Over the past two weeks, the federal government has relied on nearly every legal authority available to address the unfolding crisis in financial institutions with large mortgage-related holdings — direct and indirect financial assistance, government takeovers and even a decision to let the bankruptcy process run its course have all come into play. Today, several new actions have been announced, together with proposals that would require Congressional action. Beyond that, according to press accounts from late yesterday, the Treasury Department and the Federal Reserve Board now may be seeking additional authority to form a liquidation agency, presumably modeled on the Resolution Trust Corporation.

Beginning on September 14, the Federal Reserve (with Treasury’s moral support, at least) took several significant legal steps to bail out AIG and to increase liquidity for many participants in the markets in which Lehman Brothers (“Lehman”) was active (although not assisting Lehman itself). Later in the week, both agencies enhanced liquidity in other ways. The Securities and Exchange Commission (SEC) also weighed in with new interim rules designed to prevent short sale abuses.

Within the last 24 hours, government action has, if anything, accelerated. The SEC has halted short selling in the shares of 799 financial institutions for at least 10 days, effectively superseding, for those financial institutions, the interim rules issued two days ago. Treasury has proposed a liquidation agency for the assets of failed or troubled institutions, presumably modeled on the Resolution Trust Corporation (RTC), and has put in place a temporary guarantee program for money market funds. The Federal Reserve has also taken additional extraordinary steps to boost liquidity.

We review below the important legal aspects of the government actions with respect to Lehman (including highlights of its bankruptcy filing), the assistance given to AIG, the SEC’s new emergency rules on short sales, Treasury’s money market guarantee program and the Federal Reserve’s related non-recourse asset-backed commercial paper lending facility, and the outlines of the Treasury’s mortgage assets liquidation proposal. Another important development this week from an economic perspective was the acquisition of Merrill Lynch by Bank of America, but the transaction documents that have been made public do not indicate that the parties broke any significant new legal ground.

Lehman

Federal Reserve Actions

On Sunday, September 14, although no government action was taken to provide capital or funding for Lehman, the Federal Reserve announced three actions to increase the liquidity available to primary dealers and to certain broker-dealers and other securities firms that could be adversely affected by Lehman’s then-anticipated bankruptcy filing. These actions were based on the Federal Reserve’s rarely used authorities under sections 13(3) and 23A of the Federal Reserve Act.

  • Regulation W – Temporary Relief from Limits on Certain Loans to Securities Affiliates. Because of the threat that the Lehman bankruptcy may pose to the continued functioning of the U.S. tri-party repurchase agreement market (the “Repo Market”), the Federal Reserve has now allowed broker-dealers and others that had funded securities and other assets through the Repo Market to look to affiliated banks for funding. Such bank funding historically has been strictly limited by Section 23A of the Federal Reserve Act and Regulation W.1 As a general rule, an insured depository institution may extend credit to any affiliate, provided that the total credit exposure to the affiliate does not exceed 10 percent of the lending institution’s capital and that the loans or other credits are properly over-collateralized (unless the collateral is Treasury securities).

The September 14 announcement included an interim final rule that lifts — until January 30, 2009 — the Section 23A quantitative and collateral constraints for loans to affiliates, where such loans essentially act as a replacement for Repo Market financing. There are some important limitations on this exemption.

  • The exemption only applies to the financing of assets of the type that the affiliate had financed in the Repo Market during the week of September 8-12, 2008. Any bank and its affiliate that take advantage of the exemption clearly should be prepared to demonstrate this fact to the Federal Reserve.
  • The transaction must be marked to market daily and is subject to daily margin-maintenance requirements.
  • The bank must be at least as over-collateralized in these transactions as the clearing bank was in its comparable Repo Market transactions with the affiliate on September 12, 2008.
  • The aggregate risk profile of the bank financings must be no greater than the aggregate risk profile of the affiliate’s Repo Market transactions on September 12, 2008.
  • The top-tier holding company must guarantee the obligations of the borrowing affiliate or must provide additional security acceptable to the Federal Reserve. Any transaction not guaranteed or otherwise secured by the holding company would be subject to the standard Section 23A constraints.

The Federal Reserve has the authority to impose additional conditions or restrict a bank from utilizing this exemption where an unacceptable risk to the bank is likely. The rule became effective September 14, 2008, but the Federal Reserve is seeking comments that must be received by October 31, 2008.

