On Feb. 10, 2009, Timothy Geithner, the newly appointed Secretary of the Treasury, announced a new Financial Stability Plan (the "Plan") designed to "restart the flow of credit, clean up and strengthen our banks, and provide critical aid for homeowners and for small businesses." The Plan is designed to be "comprehensive and forceful" to meet the challenges presented by the current financial crisis. To that end, the Plan earmarks the second $350 billion that was authorized by the Emergency Economic Stabilization Act of 2008 (the "EESA"), establishes new initiatives, and builds upon existing programs.
The major elements of the Plan are: (i) the injection of additional capital into banks that have undergone a comprehensive "stress test" through the new Capital Assistance Program (the "CAP"); (ii) creation of a public/private investment fund to purchase troubled "legacy" assets from financial institutions; (iii) provision of assistance to homeowners by furnishing funds to support loan modifications and by establishing formal loan modification guidelines; and (iv) expansion of the Federal Reserve's existing Term Asset-Backed Securities Loan Facility (the "TALF") to help fund new consumer loans, small business loans, and commercial mortgage asset-backed securities issuances. Secretary Geithner's announcement did not contain many details regarding these initiatives.
The lack of details and specifics had a definitive negative impact on how Treasury's Plan was perceived by many constituencies. For example, almost immediately the Dow Jones Industrial Average fell by 382 points, or 4.6 percent and the S&P 500 declined by almost 43 points, or 4.9 percent; both indices are now close to five-year lows. The Congressional reaction was not as supportive as the Obama administration would have wanted, and in some cases was fairly negative. At the recent G-7 meeting, the finance chiefs from the Group of Seven nations urged Treasury Secretary Geithner to move faster to fix the U.S. banking system. Some also expressed concern with the lack of details.
Transfer Pricing Remains an Issue for Legacy Assets
While the new Treasury Plan is more comprehensive and broader in scope than the one announced Oct. 14, 2008 by then Treasury Secretary Paulson, just like that Treasury proposal, the new Plan fails to deal with the "Achilles heel" of any bank balance sheet clean up: What is the right methodology for fairly pricing the problem legacy assets? If the transfer pricing advantages the bank selling the assets, the Treasury Department and the U.S. taxpayer may not recover on the original investment. If the transfer pricing too advantages the buyer, in this case the Treasury Department and the U.S. taxpayer, the resulting writedown on the selling bank's books may render the bank "book insolvent." Thus, the issue of transfer pricing is critical to clearing banks' balance sheets.
For example, in Mellon's Good Bank-Bad Bank scenario, while Mellon knew the problem assets very well—having been the lender in almost every instance—it took Mellon and its team a number of months to determine the value of each asset based on a discounted estimated projected cash flow model. The internal results were then reviewed by outside auditors, as well as by a well-respected outside audit firm skilled in dealing with real estate type assets, that reviewed all of the projections and assigned values, and signed off on the results. In addition, the underlying assumptions were verified by an independent third-party consulting firm.
The Treasury proposal anticipates that participation by the private sector in helping clear the legacy assets will help establish market prices. However, there are a number of considerations to bear in mind. As time passes and the "legacy assets" age, they will continue to be written down until at some point they will actually reach a price at which they will clear the market. However, the concern is whether banks will have sufficient capital to absorb the writedowns.
Another consideration is that prior to the FDIC agreeing to enter into a stop-loss agreement with private equity investors in connection with the sale to those investors of IndyMac Bank, the view in the marketplace was that the FDIC's stop-loss agreements were intended just for banking organizations to help the FDIC resolve failed banks. Now that private equity is viewed as a source of capital, it is likely that such venture capital investors not only will seek to obtain the problem legacy assets at a low market price, but also will seek to obtain some form of downside loss protection. This will somewhat distort market pricing and challenge the idea in Treasury's Plan that the private sector can more readily establish the correct market price. Unfortunately, the issue remains open at this time.
The five key elements of the Plan are outlined below.
