Following the lead of European governments, and in a dramatic shift from its position of barely a week ago, the U.S. government announced yesterday a series of new actions to strengthen market stability. In this update, we review the following:

Treasury’s Capital Purchase Program. These actions include an announcement by Treasury that it is making available up to $250 billion of capital to qualifying U.S.-controlled financial institutions ($125 billion of which has been allocated to nine banks), thus moving away in this immediate phase from purchases of assets as contemplated by the Troubled Asset Relief Program (“TARP”). In addition to the nine banks, a wide array of small and mediumsized banks and thrifts are to benefit under the program. The capital will be injected in the form of non-voting preferred stock, redeemable after three years, and earlier out of the cash proceeds of offerings on Tier 1 qualifying perpetual preferred stock or common stock. Treasury is expected to continue to move forward on TARP, with the program guidelines to be forthcoming shortly. Having allocated $250 billion of TARP funds for the capital injections, Treasury has an additional $100 billion available for purchases of assets under TARP before it needs to go back to Congress.

The FDIC’s Temporary Liquidity Guarantee Program. Separately, the FDIC announced a program with two components: guarantees of new senior debt issued by FDICinsured institutions and their holding companies for three years and full guarantees in respect of deposits in non-interest bearing transaction accounts. (This latter relief does not extend to deposit insurance for accounts of individual customers.) The debt guarantees cover eligible debt issued through June 30, 2009, and the additional deposit protection expires December 31, 2009.

The Fed’s Commercial Paper Funding Facility. The Federal Reserve announced additional details of its commercial paper backstop facility to facilitate the issuance of term commercial paper by eligible issuers.

European Efforts Lead the Way

The U.S. announcement follows a flurry of activity in Europe, starting last week in the United Kingdom. The U.K. plan includes a £50 billion Tier 1 capital facility to be made available to U.K. financial institutions in the form of preference shares or other permanent interest bearing shares, half to be available for eight designated institutions and the other half available upon application. To reopen the medium-term funding market for participating institutions that raise appropriate amounts of Tier 1 capital, the U.K. government will make available a government guarantee of short and medium term debt issuances to assist in refinancing maturing, wholesale funding obligations as they fall due. The program envisages the issuance of senior unsecured debt instruments of varying terms of up to 36 months. The announcement stated that the government expects the take-up of the guarantees to be in the range of £250 billion and will keep this amount under review. In addition, the Bank of England will make available under its “Special Liquidity Scheme” at least £200 billion in short term liquidity.

The British move was followed by announcements by the German government that it would issue up to €400 billion in guarantees for inter-bank lending and would commit up to €100 billion (up to €80 billion for capital injection and up to €20 billion to cover potential losses), and by the French government that it would guarantee up to €320 billion of inter-bank loans and commit up to €40 billion in the form of capital injections. Austria, Italy, the Netherlands, Portugal and Spain also committed capital for guarantees and capital injections. Britain this week moved to provide £37 billion in new capital to three of its banks as part of the plan it unveiled last week, with controlling stakes taken in each.

Capital Purchase Program

The Capital Purchase Program announced yesterday envisions using $250 billion of the authority granted under the Emergency Economic Stabilization Act of 2008 (“EESA”). Half of the committed amount ($125 billion) is to be made available to nine U.S. financial institutions that have already agreed to participate, with the balance to be provided to smaller qualifying institutions on a voluntary basis. The deadline to elect to participate in the program is 5:00 pm (EDT) on November 14, 2008.

Capital injections will take the form of purchases of senior preferred stock (“Senior Preferred”) that will pay cumulative (or, in the case of banks that are not subsidiaries of holding companies, non-cumulative) dividends at a rate of 5%, increasing to 9% after five years. The Senior Preferred will constitute Tier 1 capital and will have perpetual life. Treasury will also receive warrants worth 15% of the face amount of the Senior Preferred (on the date of investment). Each participating institution is to issue an amount of Senior Preferred equal to not less than 1%, and not more than 3%, of its risk-weighted assets, with an upper limit of $25 billion.