  • Primary Dealer Credit Facility – Eligible Collateral Expanded. In March of this year, the Federal Reserve established the Primary Dealer Credit Facility (PDCF), which allows 19 “primary dealers” to borrow, on an overnight basis, from the Federal Reserve Bank of New York (FRBNY) at the same rate charged for primary credit at the FRBNY’s discount window.2 Any such loan must be collateralized, and eligible collateral originally was limited to investment-grade debt securities. As of September 15, the Federal Reserve expanded its view of eligible collateral to include all collateral that was eligible, as of September 12, 2008, for pledge in tri-party funding arrangements through either of the major clearing banks. The principal amount of a loan may not exceed the margin-adjusted eligible collateral pledged and assigned to the FRBNY’s account at the borrower’s clearing bank. This facility is open to primary dealers until January 30, 2009, but, depending on conditions, may be extended.
     
  • Term Securities Lending Facility – Additional Collateral, More Frequent Schedule 2 Auctions and Increases in Securities Auctioned. The Term Securities Lending Facility (TSLF) is another financialcrisis liquidity facility that was created by the Federal Reserve in March 2008, shortly before the PDCF, to provide liquidity to primary dealers through 28-day loans of Treasury securities. The loans are offered and rates set in two types of periodic auctions — Schedule 1 and Schedule 2 — that, until now, have been held on a bi-weekly basis. Schedule 1 auctions are of loans collateralized by all collateral eligible for tri-party repurchase agreements arranged by the Open Market Trading Desk. Schedule 2 auctions are of loans supported by a broader range of collateral, including investment grade corporate securities, municipal securities, mortgage-backed securities and asset-backed securities, as well as Schedule 1 collateral. The September 14 announcement included three changes to the TSLF:
    • Eligible collateral for the securities sold in Schedule 2 auctions is expanded beyond Treasury securities, agency securities and AAA-rated mortgage-backed and asset-backed securities to include any investment-grade debt securities.
    • Schedule 2 auctions will now occur weekly, rather than bi-weekly.
    • In each Schedule 2 auction, the Federal Reserve will now make available up to $150 billion in Treasury securities; the previous Schedule 2 limit was $125 billion. The limit on the bi-weekly Schedule 1 auctions remains the same, however, at $50 billion.

Chapter 11 Bankruptcy Filing

After 158 years in business, the parent company of Lehman Brothers, Lehman Brothers Holdings, Inc., filed for bankruptcy on Monday, September 15, following weeks of growing investor concern over its holdings of mortgages and asset-backed securities, its credit rating and its ability to raise capital. The Chapter 11 filing did not include all Lehman units; the broker-dealer operations are excluded, though the parent company is attempting to sell the broker-dealer through the bankruptcy, as is Lehman’s asset-management subsidiary, Neuberger Berman.3

There appear to be several reasons for the reliance on Chapter 11 and the non-comprehensive nature of the filing. First, filing for Chapter 11 protection at the holding-company level, instead of seeking Chapter 7 liquidation or putting the entire company into bankruptcy, gives Lehman Brothers more time and control of what happens to its various assets. The company can now continue to shop around subsidiaries such as its U.S.-based broker-dealer operations, investment-management division, real-estate holdings, book of loans and its private-equity portfolio. Second, under the U.S. bankruptcy code, broker-dealers are not eligible to making a filing under Chapter 11 and can only avail themselves of protection under Chapter 7. Third, the bankruptcy code affords a filer little protection from the rights of counter-parties to derivative instruments.

Although most of Lehman Brothers’ U.S. subsidiaries are not party to its bankruptcy petition and continue to operate, certain of its foreign subsidiaries have been placed into foreign bankruptcy or insolvency proceedings, or have had regulatory limitations imposed on their operations. Several partners at PricewaterhouseCoopers LLP were appointed as joint administrators to Lehman Brothers International (Europe) on September 15, together with Lehman Brothers Ltd, LB Holdings PLC and LB UK RE Holdings Ltd. These are currently the only U.K.-incorporated companies in administration. The FSA has announced that it is working closely with the U.S. authorities to ensure an orderly wind down of Lehman Brothers International (Europe). The FSA is working with market practitioners, including the London Clearing House (LCH), to ensure the process connected with the winding down of this wholesale business is completed in an orderly manner, to minimize any market disruption.

