Treasury Secretary Geithner has announced the broad outlines of the Administration’s plan to stabilize and ensure the recovery of the financial services industry, using the second half of the $700 billion authorized by the Emergency Economic Stabilization Act of 2008 (“EESA”) as well as an unspecified additional amount of funds. Treasury has endeavored to design the Financial Stability Plan (“Plan”) to address criticisms leveled at the Capital Purchase Program, the $250 billion program at the heart of the Bush Administration’s plan for the first half of the EESA funding. The government is in a difficult position as it attempts to balance its competing and potentially conflicting roles as regulator of banks, investor in banks, and advocate for borrowers.
Many commentators have expressed concern about the lack of specificity in the Secretary’s announcement. Nevertheless, Secretary Geithner’s sketch presents sufficient information to draw some preliminary conclusions with regard to the Plan. Final reviews must await the development and publication of the complete Plan.
- The Banking Industry Under the Plan
The Plan contemplates that all large banking institutions (assets in excess of $100 billion) will undergo a “stress test” that will evaluate whether they have the capital necessary to continue lending and absorb potential losses that might arise from a severe economic downturn. In addition, any banking institution that wishes to apply for a government investment under the Plan’s Capital Assistance Program (“CAP”) must undergo the stress test, and there will likely be significant pressure to ultimately apply the stress test across the full range of banking institutions. Treasury has not provided any details regarding the stress test. As a practical matter, its appears likely that the Treasury Department and the federal banking agencies will utilize the stress test as a tool in conducting a form of economic triage for all FDIC-insured depository institutions, and that all those institutions will be sorted into three broad categories.
Category One - A Difficult Challenge Ahead
Institutions that do not pass the stress test, particularly those that are not viewed as systemically significant (i.e., small enough to fail) are likely not to receive funds under the CAP. They may continue to go it alone, but, in the face of a dramatically changing market, they may face intense pressure to find new capital or an acquirer in order to preserve value for their shareholders and avoid FDIC receivership. In some regards, this process may be analogous to the bank holiday declared by the Roosevelt Administration in 1933, during which all banks were examined and only those deemed to be sufficiently solvent were permitted to reopen.
Category Two - The Government Bank Model
Institutions that are considered “viable” under the stress test, but that may still need additional capital will face very difficult choices with regard to the acceptance of government assistance. Unlike the relatively modest government influence that accompanied investments under the Capital Purchase Program, new CAP investments will come with several significant conditions:
- Submission of a plan detailing how the bank plans to use the capital to preserve and strengthen its lending capacity and comparative monthly reports showing new loans and new purchases of assetbacked and mortgage-backed securities with and without CAP.
- Implementation of government-directed foreclosure mitigation programs that may be designed to address community needs first, and safety and soundness second.
- Compliance with recordkeeping and reporting requirements for the use of government funds consistent with, among other things, 18 U.S.C. § 1001 and the requirements of the False Claims Act regarding false statements.
- Restrictions on dividends, stock repurchases and acquisitions.
- Strict limitations on executive compensation and golden parachute payments.
The interests of the government and the CAP conditions are likely to create a very different, risk-averse operating culture for banks, and present the danger of replicating the conflicts of public and private missions and priorities that former Treasury Secretary Paulson and others have cited as primary factors leading to the conservatorship of Freddie Mac and Fannie Mae. In any event, institutions that receive CAP investments can reasonably expect that various aspects of their operations may have to be adapted to the new environment and that what they do and how they do it may be the subject of future congressional criticism and inquiry.
Investments made by the Treasury under CAP will be placed in and managed by a newly created entity, the Financial Stability Trust, the role of which remains to be explained. This may hopefully be a way to mitigate the conflicts that the government will face as regulator and investor of the same institutions at the same time.
Category Three - Going it Alone
Institutions that receive strong ratings under the stress test may not need a CAP investment. Those institutions should be best positioned to attract private investment to further bolster their financial condition, and they may find improved opportunities to make acquisitions as the ranks of authorized acquirers of healthy institutions are thinned.
- Public-Private Purchases of Troubled Assets – A New TARP?
In a portion of the Plan that clearly remains under development, Secretary Geithner signaled a possible return to the unimplemented strategy under the Troubled Asset Relief Program of buying troubled assets from financial institutions. As we discussed when the idea was first considered, such a program faces two key obstacles – (i) possible claims of favoritism if individual transactions are pursued or the government pays too much, or (ii) possible significant devaluations of various asset categories in the event that low prices are set in widely publicized auctions. See Emergency Economic Stabilization Act Offers Opportunities for Sellers, Contractors and Purchasers, 21st Century Money, Banking and Commerce Alert® No. 08-10-06 (Oct. 6, 2008).
The government appears to believe that it may be able to overcome these obstacles by placing the pricing decisions in the hands of the private sector through a Public-Private Investment Fund (“Fund”). The FDIC and the Federal Reserve also are expected to play an as yet unannounced role in the Fund. The Fund may take any, or all, of several forms.
One structure mentioned by Secretary Geithner is a side-by-side partnership between private investors and the government to purchase particular assets. Private sector investors should carefully consider how the partnership and the acquired assets will be managed. The ultimate value of the acquired assets could be significantly impacted by a government requirement, for example, that assets be managed under government loan modification standards. The profitability of the partnership may also be affected by the speed with which the government is able to respond to opportunities to purchase or sell assets and the recordkeeping and reporting requirements that the government may impose.
Another structure mentioned by the Secretary is for the Fund to use public financing to leverage private capital on more favorable terms than private investors could obtain for themselves. The government also could provide some level of financing and/or asset value guarantees to private sector purchasers of troubled assets. Here as well, private sector parties will need to carefully evaluate the impact of and risks associated with purchase transactions that involve the government.
At the most basic level, there appears to be an expectation that the ultimate value of the troubled assets currently held on the books of financial institutions are subject to further decline from their currently recorded values. The question remains how government policy will impact where this risk ultimately falls: on financial institutions currently holding these assets, private purchasers, the government, or some combination of these parties.
- Consumer and Business Lending Initiative
Secretary Geithner also announced plans to expand the previously announced, but not yet implemented, Term Asset-Backed Securities Loan Facility (“TALF”), to be administered and funded by the Federal Reserve. The expanded TALF will cover a broader range of asset classes, including non-agency residential mortgage-backed securities, commercial mortgage-backed securities, and assets collateralized by corporate debt, and will be enlarged from its original size of $200 billion (with a $20 billion contribution by the Treasury to absorb the first losses) to up to $1 trillion (with a $100 billion Treasury contribution). TALF is viewed as a method to provide financing in areas where depository institutions are not the primary source of funds. See Federal Reserve and Treasury Announce a New Facility to Provide Liquidity for Asset-Backed Securities, 21st Century Money, Banking and Commerce Alert® No. 08-11-26 (Nov. 26, 2008).