“Stunning for its stark simplicity” is how the New York Times described the three-page draft legislation, submitted Saturday by the U.S. Treasury to the U.S. Congress, that would grant the Treasury sweeping authority to buy up to $700 billion in mortgage-related assets from financial institutions. The proposal caps a week of unprecedented upheaval in the global financial markets that has left its mark in ways unimagined just a week ago and a year that has seen financial institutions write down a reported $500 billion in credit-related assets.
We set forth below a chronology of the week’s events and review the Treasury proposal, as it currently stands. We note that the details are sketchy: we have a “fact sheet” from Treasury, a draft of the proposed legislation and statements made throughout the weekend by the key players in Washington and New York. Much remains to be done in a very short period of time.
The Week’s Events
In the days leading up to the tumultuous week, Fannie Mae and Freddie Mac (two of the so-called government-sponsored enterprises (“GSE”)) had been placed in conservatorship by the government. Among other things, this put tremendous strain on the credit default swaps (CDS) market. At the end of the week, Treasury and the Fed decided they would not come to the rescue of Lehman Brothers.
On Monday morning, the markets awoke to the news that Lehman Brothers Holdings Inc. had filed for bankruptcy protection under Chapter 11 and Merrill Lynch had agreed to be bought by Bank of America. Subprime losses required AIG to deliver more collateral resulting in a credit rating downgrade, forcing it in turn to need more cash to satisfy calls for more collateral on its derivative positions. On Sunday, AIG was reported to have requested a bridge loan from the Fed and Treasury. On Tuesday, the government extended an $85 billion liquidity facility to AIG and effectively took control of the company – an insurer with global operations, a $1 trillion balance sheet and significant CDS positions (much of it with bank counterparties) that could have caused a further downward spiral (forcing financial institutions, already burdened by CDS write-offs, to close out positions and further mark to market positions reflecting fire sale prices) had it failed.
These events set off panic in the markets – the commercial paper market that provides short-term liquidity for corporates and financial institutions and the CDS market came under significant strain, as market participants scrambled to figure out how Monday and Tuesday’s events would impact them. Trading volumes in the CDS market skyrocketed and spreads widened significantly as traders rushed to unwind positions. Investors fled to short-term government bonds, driving yields to zero, and then the first money market fund saw its value fall below the sacrosanct $1.00 a share. This latter market (reported to have assets of $3.4 trillion, down $170 billion in the week) is the safe haven of the U.S. savings market – where a full range of market participants, from corporate treasurers to pension funds to retail investors, park cash, viewing the accounts as the equivalent of cash – and the money market funds are key players in the commercial paper market.
Notwithstanding an influx of a reported $180 billion of additional liquidity into the system on Thursday, as the events cascaded, culminating in the exodus from money market funds (one report estimated redemptions at $144.5 billion, compared to $7.1 billion the week before) and at least one fund closing to redemptions, trust was in short supply. Funds were hoarding cash to fund redemptions, depriving the commercial paper market of cash and driving the costs of borrowing up sharply. Traders of credit assets were finding no buyers.
Meanwhile, the shares of the standalone investment banks, whose ranks had been thinned by the disappearance of Bear Stearns in March, the Lehman Brothers Chapter 11 filing and the purchase of Merrill by Bank of America, were plummeting and their CDS spreads were widening significantly. In the U.K., HBOS, the U.K.’s largest mortgage lender, suffered a run on its stock and a withdrawal of funds by depositors, reminiscent of Northern Rock; it was taken over by Lloyd’s TSB.
Thursday and Friday saw a flurry of activity from the three agencies leading the efforts to calm the U.S. markets – the SEC, the Fed and Treasury. The SEC took emergency action on Thursday, but under intense pressure took further action on Friday, with the overall effect of temporarily banning short-selling of the securities of 799 financial institutions (announced in conjunction with similar action taken by the U.K. Financial Services Authority (“FSA”)) and temporarily banning “naked” short selling across the board (in effect forcing short sellers to borrow shares as part of the trade).
The Fed early Thursday announced a plan to inject $180 billion into the financial markets through temporary reciprocal currency arrangements with the ECB and the central banks of Britain, Canada, Japan and Switzerland. With banks remaining wary of lending to one another, further amounts were reported to have been injected.