Lehman Brothers Japan Inc. and Lehman Brothers Holdings Japan Inc. filed for bankruptcy in the Tokyo District Court on September 16. The Financial Services Agency, Japan’s financial regulator, ordered Lehman Brothers Japan Inc. to halt operations for 12 days, following its parent’s bankruptcy filing.

In addition, many securities exchanges worldwide have suspended Lehman Brothers foreign affiliates from taking on new securities and derivatives positions.

On September 17, Lehman’s bankruptcy judge approved bidding procedures in a proposed sale of Lehman Brothers, Inc.’s broker-dealer operations to Barclays Bank PLC (“Barclays”) for approximately $250 million, and its New York headquarters and some data centers in New Jersey for approximately an additional $1.5 billion. The bankruptcy judge has been asked to approve the sale on September 19.

Under the terms of the sale and bidding procedures:

  • Lehman Brothers, Inc. must pay Barclays a break-up fee of $100 million if it accepts another bid;
  • the transaction must be closed by Wednesday, September 24, or else it terminates; and
  • recognizing that the value of Lehman Brothers’ business resides in large part in its workforce, various conditions to closing were included relating to retention and business continuity, including a provision that requires Barclays to either keep Lehman Brothers’ 10,000 employees in the United States for the first 90 days after closing or pay them 20 percent of last year’s salary as severance, which reportedly could cost Barclays as much as $2.5 billion, and a provision prohibiting Barclays from reducing the bonus pool unless more than 10 percent of the Lehman Brothers employees set to receive bonuses resign by the end of the year.

It does not appear that Barclays is purchasing any of Lehman Brothers, Inc.’s commercial real estate assets, private equity investments or hedge fund investments.

AIG

Federal Reserve Assistance

On September 16, 2008, the Federal Reserve Board authorized the FRBNY to lend up to $85 billion to AIG. The loan reportedly is secured by all of the assets of AIG itself, the assets of its primary non-regulated subsidiaries and the stock of “substantially all” of its regulated subsidiaries. The assets of its various regulated subsidiaries, including its insurance and reinsurance company subsidiaries, do not serve as collateral for the loan, however.

In making this loan, the Federal Reserve has invoked its authority under Section 13(3) of the Federal Reserve Act, the same provision relied upon for the assistance given to JPMorgan Chase in connection with its acquisition of Bear Stearns in March 2008. Section 13(3) has its origins in Depression-era amendments to the Federal Reserve Act in 1932, and then was modified in 1991 as part of the Federal Deposit Insurance Corporation Improvements Act. It provides:

In unusual and exigent circumstances, the Board of Governors of the Federal Reserve System, by the affirmative vote of not less than five members, may authorize any Federal reserve bank, during such periods as the said board may determine, at rates established in accordance with the provisions of section 14, subdivision (d), of this Act, to discount for any individual, partnership, or corporation, notes, drafts, and bills of exchange when such notes, drafts, and bills of exchange are indorsed or otherwise secured to the satisfaction of the Federal Reserve bank: Provided, That before discounting any such note, draft, or bill of exchange for an individual, partnership, or corporation the Federal reserve bank shall obtain evidence that such individual, partnership, or corporation is unable to secure adequate credit accommodations from other banking institutions. All such discounts for individuals, partnerships, or corporations shall be subject to such limitations, restrictions, and regulations as the Board of Governors of the Federal Reserve System may prescribe.

The key requirements are that the circumstances are “unusual and exigent,” that the Reserve Bank must obtain evidence that the borrower “is unable to secure adequate credit accommodations” from other banks, and that the extension be approved by at least five members of the seven-person board (there are, however, currently only five board members). In its statement announcing the AIG funding arrangements, the Federal Reserve stated that the “[b]oard determined that, in current circumstances, a disorderly failure of AIG could add to already significant levels of financial market fragility and lead to substantially higher borrowing costs, reduced household wealth and materially weaker economic performance.”

The authority of the Federal Reserve Bank of New York to extend emergency credit to non-depository institutions is reiterated in Section 201.4(d) of the Federal Reserve’s Regulation A:

(d) Emergency credit for others. In unusual and exigent circumstances and after consultation with the Board of Governors, a Federal Reserve Bank may extend credit to an individual, partnership, or corporation that is not a depository institution if, in the judgment of the Federal Reserve Bank, credit is not available from other sources and failure to obtain such credit would adversely affect the economy. If the collateral used to secure emergency credit consists of assets other than obligations of, or fully guaranteed as to principal and interest by, the United States or an agency thereof, credit must be in the form of a discount and five or more members of the Board of Governors must affirmatively vote to authorize the discount prior to the extension of credit. Emergency credit will be extended at a rate above the highest rate in effect for advances to depository institutions.