The institutions that may participate (referred to in the term sheet for the program as “Qualifying Financial Institutions” or “QFIs”) are: any U.S. bank or U.S. savings association not controlled by a bank holding company or a savings and loan holding company, any U.S. bank holding company or any U.S. savings and loan holding company that engages only in activities permitted for financial holding companies under Section 4(k) of the Bank Holding Company Act, any U.S. bank or U.S. savings association controlled by such a holding company, and any U.S. bank holding company or U.S. savings and loan holding company whose U.S. depository institution subsidiaries are the subject of an application under Section 4(c)(8) of the Bank Holding Company Act. A QFI cannot be a bank holding company, savings and loan holding company, bank or savings association controlled by a foreign bank or company. Treasury will determine eligibility.

Participating institutions will be required to adopt Treasury’s standards for executive compensation and corporate governance for the periods during which Treasury holds equity issued under the Capital Purchase Program.

Treasury may transfer the Senior Preferred it acquires to third parties at any time.

Senior Preferred

Ranking. The Senior Preferred will rank pari passu with existing preferred shares other than preferred shares which by their terms rank junior to any existing preferred shares. Redemption. The Senior Preferred may not be redeemed for a period of three years from the date of investment except with proceeds from a sale of Tier 1 qualifying perpetual preferred stock or common stock for cash, which results in aggregate gross proceeds of not less than 25% of the issue price of the Senior Preferred. After the three-year period, the QFI may redeem the Senior Preferred at any time in whole or in part. Redemptions will be at 100% of the issue price and will be subject to primary regulator approval. Following redemption of all of a QFI’s Senior Preferred, it may repurchase any of its other equity securities held by Treasury at fair market value.

Restriction on Dividends and Repurchases. While Senior Preferred is outstanding, a QFI’s ability to declare and pay dividends and undertake share repurchases will be restricted. During this period, no dividends may be paid on any junior or pari passu preferred security or common shares other than on a pro rata basis in case of pari passu preferred shares. Also, a QFI may not repurchase or redeem any junior preferred shares or pari passu preferred shares or common shares unless all dividends on the Senior Preferred have been paid in full.

Until the third anniversary of the date of the investment, common dividends may not be increased and the QFI will be unable to conduct any share repurchases, other than repurchases of the Senior Preferred and the repurchases of junior preferred shares or common shares in connection with any benefit plan in the ordinary course of business consistent with past practice, in any such case without Treasury’s consent. These restrictions cease to apply if the Senior Preferred is redeemed in full or if Treasury transfers all of that QFI’s Senior Preferred to a third party.

Voting Rights. At inception, the Senior Preferred will be non-voting, except for class voting rights on issuances of shares ranking senior to Senior Preferred, amendments to the rights of the security, or any merger or similar transaction that would adversely affect the rights of the holder of the security. However, if dividends on Senior Preferred have not been paid in full for six dividend periods, whether or not consecutive, the Senior Preferred will have a right to elect two directors. This right will terminate when full dividends have been paid for four consecutive dividend periods.

Transfer. The Senior Preferred will not be subject to any contractual restrictions on transfer. The QFI will be obligated to put a shelf registration statement in place and grant piggyback registration rights to Treasury for the Senior Preferred (and the shares underlying warrants).


Amount, Term and Voting Rights. Treasury is to receive warrants to purchase common stock of a participating QFI having an aggregate market price equal to 15% of the Senior Preferred face amount, as of the date of investment. The amount of the shares underlying warrants then held by Treasury is to be reduced by half if, on or prior to December 31, 2009, the QFI has sold Tier 1 qualifying perpetual preferred stock or common stock for cash in an amount equal to 100% of the issue price of the Senior Preferred. The term of the warrants will be 10 years. Warrants will be immediately exercisable, in whole or in part. Treasury will not exercise its voting power with respect to common stock issued upon exercise of the warrants; presumably this does not apply to any third party purchaser.

Exercise Price. The initial exercise period for the warrants, and the market price for determining the number of shares of common stock underlying the warrants, will be the market price of the common stock on the date of the Senior Preferred investment (calculated on a 20- trading day trailing average), subject to customary anti-dilution adjustments. The exercise price will be reduced by 15% of the original exercise price on each six-month anniversary of the issue date of the warrants if shareholder approval (described below) has not been received, subject to a maximum reduction of 45% of the original exercise price.