I. Capital Assistance Program – Under CAP, the Treasury Department, through a newly created Financial Stability Trust that will hold Treasury's investments, will be prepared to invest additional bank capital in the form of convertible preferred shares of banking institutions that have undergone a comprehensive "stress test." The stress test is designed to determine whether any of the major banking institutions (with more than $100 billion in consolidated assets) have the capital and reserves to continue lending under a two-year stress scenario. The goal is to determine if they can survive and whether a Treasury buffer is necessary. These capital injections are envisioned to be a "bridge" to the resumption of private capital investment. Smaller banks may also participate in the program after undergoing a similar supervisory review.
Stress Test Raises Some Issues
It is somewhat surprising that Treasury's Plan calls for a "stress test" as that is what the bank examination process is intended to measure. Apparently there is concern that the current bank examination process is inadequate and bank CAMEL ratings need to be significantly revised and expanded upon. A similar concern may exist with the bank/financial holding company examination process and rating system. This is akin to concerns raised as a result of the Credit Rating Agencies' shortcomings. If that is the case, then this suggests that the examination process needs to be revisited, along with the Basel II capital rules. In the case of Basel II, much of its implementation, particularly for the "core banks" subject to the Advanced Measurement Approach, involves bank examiner review of systems, controls, and risk measurements.
The stress test is expected to be conducted under the banking agencies' bank examination privilege to preserve its confidentiality. However, that may raise questions in light of the Treasury's desire to increase transparency. Also, any subsequent injection of capital into a banking organization may be identifying the recipient as financially weaker than its peers.
II. Public-Private Investment Fund – The Treasury plans to work in partnership with the FDIC and the Federal Reserve to initiate a Public-Private Investment Fund that will purchase "legacy" assets from financial institutions. This fund might put public and private capital side-by-side and will use public financing to leverage private capital on an initial $500 billion, with the potential to expand up to $1 trillion. The hope is that this approach will allow the private sector buyers to determine the transfer price for the legacy assets (but, see discussion on Transfer Pricing). Many of the details of this initiative remain to be worked out.
III. Mortgage Loan Modification Program – On Feb. 18, 2009 the U.S. Treasury Department expanded on Treasury Secretary Geithner's initial announcement regarding loan modifications. The expanded proposal is called the Homeowner Affordability and Stability Plan (the "HASP") designed to (i) drive down mortgage rates; (ii) commit $50 billion to prevent avoidable foreclosures; (iii) establish loan modification guidelines based on industry standard best practices; (iv) require all Plan recipients to participate in foreclosure mitigation plans; and (v) build flexibility into the FHA and Hope for Homeowners to enable loan modification for a greater number of borrowers. The Treasury plans to use some of the resources already authorized under EESA to fund this program.
The HASP has three key components. The first component involves providing low-cost refinancing for up to 5 million responsible homeowners to make their mortgages more affordable. This refinancing initiative is designed to help borrowers with conforming loans whose loan-to-value ratio exceeds 80 percent and extends up to 105 percent. The second component of the plan is to support low mortgage rates by strengthening confidence in Fannie Mae and Freddie Mac (the "GSEs"). The Treasury Department plans to do this by: (i) increasing its Preferred Stock Purchase Agreements to $200 billion from their current levels of $100 billion in each of the GSEs; (ii) purchasing the GSEs mortgage-backed securities; (iii) increasing the size of the GSEs retained mortgage portfolio by $50 billion to a total of $900 billion; and (iv) working with the GSEs to support state housing finance agencies. The third and final component of the HASP is the creation of a $75 billion Homeowner Stability Initiative (the "HSI").
The HSI is designed to reach responsible homeowners who are struggling to afford their current mortgage payments. The HSI will not provide aid to speculators or house flippers; it will only be available for owner-occupied homes or for jumbo mortgage loans. The HSI will include: (i) funds to support loan modifications; (ii) incentives for loan servicers and mortgage holders who modify loans; (iii) incentives to encourage borrowers to stay current (in the nature of annual $1000 payments to reduce principal, up to $5000); (iv) incentives to encourage lenders and borrowers to modify "at-risk" loans before the borrower falls behind; (v) a partial guarantee insurance fund of up to $10 billion to protect lenders from declines in home prices on mortgages modified under the program; (vi) the development of uniform mortgage modification guidelines; (vii) strong oversight, mandatory reporting and quarterly meetings of Treasury, the FDIC, the Federal Reserve and HUD to monitor performance; (viii) support of legislation permitting judicial "cram down" modifications of home mortgages for borrowers during bankruptcy; (ix) $1.5 billion in relocation and other forms of assistance to renters displaced by foreclosure and $2 billion in neighborhood stabilization funds; and (x) improvement in the flexibility of FHA programs, including Hope for Homeowners, to modify and refinance at-risk borrowers.
