On November 12, 2008, Treasury Secretary Henry Paulson, Jr. provided an update on the state of the financial rescue package and upcoming priorities for TARP. Concurrently, the Federal bank regulatory agencies issued a joint statement innocently titled “On meeting the needs of creditworthy borrowers.” The substance of these statements, however, reflects a dramatic policy shift by the agencies toward meeting criticisms leveled at the TARP by Democratic leaders. The Treasury and the bank regulatory agencies are now focused on methods to encourage banks to mitigate foreclosures and, most notably, on imposing strict limitations on compensation and dividend payments on all financial institutions, regardless of whether they are participants in the TARP or CPP. The statements by Secretary Paulson and the Federal banking agencies are summarized below.
- The Treasury and the banking agencies are clearly focused on increasing bank lending and foreclosure mitigation. This focus applies to all banks.
- The Federal regulators will increase oversight of the dividend and compensation policies of all banks, regardless of their participation in the Capital Purchase Program.
- The Treasury has suspended the implementation of the program to use TARP funds to purchase troubled assets.
- The Treasury is designing programs for investment in non-bank financial institutions, although it will first complete bank investments under CPP and analyze the effectiveness of such investment before
- addressing non-bank entities.
- Treasury and the Federal Reserve are exploring the development of a potential liquidity facility for highly-rated AAA assetbacked securities.
- Treasury is examining strategies to mitigate mortgage foreclosures.
Mortgage Finance and Foreclosure Avoidance
Both the Treasury and the bank regulatory agencies are focused now on encouraging banks to make loans to creditworthy borrowers and to provide assistance to homeowners to avoid foreclosure. This theme is reflected several times in their statements and applies to every institution, regardless of whether the bank is participating in the CPP or other program. In his statement, the Secretary recounted the work done so far in addressing the housing market and mortgage foreclosures, citing the establishment of the HOPE NOW Alliance, a coalition of mortgage servicers, investors and counselors to help struggling homeowners. The Secretary stated that over 200,000 homeowners a month are being helped in avoiding foreclosure through the programs established by the industry.
Capital Purchase Plan
The Secretary summarized actions under the Capital Purchase Plan (“CPP”), stating that, to date, investments totaling $115 billion have been completed. The Secretary again stressed that the purpose of the CPP is to increase capital so that banks will be more confident and better positioned to play their necessary role to support economic activity. The Secretary then stated the following regarding the role of all banks in the economy:
Today banking regulators issued a statement emphasizing that the extraordinary government actions taken by the Fed, Treasury and FDIC to stabilize and strengthen the banking system are not merely one-sided; all banks – not just those participating in the Capital Purchase Program – have benefited, so they all also have responsibilities in the areas of lending, dividend and compensation policies, and foreclosure mitigation. I commend this action and I am particularly focused on the importance of prudent bank lending to restore our economic growth.
This statement, along with the joint statement issued by the agencies discussed below, is a dramatic shift in bank oversight and may herald the beginning of a new paradigm in bank regulation.
Priorities for Remaining TARP Funds and Further Strategies
The Treasury has identified three critical priorities for the remaining TARP funds. First, the funds will be used to reinforce the stability of the financial system so that banks and other institutions critical to the provision of credit are able to support economic recovery and growth. The Treasury has stressed that this includes both banks and non-banks, opening up for the first time the possibility of TARP funds being invested in non-banking entities. Treasury stated that that it will consider capital needs of non-bank financial institutions not eligible for the current capital program, although broadening access would bring both benefits and challenges. Non-bank financial institutions provide credit that is essential to U.S. businesses and consumers. However, many are not directly regulated and are active in a wide range of businesses, and taxpayer protections in a program for non-banks would be more difficult to achieve. Treasury cautioned that before embarking on a second capital purchase program that would include non-banks, Treasury must complete the first program and assess its impact and use this information to evaluate the size and focus of an additional program in light of existing economic and market conditions.
Second, the funds will be used to support those markets outside the banking system that securitize credit. Approximately 40 percent of U.S. consumer credit is provided through securitization of credit card receivables, auto loans and student loans and similar products. This market, which is vital for lending and growth, has for all practical purposes ground to a halt. The Treasury together with the Federal Reserve is exploring the development of a potential liquidity facility for highly-rated AAA asset-backed securities, that would include possibly the use of TARP funds to encourage private investors to return to this market, by providing them access to federal financing. While this securitization effort will be targeted initially at consumer financing, the program may also be expanded to support new commercial and residential mortgage-backed securities lending.
Third, TARP funds will be used to continue to reduce the risk of foreclosure. The Treasury is reviewing proposals by the FDIC that would result in direct assistance to homeowners. This topic has been the subject of intense political debate within the Congress and the Administration. It remains to be seen how the goal of mitigating foreclosure will be achieved.
Troubled Asset Purchases
Treasury stated that due to the deteriorating market conditions at the time that EESA was passed by Congress, Treasury decided that the statutory language establishing the TARP for the purchase of troubled assets was no longer feasible and determined instead to rely on the very general language in the definition of “troubled assets” to authorize direct equity purchases. Over the past weeks Treasury has continued to examine the relative benefits of purchasing illiquid mortgage-related assets and its assessment at this time is that this is not the most effective way to use TARP funds, although Treasury will continue to examine whether targeted forms of asset purchase can play a useful role, relative to other potential uses of TARP resources, in helping to strengthen our financial system and support lending. Thus, it appears that Treasury has put on hold the purchase of troubled assets in connection with the TARP.
