The last month was a historic one for the American financial system. The near total collapse of the financial markets was meant to be averted by the passage of the Emergency Economic Stabilization Act of 2008 (“EESA”). After much political jostling aimed at marketing the program as one that would help “Main Street” rather than just “Wall Street,” the EESA became law. The EESA authorizes the Secretary of the Treasury to establish the Troubled Asset Relief Program (“TARP”). Among other things, the TARP will make direct investments in United States financial institutions and purchase troubled mortgage assets of those institutions and/or guarantee the related payment obligations.
Many strings are attached for those institutions that participate in the TARP. Participants who plan to seek direct investments from the Treasury, sell assets to the TARP or obtain a Government guaranty from the TARP must (a) determine the terms of the senior preferred stock, (b) pay risk-based premiums in exchange for the Government’s “guarantee,” (c) impose limitations on executive compensation when direct sales of assets are made to the Government, (d) issue non-voting warrants or other securities (including debt and equity instruments) to the Government to prevent a windfall to financial institutions, and (e) permit the Government to “recoup” losses created by a shortfall through an increased tax bill or otherwise.
These conditions introduce a level of uncertainty that may limit the TARP’s effectiveness. How will the TARP price the premium of an uninsurable risk? What are the terms of the senior preferred instrument beyond the cumulative dividend requirement? Will the top five executives be moved to non-public entities or depart with valuable employees? How will warrants be priced to prevent stifling a company’s ability to raise capital? Is the transfer of assets to the TARP a sale or a loan with any shortfall covered through taxes?
Regardless of the uncertainty, in the end, the financial institutions might have no choice. Just as the Government found itself cornered, if enough financial institutions like the deal, others might be forced to follow. In order to retain a competitive edge in a new deleveraged environment, there may simply be no other options for even the biggest names on Wall Street.