The HSI does not impose a foreclosure moratorium, and the HSI states that short sales and deeds in lieu should be considered in lieu of foreclosure. The proposed guidelines state that (a) all recipients of future Plan funds must "participate in foreclosure mitigation plans" similar to those proposed by Treasury, (b) Fannie Mae and Freddie Mac will use the guidelines for loans they own or guarantee, and (c) the guidelines will apply to loans "owned or serviced by" insured financial institutions regulated by the OCC, OTC, FDIC, Federal Reserve or the NCUA. The guidelines also state that financial institutions receiving Plan assistance in the future will be required to implement loan modification plans "consistent with" the guidelines.
IV. Consumer and Business Lending Initiative – The Consumer and Business Lending Initiative (the "CBLI") will expand upon the Federal Reserve's already announced but not yet implemented TALF program. According to Treasury, the CBLI will support the purchase of loans in the secondary market by providing the financing to private investors to help unfreeze and lower interest rates for auto, small business, credit card, and other consumer and business credit. Under the original plan for the TALF program, Treasury was to use $20 billion to leverage $200 billion of lending from the Federal Reserve. The Plan's expansion of the TALF program will use $100 billion to leverage up to $1 trillion of lending. CBLI will also expand the TALF program to include commercial mortgage-backed securities and possibly other asset classes, such as non-agency residential mortgage-backed securities and assets collateralized by corporate debt. Purchases under CBLI will be limited to newly packaged AAA rated loans.
V. Small Business and Community Lending Initiative – In the coming days, President Obama, the Treasury and the SBA will announce a new Small Business and Community Lending Initiative. This program will provide funding under CBLI to finance the purchase of AAA-rated SBA loans in an attempt to unfreeze the secondary market for small business loans.
Improved Transparency, Accountability and Conditionality
In addition to the major initiatives discussed above, Treasury's Plan announcement included proposed new standards designed to provide for greater transparency, accountability and conditionality with tougher standards for firms receiving "exceptional assistance." Under the Plan, institutions that receive assistance will be required to show how the assistance will expand lending, and recipients of exceptional assistance must show how every dollar of capital they received is enabling them to preserve or generate new lending in comparison with what would have been possible without the Treasury's capital assistance. All contracts under the Plan will be available on FinancialStability.gov within five to 10 business days of their completion, and all information that is disclosed or reported to Treasury will be posted on that website. The website is not yet fully operational, but should be up and running soon.
The Plan includes important new restrictions on the payment of dividends, repurchasing privately held stock, acquisitions and executive compensation. These restrictions are designed to provide assurances to taxpayers that all of the capital invested by Treasury under the Plan will go to improving banks' capital bases and promoting lending. It is important to note that these new standards are not retroactive. First, banks that receive exceptional assistance will only be allowed to pay a $0.01 quarterly common dividend. The presumption is that all institutions that receive capital will abide by this restriction unless the Treasury Department and the institutions' primary regulator approve a higher dividend. Second, all institutions that receive funding from the CAP will be restricted from repurchasing any privately held shares until the government is repaid. Third, with limited exceptions, all banks that receive capital assistance will be restricted from pursuing cash acquisitions of healthy firms until the government is repaid. Finally, institutions will be required to comply with the senior executive compensation restrictions that were announced on Feb. 4, 2009, including the $500,000 cap on total annual compensation.
As indicated above and as Secretary Geithner stated, this process will be subject to some trial and error and adjustments. However, let us hope the Treasury will quickly adjust for windage and distance, and score a quick bullseye.