As contemplated by Section 201.4(d), the AIG facility will bear interest at LIBOR plus 850 basis points, a rate that is considerably higher than the highest rate in effect for advances to depositary institutions (currently 2.25 percent for primary credit and 2.75 percent for secondary credit).4

The facility has a stated term of 24 months and “is expected to be repaid from the proceeds of the sale” of AIG’s assets. According to the Federal Reserve’s announcement, the purpose of the facility is to “assist AIG in meeting its obligations as they come due” and “to facilitate a process under which AIG will sell certain of its businesses in an orderly manner, with the least possible disruption to the overall economy.” Neither the Federal Reserve nor AIG has stated which businesses are expected to be sold.

The AIG rescue arrangements also include some key features from the recent conservatorships for Fannie Mae and Freddie Mac. The Federal Reserve’s announcement states that “the U.S. government” will receive a 79.9 percent equity interest in AIG and will have the right to block the payment of dividends on AIG’s common and preferred stock. Definitive documentation for the transaction is not yet available, but it is likely that the 79.9 percent equity interest will come in the form of a warrant to purchase up to 79.9 percent of AIG’s common stock for a nominal exercise price. It is not clear whether the ability to veto the payment of dividends is a covenant in the Federal Reserve credit facility or a covenant in a warrant purchase agreement.

Impact on the Credit Derivatives Market

The Federal Reserve’s intervention in AIG could affect the credit derivatives industry in different ways. By way of background, AIG’s origins are in the traditional insurance business. In recent years, however, AIG has become a significant player in the credit derivatives market. Parallels can be drawn between insurance and credit derivatives, as both provide the buyer of protection the right to a payment upon the occurrence of specified adverse events. The products differ in fundamental respects, however, most notably that the holder of a credit derivative may collect even though it has not suffered a loss. Severing the link between the loss suffered and the right to payment has contributed to the exponential growth of the credit derivatives market, which is estimated to be at $62 trillion in notional amount.

Credit default swaps issued by AIG total about $440 billion in notional amount. Deterioration in the credit on which the swaps were written, and increased collateral required from AIG in connection with the credit default swaps, contributed significantly to AIG’s financial crisis. The Federal Reserve’s actions do not directly address AIG’s derivatives portfolio, but the loan provides AIG liquidity to meet its contractual requirements while it winds down or restructures its portfolio.

The Federal Reserve’s actions could have at least two consequences for the credit derivatives market. First, although this concern is not likely to materialize significantly, the loan to AIG could trigger credit default swaps designed to protect against a decline in AIG’s credit. The government’s action probably does not fit within industry accepted wording for trigger events incorporated into most credit derivatives contracts, but may be covered by some individually drafted provisions.

Second, the bailout will likely force fresh examination of the need for regulation of derivatives. Thus far, legislators and regulators have felt comfortable enough that the industry can manage risks associated with the

derivatives business, perhaps with good reason. The industry has designed solutions for significant problems; even as regulators grew concerned over the significant volume of undocumented derivatives transactions, the solution was to press the industry to craft its own solution, resulting in commitments by the major dealers to reduce the backlog in derivatives documentation, to institute expedited documentation processes and to establish a centralized warehouse of confirmations. ISDA developed an auction methodology for settling credit derivatives to bring orderly settlement of credit derivatives on significant reference names. Even after Congressional hearings in July of this year on systemic risk and market regulatory restructuring, no sense of urgency emerged around the need to regulate the derivatives industry. Now, however, as Washington looks back on this week’s events in the financial markets, there is likely to be a re-evaluation of the wisdom of leaving the derivatives markets unregulated. Legislators and regulators may well conclude that it is time to manage the large scale risks directly.

SEC Rules on Short Selling

On Wednesday, September 17, the SEC made its own entrance into the crisis by invoking its emergency rulemaking authority under Section 12(k)(2) of the Securities Exchange Act of 19345 to issue several new rules that are intended to “strengthen investor protections against ‘naked’ short selling.”6 On Thursday, September 18, the SEC followed the lead of the U.K.’s Financial Services Authority7 in temporarily suspending all short selling in the stocks of 799 listed financial services companies8 and imposing new daily short sale disclosure requirements on large institutional investors, including larger hedge funds.