Shareholder Approval. In the event the QFI does not have sufficient authorized but unissued shares reserved for issuance upon exercise of the warrants or needs shareholder approval under stock exchange rules for issuances of underlying shares upon exercise, the QFI is obligated to obtain shareholder approval as soon as practicable.

Alternative Security. If the QFI’s common stock is not listed or traded or the QFI fails to obtain shareholder approval within 18 months after the issuance of the warrants, the warrants will be exchangeable, at the option of Treasury, for senior term debt or another instrument or security of the QFI with equivalent economic value.

FDIC Guarantee Program

The FDIC announced a Temporary Liquidity Guarantee Program that has two components. Any eligible institution that avails itself of either of the guarantees will be subject to enhanced supervisory oversight.

Debt Guarantee. The first component provides for guarantees of new, senior unsecured debt issued by FDIC-insured depository institutions, U.S. bank holding companies and financial holding companies and certain U.S. savings and loan holding companies (the “Eligible Entities”). This guarantee will cover all new senior unsecured debt issued by Eligible Entities on or before June 30, 2009, including promissory notes, commercial paper, inter-bank funding, and any unsecured portion of secured debt. The amount of debt covered by the guarantee may not exceed 125% of the Eligible Entity’s debt outstanding as of September 30, 2008 that was scheduled to mature before June 30, 2009. The guarantee will extend only until June 30, 2012, even if the debt has not then matured.

Deposit Guarantee. The FDIC will also offer unlimited guarantees on bank deposits that do not bear interest (i.e., in respect of small business transactional deposits) until December 31, 2009.

Coverage. All Eligible Entities will be covered by the guarantees for the first 30 days. Thereafter, Eligible Entities must inform the FDIC whether they intend to opt-out of the guarantee programs.

Fees. Fees for these guarantees will be waived for the first 30 days. Thereafter, an annualized fee of 75 basis points will be charged for the debt guarantee and a 10 basis point surcharge will be added to the existing risk-based deposit insurance premium for any amount in the deposit accounts in excess of the existing limit of $250,000.

Executive Compensation Restrictions

The Treasury announced executive compensation guidelines corresponding to the three programs adopted under the EESA. These rules apply to the CEO, CFO and the next three most highly compensated executive officers (collectively, the “Senior Executives”). Any financial institution participating in the following three programs will be required to adhere to these guidelines. Additional guidance has been posted on the Treasury's web site in the form of two Treasury notices, an IRS notice and an interim final rule promulgated under the EESA. Briefly the guidelines address the following:

  • Troubled Asset Auction Program: during the term of the program, any financial institution that sells more than $300 million of troubled assets to Treasury through an auction under TARP would be prohibited from entering into new executive employment contracts that include golden parachutes. In addition, (i) the financial institution may not deduct, for tax purposes, executive compensation in excess of $500,000 for each Senior Executive; (ii) it may not deduct certain golden parachute payments made to its Senior Executives; and (iii) a 20 per cent excise tax will be levied on a Senior Executive for these golden parachute payments. 
  • Capital Purchase Program: for the period during which Treasury holds equity or debt securities issued by a financial institution under the Capital Purchase Program, a QFI must, among other things, (i) provide for a claw-back of any bonus or incentive compensation paid to a Senior Executive based on statements of earnings, gains, or other criteria that are later proven to be materially inaccurate; (ii) not make any golden parachute payment to a Senior Executive; and (iii) not deduct for tax purposes executive compensation in excess of $500,000 for each Senior Executive. Existing arrangements and agreements are to be modified or terminated before the closing of the relevant capital purchase to the extent necessary to be in compliance with, and agree to be bound by, these requirements. 
  • Programs for Systemically Significant Failing Institutions: the standards under this third program, which is being developed to provide direct assistance to failing institutions on terms negotiated on a case-by-case basis, are similar to those under the Capital Purchase Program, except that golden parachutes will be defined more strictly to prohibit any payments to departing Senior Executives.

Commercial Paper Funding Facility (“CPFF”)

Further details of the CPFF were announced yesterday, including its terms and conditions and an FAQ.

