously announced measures by Treasury to ensure that lobbyists do not influence decisions on applications for or disbursements of Plan funds. Treasury will certify that each “investment decision” is based only on investment criteria and the facts of the case. This policy does not prohibit lobbying on broader, non-case-specific decisions. Most trade association lobbying, for example, should not be affected.  

Principles and Consequences

Despite the lack of detail in the announced Plan, several critical concepts and consequences are embedded in the Plan:  

  • The Plan distinguishes two categories of banking organizations — those with more than $100 billion in assets and those with less. The Plan treats them differently in important respects. The banks with the most complicated decisions to make are community banks with assets of between $1 billion and $10 billion, where private investors may or may not have an interest in investing.
  • The price of assets sold through the PPFI will be set entirely through negotiations between buyers and sellers. Treasury will not play a role in this process. In the current circumstances, these prices are likely to be at near liquidation levels. Of course, not all institutions holding troubled assets will be prepared to sell at such prices. In this case, the PPIF will not succeed in loosening the secondary market.
  • To the extent that asset sales do occur, the clearing prices may adversely affect non-selling banks that hold comparable assets on their books.
  • Banking organizations with more than $100 billion in assets are required to undergo a “stress test” and to submit to heightened supervision in return for CAP investments, but these institutions appear to be guaranteed to receive new Treasury investments as needed.
  • For organizations with less than $100 billion in assets, capital investments by Treasury would appear to be available only to the healthiest banking organizations that can “pass” a stress test.
  • The combination of the stress test and the nature of the existing Capital Purchase Program unavoidably will create “winners” and “losers” among banking institutions with less than $100 billion in assets — and at an earlier stage than would otherwise be the case under the established Prompt Corrective Action regime.
  • Winning is not an unmitigated benefit. A recipient of new Treasury aid will be restricted in the dividends it can pay. The organization also will have to comply with stricter limits on compensation and expenditures and with new reporting requirements. Still, the winners should receive sufficient capital to ride out the current crisis.
  • Interestingly, under the ARRA, winners may opt out, if their primary federal regulator agrees. A banking organization may return TARP funds without raising replacement Tier 1 capital, as had previously been the case. Regulatory approval for the return of funds may not be readily forthcoming, however.
  • Potential losers may include even banking institutions that are adequately capitalized but nevertheless excluded from receiving additional capital from Treasury. Organizations that do not receive capital from Treasury will face three daunting options: seeking a merger with a financially stronger bank, attracting private equity on very dilutive terms or simply attempting to manage through the crisis.
  • Attracting private equity will continue to be challenging for both winners and losers with less than $100 billion in assets.12 For winners, the Treasury assistance inevitably will mean increased supervision — and even a fair degree of control — by the primary federal banking regulators Although private investors typically would not seek a control position, the idea that the banking agencies will be able to limit operations, if not dictate them, may be a significant deterrent. Moreover, Treasury’s views about the stabilization and later growth of a recipient institution may be at odds with the time horizons of private investors.
  • For losers, where investors will understand that a bank is unable to pass the stress test, these institutions would present a substantial investment risk to potential investors. The most attractive institutions to investors may be those with profitable, niche business lines or those with an appealing branch or deposit footprint.
  • Given the probable difficulty of raising additional private capital, the rate of consolidation in the banking industry is likely to increase. Early in the development of TARP during the Bush administration, consolidation was a stated goal. The Obama administration has not stated an official position on the consolidation issue, and in a Senate Banking Committee hearing last Tuesday, Secretary Geithner declined to address the matter.
  • Stock-for-stock mergers and acquisitions will constitute the vast bulk of new consolidations because the Plan bars recipients of CAP funds from making cash acquisitions of healthy institutions.13  

Historians of past banking crises may want to consider two past experiences with resolution efforts in the banking industry that seem to inform the Plan — and that may reflect some of the principles above or point the way to the revision of others.  

First, the substance and probable effects of the Plan hearken back to part of the philosophy of Resolution Trust Corporation (RTC) in dealing with thrift failures in the early 1990s. The Plan will open the door to, if not compel, the sale of troubled assets at market-clearing prices, however low those may be. The RTC took a similar but more aggressive approach in selling the assets of failed institutions as quickly as possible. One beneficial effect of the RTC’s expedited sales in the early 1990s was a substantial increase in liquidity in the thrift sector and, indirectly, in the banking industry as a whole. Of course, the existence of the RTC and its resolution procedures were made necessary by the failure of several hundred thrift organizations. Treasury doubtless hopes to avoid events of this magnitude, but the results of stress tests and asset sale pricing may well endanger some banking organizations.  

Of course, the RTC program was a form of nationalization, in that the RTC managed and sold thrifts (or their assets and deposits) only after these institutions had failed and the stockholders were wiped out. The Treasury Department in both the Bush and Obama administrations has assiduously avoided the concept of nationalization, but the alternative under the Plan combines government influence over banking operations with limited protection for existing stockholders.

Second, nearly every program in the Plan, as well as earlier TARP and Federal Reserve programs, represent a form of open bank assistance. The FDIC (and its then thrift industry counterpart) provided various forms of open bank assistance during the 1980s, but the concept became discredited during the resolution of the thrift crisis. The FDIC now is, permitted by statute, to provide open bank assistance only where the recipient bank presents a systemic risk to the financial industry. Certainly recent events call for a more expansive approach than the federal government took in the early 1990s; however, the implications of the renewed interest in open bank assistance for the banking industry after the current crisis abates, including, for example, the increase in moral hazard, are unexplored territory.

Concluding Observations

The Plan represents a serious effort to comprehensively remedy the crisis in the banking industry. Nevertheless, two fundamental issues remain which, if not addressed, may diminish the effectiveness of the Plan.  

First, as currently articulated, the Plan will accelerate troubled asset sales — and the corresponding “cleansing” of a seller’s balance sheet — only to the extent that the PPIF gives purchasers some confidence that they are not over-paying for the assets. Currently, such sales occur only where the seller is willing to accept a liquidation price. In many more instances, sales do not take place because a seller has a different view of the value of the assets, and the bid-ask spread is too wide. The Plan expressly does not provide any answer to the pricing issue. This answer probably resides in some kind of guarantee or loss-sharing arrangement — tools that the FDIC has used in asset sales from failed banks. Such arrangements could be part of the broadly defined financing element in the PPIF.

Second, the Plan establishes an investment scheme that will quickly identify winners and losers, at least among banking institutions with less than $100 billion in assets. Consolidation in the industry will increase rapidly and on markedly unfavorable terms for stockholders in the target institutions. If this result is the intent of Treasury, it should be clear about its purpose. If it is not, then greater support — again, probably in the form of a guarantee or loss-sharing arrangement — of these institutions will be necessary in order for them to attract private capital.