September 17 Emergency Rules

The SEC’s September 17 emergency rules focused almost exclusively on curbing “naked” short selling abuses.9 Those rules, which apply to all public company securities, became effective at 12:01 a.m. on September 18, and will terminate at 11:59 p.m. on October 1, 2008, unless extended by the SEC. Although the rules are

effective immediately, the SEC is seeking comment for 30 days on all aspects of its order. The SEC stated that it expects to follow further rulemaking procedures at the expiration of the comment period.

  • Hard T+3 Close-Out Requirement; Penalties for Violation Include Prohibition of Further Short Sales, Mandatory Pre-Borrow.
    • The SEC adopted a new temporary rule (Rule 242.204T) requiring that short sellers and their brokerdealers deliver securities by the close of business on the settlement date (three days after the sale transaction date, or T+3) and imposing penalties for failure to do so.
    • If a short sale violates the new close-out requirement, then any broker-dealer acting on the short seller’s behalf will be prohibited from further short sales in the same security unless the shares are not only located but also pre-borrowed. The prohibition on the broker-dealer’s activity applies not only to short sales for the particular naked short seller, but to all short sales for any customer.
  • Exception for Options Market Makers from Short Selling Close-Out Provisions in Regulation SHO Repealed. The SEC eliminated the options market maker exception from the close-out requirement of Rule 203(b)(3) in Regulation SHO.
  • New Short Selling Anti-Fraud Rule. The SEC also adopted Rule 10b-21, which prohibits any person from submitting “an order to sell an equity security if such person deceives a broker or dealer, a participant of a registered clearing agency, or a purchaser about its intention or ability to deliver the security on or before the settlement date, and such person fails to deliver the security on or before the settlement date.” The SEC first proposed new Rule 10b-21 in March 2008,10 but had taken no further action on its adoption until issuing this order.

While the SEC expressed hope that these efforts would quell manipulative practices that could lead to further investor loss of confidence in the securities markets, the SEC chose not to revive the “uptick” rule, which had been the SEC’s historic measure for regulating against short sale manipulation. The uptick rule (former Rule 10a-1) was originally adopted by the SEC in 1938 after conducting an inquiry into the effects of concentrated short selling during the market break of 1937. The uptick rule provided that, subject to certain exceptions, at the time a listed security was sold short, it had to be sold either at a price above the price at which the immediately preceding sale was effected or at the last sale price, if the last sale price was higher than the last different price. The SEC eliminated the uptick rule on July 6, 2007, after concluding that it did not appear necessary to prevent manipulation.11 Although a number of commentators are clamoring for reinstatement of the uptick rule, there is no indication that Chairman Christopher Cox is willing to entertain the idea.

September 18 Emergency Rules

The SEC’s September 18 emergency rules prohibit all short selling in the stocks of 799 listed financial institutions12 and impose new daily short sale reporting requirements on Form 13F filers.13

  • Prohibition Against Short Selling in Financial Stocks. Effective immediately and until 11:59 p.m. on October 2, 2008, all short selling in the stocks of 799 listed financial services companies is prohibited. The SEC included limited exemptions for short sales by registered market makers, block positioners, or other market makers obligated to quote in the over-the-counter market as part of their bona fide market making activities, for short sales resulting from automatic exercise or assignment of an equity option held prior to the effectiveness of the SEC’s order due to expiration of the option, and a one-day exemption for options market makers who sell short on September 19 as part of their bona fide market making and hedging activities related directly to market making in equity derivatives.
  • New Daily Short Sale Reporting Obligations. Effective at 11:59 p.m. on September 18, 2008, until 11:59 p.m. on October 2, 2008, all Form 13F filers14 will be required to submit a new daily form (Form SH)15 on the first business day of every week immediately following any week in which it effected any short sales. Form SH requires disclosure of the number and value of securities sold short for each Section 13(f) security (except for short sales in options), the opening short position, closing short position and the amount and time of the largest intraday short position during each day of the prior week. The disclosure requirements will only apply to short sales effected after September 18, 2008, and no filing will be required if the short position constitutes less than the 0.25 percent of the issuer’s outstanding shares and the fair market value of the short position is less than $1 million.

