We set out below the principal elements of the following programs and initiatives:
- the Capital Purchase Program (the “CPP”)
- the Emergency Economic Stabilization Plan (the “EESA”) and the Troubled Asset Relief Program (“TARP”) established thereunder
- the executive compensation limitations under the EESA and CPP
- the FDIC’s Temporary Liquidity Guarantee Program
- the Federal Reserve’s Commercial Paper Funding Facility (“CPFF”)
- the Treasury’s Temporary Guarantee Program for Money Market Funds
- the Federal Reserve’s Money Market Investor Funding Facility (“MMIFF”)
- efforts to address mark-to-market accounting
- the proposed regulation of credit default swaps (“CDS”)
We also highlight certain developments in Europe.
We have included in Annex A to this memorandum a list of (and hyperlinks to) the relevant announcements and other notices relating to the U.S. legislative and regulatory efforts.
The Capital Purchase Program
- Treasury is making available up to $250 billion of capital to qualifying U.S.- controlled financial institutions ($125 billion of which has been allocated to nine banks). In addition to the nine banks, a wide array of small and medium-sized banks and thrifts are to benefit under the program. Treasury Secretary Paulson has stated that sufficient capital is available under the CPP and all eligible institutions will be able to participate. The capital will not be allocated on a first-come, first-served basis.
- The capital will be injected in the form of non-voting preferred stock, redeemable after three years, and earlier out of the cash proceeds of offerings of Tier 1 qualifying perpetual preferred stock or common stock. There are incentives for the issuers of the preferred stock, in the form of a reduction in the number of shares underlying the warrants, to issue Tier 1 capital by December 31, 2009 offsetting the capital injected.
- Treasury is expected to continue to move forward on other aspects of TARP, with the program guidelines to be forthcoming shortly. Having allocated $250 billion of TARP funds for the capital injections, Treasury has an additional $100 billion available for purchases of assets under TARP before it needs to go back to Congress.
Generally. The CPP envisions using $250 billion of the authority granted under the EESA. Half of the committed amount ($125 billion) is to be made available to nine U.S. financial institutions that have already agreed to participate, with the balance to be provided to smaller qualifying institutions on a voluntary basis. The deadline to elect to participate in the program is 5:00 pm (EDT) on November 14, 2008. Capital injections are expected to be made before year-end.
The securities. Capital injections will take the form of purchases by Treasury of senior preferred stock (“Senior Preferred”) that will pay cumulative (or, in the case of banks that are not subsidiaries of holding companies, non-cumulative) dividends at a rate of 5%, increasing to 9% after five years. All capital purchases will occur at the highesttier holding company, if any. The Senior Preferred will constitute Tier 1 capital and will have perpetual life. Treasury will also receive warrants worth 15% of the face amount of the Senior Preferred (on the date of investment).
Each participating institution is to issue an amount of Senior Preferred equal to not less than 1%, and not more than 3%, of its risk-weighted assets, with an upper limit of $25 billion. The measurement of the maximum amount of capital eligible for purchase by Treasury will be based on the information contained in the latest quarterly supervisory report filed by the applicant with its primary federal regulator, updated to reflect any material changes since the filing date.
Treasury may transfer the securities it acquires to third parties at any time.
Participation. The following institutions may participate (referred to in the term sheet for the program as “Qualifying Financial Institutions” or “QFIs”) in the CPP:
- any U.S. bank or U.S. savings association not controlled by a bank holding company or a savings and loan holding company,
- any U.S. bank holding company or any U.S. savings and loan holding company that engages only in activities permitted for financial holding companies under Section 4(k) of the Bank Holding Company Act,
- any U.S. bank or U.S. savings association controlled by such a holding company, and
- any U.S. bank holding company or U.S. savings and loan holding company whose U.S. depository institution subsidiaries are the subject of an application under Section 4(c)(8) of the Bank Holding Company Act.
A bank holding company, savings and loan holding company, bank or savings association controlled by a foreign bank or company cannot be a QFI (and therefore cannot participate in the CPP).