The Fed, acting to reduce liquidity and other strains affecting money market mutual funds, also opened the discount window to financial institutions (U.S. depository institutions, bank holding companies, and U.S. branches and agencies of foreign banks) on the condition they use the funds to purchase asset-backed commercial paper (ABCP) from money market mutual funds. In support of the special ABCP lending facility, the Fed adopted temporary exemptions to increase the capacity of banks to buy ABCP from affiliated mutual funds and temporary exemptions from its leverage and risk-based capital rules for ABCP. This relief is available through January 30, 2009.
Meanwhile, the Treasury put in place a temporary insurance program, by tapping assets of the Exchange Stabilization Fund (established in 1934 to deal in gold, foreign exchange and other instruments of credit and securities to promote international financial stability) of up to $50 billion to support money market mutual funds (to allow them to maintain their net asset value at $1.00 per share). Treasury also announced that Fannie Mae and Freddie Mac would increase their purchases of mortgage-backed securities to provide additional funding and that it would expand a plan announced at the time of the Fannie Mae/Freddie Mac takeover to buy in the open market mortgage-backed securities of those two companies.
By week’s end, with inter-bank lending still essentially frozen, the Treasury saw it had little choice but to put forward the plan of last resort, which reportedly had been circulating for a month, to get the financial markets back on the right track. Reports of the plan started circulating late Thursday. Markets soared in late afternoon trading in the U.S. on Thursday and global markets soared on Friday, led by a rebound in the shares of financial institutions. Institutional investors pulled back out of the safe haven of the Treasury bond market, sending yields up.
The Treasury plan calls for taking distressed assets off the balance sheets of the U.S. financial services sector, thereby addressing, in the words of Treasury Secretary Paulson, with “the systemic risks and stresses in [the U.S.] capital markets.” In a statement issued on Friday, Secretary Paulson, charted the evolving crisis:
- lax lending practices leading to 5 million homeowners being delinquent or in foreclosure;
- a spread of the subprime crisis to less risky mortgages, impacting lenders of these mortgages and those that bought, repackaged and resold them;
- troubled loans remaining frozen on bank balance sheets preventing other loans from being made;
- an inability to value mortgage assets, creating further uncertainty about the assets and the financial condition of the institutions that hold them, constraining the trading of such assets;
- leading to the conclusion that action is needed to remove the illiquid assets from the balance sheets of financial institutions to avoid further failures and a continued paralysis of the credit markets.
Summary of Regulatory and Legal Steps
Lehman Brothers Holding Inc. (“LBHI”) filed for Chapter 11 protection, the largest such case ever filed. None of Lehman’s subsidiaries in the United States (including its broker-dealer, Lehman Brothers Inc. (“LBI”)) were covered by the filing. Brokerage firms are unable to file for Chapter 11 protection under the Bankruptcy Code. The filing triggered the “automatic stay” provisions of the Bankruptcy Code, which prohibit creditors from taking any action against LBHI to collect on claims or exercise control of any kind over LBHI’s property. The automatic stay is not absolute, however; for example, the automatic stay does not apply to the enforcement of contractual rights under swap agreements. Various of Lehman’s non-U.S. subsidiaries filed for bankruptcy protection or for administration outside the United States.
On Saturday, following an 11-hour hearing at which the SEC and other government agencies supported Lehman’s arguments for swift approval, the Bankruptcy Court approved the sale of LBI to Barclays Capital.
On Monday, AIG obtained permission from New York State to tap $20 billion in its operating subsidiaries. This did not stem AIG’s liquidity crisis, and Tuesday night the Fed announced that the Federal Reserve Bank of New York would extend a 24-month liquidity facility to AIG of up to $85 billion. In its announcement, the Fed stated that the purpose of the liquidity facility was to assist AIG in meeting its obligations as they become due, and that the facility would facilitate a process under which AIG would sell certain businesses. The facility is collateralized by the assets of AIG and its primary non-regulated subsidiaries, including the stock of substantially all of its regulated subsidiaries. The facility is expected to be repaid out of asset sale proceeds. In return, the government is to receive a 79.9% equity interest, with rights to veto dividends on common and preferred stock. It remains unclear how the equity interest is to be structured; a press release announcing the need for shareholder approval was rescinded.