Expanded Market Manipulation Investigations

At the same time he announced the September 17 emergency orders, Chairman Cox announced that the SEC’s Enforcement Division plans to expand its ongoing investigations of securities industry controls against manipulation of securities prices by undertaking additional enforcement measures against market manipulation. Previously, on July 13, 2008, the SEC had issued an unusual Sunday afternoon press release announcing that it, FINRA and the NYSE would be conducting “examinations aimed at the prevention of the intentional spread of false information intended to manipulate securities prices.”16 Chairman Cox announced that theSEC’s Enforcement Division would be seeking information from “significant hedge funds and other institutional traders” of their past trading positions in specific securities (without specifying which securities) and that those institutions will be “required immediately to secure all of their communication records in anticipation of subpoenas for these records.” The New York Attorney General also has made it clear that his office will be looking into possible wrongdoing on the part of short sellers.

Support for Money Market Mutual Funds

On September 16, the Reserve Primary Fund, one of the United States’ largest and oldest money market mutual funds, announced that it had “broken the buck,” due to losses in its Lehman debt holdings. To stop what was in essence a run on the fund, the Primary Fund stopped all redemptions for up to seven days. So far, it appears that no other money market funds have fallen below $1.00 a share as a result of the current market crisis.17

On September 19, to address concerns that the net asset values of other money market funds may fall below $1.00, the U.S. Treasury Department announced the establishment of a temporary guaranty program for U.S. money market mutual funds.18 For the next year, the U.S. Treasury will insure the holdings of any publicly offered eligible money market mutual fund — both retail and institutional — that pays a fee to participate in the program. The new guaranty program will be funded from the Exchange Stabilization Fund, which was established in the Depression.

Simultaneously, the Federal Reserve announced that will extend non-recourse loans at the primary credit rate to U.S. depository institutions and bank holding companies to finance their purchases of high-quality asset-backed commercial paper from money market mutual funds. This measure is intended to help money market mutual funds that hold asset-backed commercial paper fund investor redemptions.

Treasury Actions and Proposals

Today, Treasury announced increased purchases of mortgage-backed securities and proposed a new mortgage-related asset disposition program. These actions conceivably could have great significance for the financial services industry.

  • Purchases of MBS. In connection with the resolutions of Fannie Mae and Freddie Mac announced on September 7, these two government-sponsored enterprises (GSEs) became subject to limits on their mortgage-backed securities (MBS) portfolios. At that time, Treasury announced its intention to purchase GSE-issued MBS in the open market in unspecified amounts. This morning, Secretary Paulson said that the GSEs would be allowed to increase purchases of MBS and that Treasury would expand its own MBS purchase program. Evidently, both kinds of purchases would exceed previous limits, but by just how much is unclear.
  • Mortgage Asset Clearing. Discussions between Treasury, the Federal Reserve, and House and Senate leaders began in earnest yesterday over an as-yet undefined taxpayer-funded program in which the government (acting through an existing or new agency) would purchase distressed mortgage assets from investors at a discount and later sell the assets in the secondary market. According to press reports, Democrats are likely to condition their participation on an accompanying effort to relieve distressed homeowners. Secretary Paulson said today that Treasury hoped to complete legislation by September 26, the last scheduled day of this Congressional session before the elections in November. The apparent model would be the Resolution Trust Corporation (RTC), which managed the liquidation of failed thrifts in the early 1990s. There were reports earlier this year that Congress and the regulators were also looking to the Home Owners Loan Corporation (HOLC), which was established in 1933 to assist homeowners, but if the concept is asset disposition, that was not a function of the HOLC.

In a somewhat lesser noted statement on Wednesday, September 17, Treasury announced a Supplementary Financing Program, under which it would auction Treasury bills to provide cash for various Federal Reserve financing initiatives. Dates, amounts and other conditions for the auctions were not disclosed.

Other Federal Reserve Actions

In addition to its actions related to Lehman, the Federal Reserve has taken other steps to improve market liquidity. Today, it announced plans to purchase from primary dealers federal agency discount notes, which are short-term debt obligations issued by Fannie Mae, Freddie Mac and the Federal Home Loan Banks. Yesterday, the Federal Reserve expanded its swap lines with several central banks by $180 billion.