Executive compensation. Participating institutions will be required to adopt Treasury’s standards for executive compensation and corporate governance for the periods during which Treasury holds equity issued under the CPP.
Ranking. The Senior Preferred will rank pari passu with existing preferred shares other than preferred shares which by their terms rank junior to any existing preferred shares.
Redemption. The Senior Preferred may not be redeemed for a period of three years from the date of investment except with proceeds from a sale of Tier 1 qualifying perpetual preferred stock or common stock for cash, which results in aggregate gross proceeds of not less than 25% of the issue price of the Senior Preferred. After the threeyear period, the QFI may redeem the Senior Preferred at any time in whole or in part. Redemptions will be at 100% of the issue price and will be subject to primary regulator approval. Following redemption of all of a QFI’s Senior Preferred, the QFI may repurchase any of its other equity securities held by Treasury at fair market value.
Restriction on dividends and repurchases. While Senior Preferred is outstanding, a QFI’s ability to declare and pay dividends and undertake share repurchases will be restricted. During this period, no dividends may be paid on any junior or pari passu preferred security or common shares other than on a pro rata basis in case of pari passu preferred shares. Also, a QFI may not repurchase or redeem any junior preferred shares or pari passu preferred shares or common shares unless all dividends on the Senior Preferred have been paid in full.
Until the third anniversary of the date of the investment, common dividends may not be increased and the QFI will be unable to conduct any share repurchases, other than repurchases of the Senior Preferred and the repurchases of junior preferred shares or common shares in connection with any benefit plan in the ordinary course of business consistent with past practice, in any such case without Treasury’s consent. These restrictions cease to apply if the Senior Preferred is redeemed in full or if Treasury transfers all of that QFI’s Senior Preferred to a third party.
Voting rights. At inception, the Senior Preferred will be non-voting, except for class voting rights on issuances of shares ranking senior to Senior Preferred, amendments to the rights of the security, or any merger or similar transaction that would adversely affect the rights of the holder of the security. However, if dividends on Senior Preferred have not been paid in full for six dividend periods, whether or not consecutive, the Senior Preferred will have a right to elect two directors. This right will terminate when full dividends have been paid for four consecutive dividend periods.
Transfer. The Senior Preferred will not be subject to any contractual restrictions on transfer. The QFI will be obligated to put a shelf registration statement in place and grant piggyback registration rights to Treasury for the Senior Preferred (and the shares underlying warrants).
Amount. Treasury is to receive warrants to purchase common stock of a participating QFI having an aggregate market price equal to 15% of the Senior Preferred face amount, as of the date of investment. The amount of shares underlying warrants then held by Treasury is to be reduced by half if, on or prior to December 31, 2009, the QFI has sold Tier 1 qualifying perpetual preferred stock or common stock for cash in an amount equal to 100% of the issue price of the Senior Preferred.
Term. The term of the warrants will be 10 years.
Voting rights. Treasury will not exercise its voting power with respect to common stock issued upon exercise of the warrants; presumably this does not apply to any third party purchaser.
Exercise price. Warrants will be immediately exercisable, in whole or in part. The initial exercise period for the warrants, and the market price for determining the number of shares of common stock underlying the warrants, will be the market price of the common stock on the date of the Senior Preferred investment (calculated on a 20-trading day trailing average), subject to customary anti-dilution adjustments. The exercise price will be reduced by 15% of the original exercise price on each six-month anniversary of the issue date of the warrants if shareholder approval (described below) has not been received, subject to a maximum reduction of 45% of the original exercise price.
Shareholder approval. In the event the QFI does not have sufficient authorized but unissued shares reserved for issuance upon exercise of the warrants or needs shareholder approval under stock exchange rules for issuances of underlying shares upon exercise, the QFI is obligated to obtain shareholder approval as soon as practicable.
Alternative security. If the QFI’s common stock is not listed or traded or the QFI fails to obtain shareholder approval within 18 months after the issuance of the warrants, the warrants will be exchangeable, at the option of Treasury, for senior term debt or another instrument or security of the QFI with equivalent economic value.