SEC short selling action
Concerned with investors’ confidence in the face of precipitous declines in stock prices, particularly of financial institutions, regulators worldwide acted on an emergency basis. The SEC had acted in July to address short sale practices in respect of the securities of the 19 primary dealers in the U.S. by imposing a 30-day ban on “naked” short sales, limited to securities of those issuers. Starting Thursday, the SEC took multiple actions, including (a) imposing a temporary ban through October 2 on short sales of publicly traded securities of 799 banks, insurance companies and securities firms, (b) requiring investment managers with Form 13F filing obligations as of June 30th that sell short to report short sales, again through October 2; and (c) imposing new rules that in effect ban “naked” short sales applicable to the securities of all public companies, by requiring that underlying shares be borrowed failing which the position is to be closed out. The FSA, acting in parallel with the SEC, imposed a ban on short sales of U.K. financial institutions (29 were specified in an annex) and imposed and reporting requirements. Other regulators took similar action.
Enforcement action aimed at market manipulation
Just as the SEC action on short sales was phased in (with Friday’s action imposing more stringent rules over and above Thursday’s), so too were the announcements regarding enforcement action. On Thursday, the SEC announced that the Division of Enforcement would step up its enforcement activities aimed at curbing market manipulation. (Back in July, when the SEC announced its emergency order in respect of short sales of primary dealers’ securities, it reminded the market that it was concerned about the spreading of false rumors and that the principal regulators had stepped up examinations of broker-dealers to curb these rumors and ensure compliance procedures were in place.)
Then, late Friday, the SEC announced a sweeping expansion of its ongoing investigations into possible market manipulation. The SEC stated that hedge fund managers, broker-dealers and institutional investors with significant trading activity in financial issuers or CDS positions would be required, under oath, to disclose their positions and provide other information to the SEC.
The SEC has also approved an order of investigation that will allow its enforcement staff to obtain additional documents and testimony by subpoena. Investigators from NYSE Regulation and the Financial Industry Regulatory Authority will also conduct a parallel investigation, through on-site visits to broker-dealers.
Separately, the Office of the New York Attorney General announced an investigation of short selling practices focused on short sales combined with the spreading of false rumors to manipulate the price of traded stock.
The Treasury proposal
The following is based on the “fact sheet” provided by Treasury in respect of its proposal for legislative authority to buy troubled assets:
Scale and Timing of Asset Purchases
- Treasury will have authority to issue up to $700 billion of Treasury securities to finance the purchase of troubled assets.
- The purchases are intended to be residential and commercial mortgage-related assets, which may include mortgage-backed securities and whole loans.
- The Treasury Secretary will have the discretion, in consultation with the Chairman of the Federal Reserve, to purchase other assets, as deemed necessary to effectively stabilize financial markets.
- The timing and scale of any purchases will be at the discretion of Treasury and its agents, subject to this total cap.
- The price of assets purchases will be established through market mechanisms where possible, such as reverse auctions. The dollar cap will be measured by the purchase price of the assets.
- The authority to purchase expires two years from date of enactment.
Asset and Institutional Eligibility for the Program
- To qualify for the program, assets must have been originated or issued on or before September 17, 2008.
- Participating financial institutions must have significant operations in the United States, unless the Treasury Secretary makes a determination, in consultation with the Chairman of the Federal Reserve, that broader eligibility is necessary to effectively stabilize financial markets.
Management and Disposition of the Assets
- The assets will be managed by private asset managers at the direction of Treasury to meet program objectives. Treasury will have full discretion over the management of the assets as well as the exercise of any rights received in connection with the purchase of the assets.
- Treasury may sell the assets at its discretion or may hold assets to maturity.
- Cash received from liquidating the assets, including any additional returns, will be returned to Treasury's general fund for the benefit of U.S. taxpayers.
- Funding for the program will be provided directly by Treasury from its general fund.
- Borrowing in support of this program will be subject to the debt limit, which will be increased by $700 billion accordingly.
The Treasury Proposal
The Treasury plan is expected to be voted on this week (Congress is scheduled to adjourn on Friday). From a purely political standpoint, this is a sensitive time in view of the upcoming presidential election only weeks away and the state of the U.S. economy being by far the major concern of voters. The Bush administration had steadfastly refused bailouts – but that had changed with Bear Stearns, the two GSEs and AIG. Now a bipartisan solution will need to be crafted. The final outline of the plan will depend in part on the outcome of efforts of Democrats in Congress to include measures to protect taxpayers and homeowners. There have been calls to include provisions for tighter regulation of the industry, and one influential lawmaker has called for limits on executive pay for firms that take advantage of the plan.