Structure. The previously announced CPFF will become operational on October 27, 2008 and purchases will continue until April 30, 2009. It will be structured as a credit facility made available to a special purpose vehicle (“SPV”). The Federal Reserve Bank of New York will lend to the SPV on a recourse basis and will be secured by all assets of the SPV. The SPV will purchase from eligible issuers eligible commercial paper through the New York Fed’s primary dealers. The SPV will hold the paper until maturity and will use proceeds from maturing paper and other assets of the SPV to repay its loan. The SPV will not purchase commercial paper from investors. However, issuers are permitted to repurchase outstanding commercial paper from investors and finance those repurchases by selling commercial paper to the SPV.

Eligible Issuers. Issuers of commercial paper organized under the laws of the United States or the individual States and territories, including those with a foreign parent, are eligible to participate.

Eligible Paper. The commercial paper must be unsecured or asset-backed, have a threemonth maturity, be U.S. dollar-denominated, and be rated at least A-1/P-1/F1. Interest-bearing commercial paper and commercial paper with an extendable maturity will not be eligible for purchase by the SPV.

Registration and Fee. Eligible issuers must register with the CPFF by no later than October 23, 2008 to access the facility by October 27, 2008. The registration will open on October 20, 2008 and the registration materials will be available on the New York Fed’s website. Thereafter, issuers will be required to register two business days in advance of their intended use of the CPFF. At the time of the registration, the issuer will have to pay a 10-basis point facility fee based on the maximum amount of its commercial paper the SPV may own. Issuers not intending to access the CPFF need not register.

Maximum Amount. The maximum allowable amount for each issuer is the greatest amount of U.S. dollar-denominated commercial paper the issuer had outstanding on any day between January 1 and August 31, 2008, as certified by the issuer to the Fed at the time of registration.

Price. The price of the purchased commercial paper will be discounted based on a rate equal to a spread over the three-month overnight index swap (OSI) rate on the day of purchase. The spread for unsecured commercial paper will be 100 basis points per annum and the spread for asset-backed commercial paper will be 300 basis points per annum. For unsecured commercial paper, an additional 100 basis points per annum unsecured credit surcharge must be paid on each trade execution date. The daily lending rates under CPFF will be posted on the New York Fed website at 8:00 am (EST) and via Bloomberg screen.

Other Developments

In other developments, Neel Kashkari, Treasury’s point person on TARP, announced Monday that Treasury is designing the implementation of TARP in close consultation with both domestic and international regulators. Treasury has created seven policy teams to deal with specific elements of TARP:

  • mortgage-backed securities purchases – focusing on which assets to buy, from which institutions to buy them and which mechanisms to use; 
  • whole loan purchases – focusing on which types of loans to buy first, how to value them and which mechanisms to use; 
  • the insurance program – public comment has been requested as to how best to structure the program; 
  • the equity purchase program – focusing on design of a program to encourage private sector participation to complement public capital; 
  • homeownership preservation – evaluating how best to maximize opportunities; 
  • executive compensation – see above; and 
  • compliance and oversight – focusing on establishing the structures.

The markets await the TARP program guidelines and answers to the many questions raised by the proposed purchase of troubled assets, including

  • what criteria will be considered for buying troubled assets and what assets will be given priority. The further one moves away from the underlying mortgage assets, the more difficult the task of determining intrinsic value. To work, TARP will need to buy up the more complex assets for which there is no market or that are valued at a level wholly unrelated to intrinsic value; 
  • how valuation/pricing mechanisms will be addressed in the program guidelines; 
  • how well the reverse auction system can be expected to function – where the mortgage-backed securities market is so fragmented, where all tranches in a pool are widely held and where institutions have different values ascribed to them; 
  • how will asset allocations be determined; 
  • what data will be relied upon in executing the auctions and how that data will be made available to Treasury; as difficult as it may seem from an optics perspective, Treasury needs the assistance of the institutions themselves as they are in the best position to know what asset classes have been hit the hardest; 
  • who can participate – foreign institutions, hedge funds, private equity funds, retirement accounts, SIVs, and so on; 
  • the basis for setting insurance premiums and more broadly how the insurance program is used – presumably for the less riskier asset classes that nonetheless have no market – and how it is structured; 
  • how the private sector is to be “encouraged” to participate in TARP and invest in financial institutions (and whether the private sector is to be encouraged to buy up any Senior Preferred issued under the Capital Purchase Program); and 
  • the impact on the market in general as new values are established.