The Application Process
All applicants seeking to participate in the CPP will be required to file a short application form. Prior to making a submission to participate in the CPP, applicants must consult with their primary federal regulator. Treasury approval is necessary to participate in the CPP, and Treasury will be consulting the applicant’s primary federal regulators in evaluating any application.
The application form requires basic information about the applicant, the amount of capital requested from Treasury and information regarding the amount of authorized but unissued preferred stock and common stock that the applicant currently has available for purchase. The applicant must also identify and describe any mergers, acquisitions or other capital raisings that are currently pending or are being negotiated and the expected consummation date.
The CPP application form and any attachments are to be submitted to the applicant’s primary federal regulator. If the applicant is a bank holding company, the application materials must be submitted both to the applicant’s holding company supervisor and the supervisor of the largest insured depository institution controlled by the applicant.
If the applicant is unable to comply with all of the terms and conditions of the CPP, including its representations and warranties, by November 14, 2008, the applicant is to attach to the application form a robust explanation of the conditions that the applicant is unable meet and the reasons for such inability.
The processing times of the application will vary and the decisions will be communicated to representatives of the applicant identified on the form.
Each applicant will also be required to execute an investment agreement and associated documentation. Applicants will have 30 days from the date of receipt of the preliminary approval to submit final documentation and to fulfill any outstanding requirements (such as obtaining a shareholder or board approval of the equity issuance).
Any questions in respect of participation in the CPP should be directed to the applicant’s primary federal regulator.
Tier 1 Capital Treatment
The Federal Reserve has adopted an interim final rule that will permit bank holding companies to include in their Tier 1 capital 100% of the Senior Preferred to be issued to Treasury under the CPP.
Tax Treatment of Senior Preferred and Warrants under the CPP
The Treasury has clarified that any amounts given to a financial institution pursuant to TARP will not be treated as the provision of Federal financial assistance under Section 597 of the Internal Revenue Code (“IRC”), meaning that such amounts will not be treated as taxable income.
The Treasury has further clarified that securities issued under the CPP to the Treasury will not trigger the change in ownership rules under section 382 of the IRC. Section 382 of IRC limits a corporation’s deduction for net operating losses and certain built-in losses that are realized after an ownership change.
The Emergency Economic Stabilization Act of 2008
- Up to $700 billion may be used to buy troubled assets from financial institutions. The money was to be disbursed in tranches – $250 billion immediately, the next $100 billion upon certification by the President that it is needed, and the remaining $350 billion (if needed) unless, within 15 days of the request, Congress objects through a joint resolution. The first $250 billion has been allocated to the CPP.
- Sellers of troubled assets will be required, subject to a de minimis exception, to issue warrants to Treasury exercisable for nonvoting common or preferred shares, or voting shares as to which the Treasury Secretary will waive voting rights (or, in the case of participating institutions that are not listed in the United States, warrants for common or preferred shares or senior debt instruments).
- Participating institutions selling more than $300 million of troubled assets in an auction would be subject to limitations on the ability to provide new “golden parachute” arrangements to certain senior executive officers. Those institutions selling troubled assets directly, where Treasury has a meaningful equity participation, would be subject to limitations on golden parachutes. They would also be subject to limitations on compensation that increases risk-taking and provisions for bonus recapture where earnings or other statements later prove to be materially inaccurate. Separately, participating institutions with sales of more than $300 million (excluding sales made directly, if any such institution only sells directly) would not be entitled to tax deductions for annual compensation payable to their CEO, CFO and their three other most highly compensated officers in excess of $500,000 per covered employee.
- Treasury is to create a federal insurance program, the premiums for which are to be paid by participating institutions.
- Oversight is to be provided by a newly established Financial Stability Oversight Board, consisting of the Chairman of the Fed, the Treasury Secretary, the Chairman of the SEC, the Director of the Federal Housing Finance Agency and the Secretary of Housing and Urban Development, as well as by an Office of the Special Inspector General for TARP and a Congressional Oversight Panel.