Details will have to be worked out, among them who will manage the assets and how they will be bought. The plan is broad in its coverage, subject only to the $700 billion cap, the September 17th origination date cut-off, the requirement that sellers be U.S.-headquartered and the two-year deadline for purchases. (The proposal is clear that the two-year “sunset” provision does not apply to holding the purchased assets.) The proposal provides for authority to hire asset managers and to set up vehicles to acquire and hold the assets.
A new vehicle, possibly modeled on the Resolution Trust Corporation formed in the wake of the savings and loan (“S&L”) meltdown in the 1980s, is expected to be formed.1 The difference is that this time the vehicle will acquire distressed assets rather than takeover the institutions holding the assets and then liquidate the positions. A key consideration to watch will be the nature of the structure established to execute the goals of the proposal.
There are many unanswered questions about the plan itself, not to mention what additional provisions will need to be added to get bipartisan support in Congress. Some will be answered as the legislation takes shape; others, such as the ultimate costs and how long the program will last, may not be answered for years to come. Among the immediate threshold questions to watch:
- Which institutions can participate? The draft legislation refers to U.S.-headquartered financial institutions. Will hedge funds and private equity funds be able to participate? (Statements by the Treasury Secretary on Sunday suggest the answer will be no.) What of non-U.S. institutions, or their U.S. subsidiaries, branches and agencies in the United States? The fact sheet refers to significant U.S. operations, and contemplates discretion to expand coverage. (Sunday’s statements suggest that the key will be the presence of operations in the United States, though it is also clear that the Treasury Secretary expects his fellow regulators outside the United States to follow suit )
- How will assets for sale be priced, particularly given the lack of readily available market prices? Will the vehicle’s mandate be to buy at the lowest price (presumably yes, in the form of a reverse Dutch auction process), potentially putting further markto- market pressure on assets (the one sold and potentially other similar assets) held around the world by financial institutions? And a more general question, how will the auctions be conducted – and how narrow will the asset class be?
- What will the ultimate scope of eligible assets be?
- How will the $700 billion capacity be allocated?
- What will sellers receive for their sales (cash or some instrument)?
- Will sellers have any liability to Treasury as purchaser?
What effect this will have in the short- as well as the long-term remains an open question. One effect is that purchases will provide greater transparency to pools of assets that today may be carried at different values from firm to firm. Clarity in turn could have further mark-to-market impacts – in either direction.
The other interesting set of considerations to watch will be the additional provisions that are added as the proposal winds its way through the political process.
Strengthening Regulatory Oversight
In his statement on Friday, Treasury Secretary Paulson did not mince words on one of the root causes of the problem: “This crisis demonstrates in vivid terms that our financial regulatory structure is sub-optimal, duplicative and outdated. I have put forward my ideas for a modernized financial oversight structure that matches our modern economy, and more closely links the regulatory structure to the reasons why we regulate.”
In March, Treasury issued its Blueprint for a Modernized Financial Regulatory Structure. Among other recommendations, it called for a fundamental overhaul of the current structure’s diffuse system of regulation over the securities, commodities, banking and insurance sectors. It surveyed regimes worldwide and concluded the United States has four choices: (a) maintain functional regulation divided by the historical industry segmentation, (b) move to a functionalbased system regulating activities as opposed to industry segments, (c) move to a universal regulator regime (as adopted by the FSA in the U.K.) or (d) move to an objectives-based approach focusing on the goals of regulation (as adopted in Australia and Holland). The Blueprint recommends the fourth approach, with three lead actors – a market stability regulator (the Fed), a prudential financial regulator and a business conduct regulator.
That proposal attracted significant criticism, not least from the SEC, which would see the scope of its mandate reduced significantly as oversight of investment banks is moved elsewhere. In the meantime, the SEC Chairman has come under criticism from a variety of quarters. The Fed has played increasingly significant roles, from the bailout of Bear Stearns to this past week’s events, and benefits from significant advantage; it can lend money.
Just as the landscape of market players has shifted significantly in the past week, with implications extending well into the future, so too can we expect the regulatory landscape to shift significantly in the months to come, with far reaching consequences for the U.S. financial markets. And, after last week’s events, we hardly need a reminder of the extent to which events in the United States impact the global markets, and that is as true for stock prices and asset writedowns as it is for regulation.