Interagency Statement on Meeting the Needs of Creditworthy Borrowers
On the same day as Secretary Paulson gave his remarks, the Federal bank regulatory agencies issued a joint statement on actions needed to meet the credit needs of borrowers. This statement is notable, not just for its tone in encouraging banks to resume the normal flow of loan generation, but also for the principles on which the bank regulators believe govern prudent lending. The joint statement provides:
At this critical time, it is imperative that all banking organizations and their regulators work together to ensure that the needs of creditworthy borrowers are met. As discussed below, to support this objective, consistent with safety and soundness principles and existing supervisory standards, each individual banking organization needs to ensure the adequacy of its capital base, engage in appropriate loss mitigation strategies and foreclosure prevention, and reassess the incentive implications of its compensation policies.
The regulators stressed that these principles apply to every banking institution in the country, regardless of whether the bank participates in the CPP.
It appears that the shift by the banking agencies in making compensation and dividend restrictions applicable to all banks is in response to key Democratic criticisms of the rescue package. Recently, New York Attorney General Andrew Cuomo sent a letter to the nine initial recipients of TARP funds seeking information on bonuses to be paid and stating that “Obviously, [the Attorney General’s Office] will have grave concerns if your expected bonus pool has increased in any way as a result of your receipt or expected receipt of taxpayer funds from TARP.” Senator Charles Schumer (D-NY) has warned banks of increasing regulation and House Financial Services Committee Chairman Barney Frank (D-MA) has openly complained about the use of TARP funds for anything other than lending stating that, “I am deeply disappointed that a number of financial institutions are distorting the legislation that Congress passed at the President’s request to respond to the credit crisis by making funds available for increased lending. Any use of the these funds for any purpose other than lending— for bonuses, for severance pay, for dividends, for acquisitions of other institutions, etc.— is a violation of the terms of the Act.”
A summary of the Federal banking agencies’ joint statement follows:
Lending to Creditworthy Borrowers
The agencies expect all banking organizations to fulfill their fundamental role in the economy as intermediaries of credit to businesses, consumers, and other creditworthy borrowers. This implies the agencies’ view that with a banking charter comes the obligation to provide credit to worthy borrowers. Moreover, the agencies believe the obligation to lend will increase as a result of problems in financial markets, and the economy likely becoming more reliant on banking organizations to provide credit formerly provided or facilitated by purchasers of securities.
The Federal banking regulators stress that banking organizations should focus on effective and efficient capital planning and longer-term capital maintenance. Such a capital planning process includes assessing both the risks to which the bank is exposed and the risk management processes in place to manage and mitigate those risks; evaluating its capital adequacy relative to its risks; and considering the potential impact on earnings and capital from economic downturns. Further, an effective capital planning process requires a banking organization to recognize losses on bank assets and activities in a timely manner; maintain adequate loan loss provisions; and adhere to prudent dividend policies.
With TARP’s focus on dividend restrictions, the regulatory agencies admonish all banks that, in setting dividend levels, a banking organization should consider its ongoing earnings capacity, the adequacy of its loan loss allowance, and the overall effect that a dividend payout would have on its cost of funding, its capital position, and, consequently, its ability to serve the expected needs of creditworthy borrowers. Banking organizations should not maintain a level of cash dividends that is inconsistent with the organization’s capital position, that could weaken the organization’s overall financial health, or that could impair its ability to meet the needs of creditworthy borrowers. Bank regulators will review the dividend policies of individual banking organizations and will take action when dividend policies are found to be inconsistent with sound capital and lending policies.
In making the above referenced statement, it appears that the banking agencies in the future will take a more restrictive posture in approving dividend payments from depository institutions over which they have direct authority to impose dividend restrictions based on safety and soundness principles. A question then is raised as to whether the Federal Reserve or the OTS will seek to restrict dividends paid by holding companies (entities that historically have not been subject to the same level of regulation as the insured depository when it comes to dividend payments). The agencies could for instance claim tighter dividend restrictions are necessary, particularly for holding companies that receive CPP funds.
Working with Mortgage Borrowers
The agencies expect banking organizations to work with existing borrowers to avoid preventable foreclosures and to mitigate other potential mortgage-related losses. Given escalating mortgage foreclosures, the agencies urge all lenders and servicers to adopt systematic, proactive, and streamlined mortgage loan modification protocols and to review troubled loans using these protocols. Lenders and servicers should first determine whether a loan modification would enhance the net present value of the loan before proceeding to foreclosure, and they should ensure that loans currently in foreclosure have been subject to such analysis. Such practices are not only consistent with sound risk management but are also in the long-term interests of lenders and servicers, as well as borrowers.
Management compensation policies should be aligned with the long-term prudential interests of the institution, should provide appropriate incentives for safe and sound behavior, and should structure compensation to prevent shortterm payments for transactions with long-term horizons. Management compensation practices should balance the ongoing earnings capacity and financial resources of the banking organization, such as capital levels and reserves, with the need to retain and provide proper incentives for strong management.
Further, it is important for banking organizations to have independent risk management and control functions.
The agencies expect banking organizations to regularly review their management compensation policies to ensure they are consistent with the longer-run objectives of the organization and sound lending and risk management practices.
The above statement by the banking agencies raises a number of important legal questions, including what restrictions will regulators place on new employment contracts and benefit plans and what will be the effect on employees and officers under current contracts, particularly those at banks that do not participate in TARP. It is interesting to note that many banks have declined to participate in the TARP because of the fear that strings will be attached and the open ended ability of the government to change the terms of the deal, as contained in the CPP documents. It is ironic then that those banks that considered CPP’s restrictions too onerous may find themselves subjected to the same standards and restrictions that motivated them to pass on the CPP.