One final note on Federal Reserve activity: On September 15, the Federal Reserve, together with the other federal agencies, proposed a loosening of the capital rules relating to the amount of goodwill that must be deducted from Tier 1 capital. Currently, goodwill must be deducted in its entirety, with no netting for deferred tax liability associated with the goodwill.19 The proposal, if finalized, would allow a banking organization to deduct associated deferred tax liability from goodwill before making the Tier 1 capital deduction. The proposal was prompted by banking organizations seeking some relief from the capital consequences of impairments in goodwill.

SEC Relaxes Stock Repurchase Safe Harbor Requirements

On September 18, the SEC also invoked its Section 12(k)(2) emergency authority to temporarily relax two requirements for compliance with the limited share repurchase safe-harbor provided under Exchange Act Rule 10b-18.20 The relief became effective at 12:01 a.m. on September 19, and will terminate at 11:59 p.m. on October 2, 2008, unless extended by the SEC.

Specifically, the SEC has temporarily relaxed the Rule 10b-18(b)(2) timing condition to permit otherwise compliant Rule 10b-18 purchases to constitute the opening transaction in a reported or exchange-traded security or to occur during the one-half hour before the scheduled close of trading on the primary market for the security. The SEC also has relaxed the Rule 10b-18(b)(4) daily volume condition to permit Rule 10b-18

purchases up to 100 percent of the average daily trading volume (ADTV) of the security. All other requirements of Rule 10b-18, including limitations on the manner in which purchases are effected and the prices at which shares are acquired, remain applicable. The SEC concluded that temporarily relaxing the timing and volume conditions in the rule 10b-18 safe harbor “will provide additional flexibility and certainty to issuers that consider executing repurchases during the current market conditions.”

Observations

Most opinions or conclusions about the federal government actions during the week of September 14 are likely to be superseded (if not reversed) by decisions in the coming weeks and months. A few principles seem to have emerged, however.

First, although Treasury and the Federal Reserve have maintained steadfastly that their three priorities are providing stability to financial markets, supporting the availability of mortgage finance and protecting taxpayers, the government has placed the greatest emphasis on providing liquidity for market participants that do not otherwise appear to be in danger. The ideal is probably the Lehman situation, in which the Federal Reserve was able to take relatively modest steps to protect participants, while the ailing institution failed. Avoidance of taxpayer costs (and the corollary prevention of moral hazard) is a decidedly lower priority, however. If the protection of apparently healthy participants requires federal assistance, the Federal Reserve and Treasury are prepared to provide it, as they have for AIG.

Second, one can anticipate that federal agencies will, at some point, use even their most arcane powers. The Federal Reserve’s various loan programs in 2008 mark the first time that it has invoked its section 13(3) lending authorities since the Depression, and the temporary exemption for bank loans to securities affiliates is only the second time that that power has been relied upon.

Third, while the loans and other actions provided by the Federal Reserve and Treasury are doubtless welcome, these two institutions do not make a market, and ultimately the private market will have to absorb — at significant loss — the troubled assets that are at the source of the current crisis. It may be appropriate to turn to an RTC-like disposition mechanism, as has been reported, but it will be a deep historical irony. As a liquidator, the RTC depressed real estate prices for a number of years. Furthermore, the RTC was a strong proponent of the securitization structure — RTC assets were among the first assets sold into securitization pools — yet it is that structure that several observers believe has contributed significantly to the problems today.

Fourth, to the extent the proposed mortgage asset disposition program is available to insured depository institutions, it would appear to constitute an indirect subsidy of the Deposit Insurance Fund (DIF). Veterans of the thrift crisis will recall that the RTC came into existence primarily because the insurance fund for thrift institutions had become insolvent. Even with recent failures, the DIF should have over $30 billion available to resolve failing banks and thrifts.

Fifth, an unalterable rule for bank resolutions ever since the savings and loan crisis has been that any government-approved transaction, including any transactions out of conservatorship or receivership, must be at the “least cost” to taxpayers. Presumably the same principle would apply to the proposed disposition program. If it does not, banks, their investors and the DIF will have an arbitrage opportunity.

In any event, it is clear that several legal developments in Washington will continue to unfold over the next several days. Secretary Paulson’s hope for legislation by the end of next week may be optimistic, considering that comparable legislation in 1989 required several months of intense work, but even if Congress is unable to reach a legislative conclusion, the stage will be set for further legal activity later this year and next.