- Judicial review of Treasury decisions will be available.
- The SEC will have authority to suspend the application of the mark-tomarket accounting standards in Statement of Financial Accounting Standards No. 157. The SEC is also directed to study the mark-to-market accounting standards and to report its findings to Congress within 90 days.
- In five years, if TARP has generated a shortfall, the President is to submit proposed legislation to recoup amounts from the financial industry to avoid adding to the deficit or national debt.
Key Elements of the EESA
The EESA has the following key elements:
Authority. The Treasury Secretary is authorized to purchase “troubled assets” from “financial institutions.”
Term. Authority in respect of TARP terminates on December 31, 2009, subject to extension until the second anniversary of enactment of the EESA. The authority to hold troubled assets is not subject to these termination dates.
“Troubled assets.” Troubled assets are defined as residential and commercial mortgages and other securities, obligations and instruments based on or related to such mortgages, in any case originated or issued before March 14, 2008. The Treasury Secretary may treat other financial instruments as “troubled assets” if the purchase of the assets would promote financial market stability. In making such a determination, the Treasury Secretary would be required to consult with the Chairman of the Federal Reserve and provide notification to Congress.
“Financial institution.” The term “financial institution” may also be interpreted broadly. The term includes any institution, including, but not limited to, any bank, saving association, credit union, securities broker or dealer, or insurance company “established” and regulated under the laws of the United States and that has significant operations in the United States. It excludes non-U.S. central banks. The use of the phrase “but not limited to” appears to permit the Treasury Secretary to include other types of institutions not specifically listed. In light of some of the other requirements of the EESA, such as the limitations on compensation and the obligation to provide equity participations, non-U.S. institutions will have additional issues to consider as they weigh the consequences of participation.
Mechanisms for purchase. The EESA does not mandate how TARP will operate. Instead, the Treasury Secretary is to issue program guidelines no later than 45 days after enactment of the EESA or, if earlier, the end of the second business day after the first purchase under TARP. The guidelines are to address the mechanisms for asset purchases, the methods for pricing and valuing assets, procedures for the selection of asset managers and the criteria for identifying troubled assets for purchase. TARP is to ensure that assets are not purchased at a price higher than that initially paid for them by the selling institution.
In making purchases, the Treasury Secretary is to purchase assets at the “lowest” price consistent with the purposes of the EESA. The Treasury Secretary may use auctions or reverse auctions and, where such mechanisms are deemed not feasible or not appropriate, may purchase troubled assets directly (using appropriate pricing measures). In determining whether to engage in direct purchases, the Treasury Secretary is to consider the long-term viability of the institutions in question.
The Treasury Secretary is to “encourage” private sector participation in purchases of troubled assets and in investment in financial institutions.
The Treasury Secretary may hold assets to maturity or for resale, and may sell assets at prices to maximize the government’s return. The Treasury Secretary may also enter into securities loans, repurchase transactions or other transactions in respect of purchased troubled assets. Revenues and proceeds of sale, as well as from sale, exercise or surrender of warrants or senior debt received under TARP (see below), are to be applied to reduce the public debt.
Oversight. Oversight is to be provided by the newly established Financial Stability Oversight Board. The EESA also establishes an Office of the Special Inspector General for the Troubled Assets Relief Program and a Congressional Oversight Panel.
Insurance program. If the Treasury Secretary uses the TARP authority to purchase troubled assets, the Treasury Secretary is required to establish a program to guarantee troubled assets issued or originated prior to March 14, 2008. Upon the request of a financial institution, the Treasury Secretary would guarantee principal and interest on troubled assets. Financial institutions that participate in the insurance program would pay premiums into a newly established Troubled Assets Insurance Financing Fund. Premiums could be based on credit risk of the assets being guaranteed. The Treasury Secretary is to publish the methodology for setting premiums by asset class.
Equity participations. The Treasury Secretary is directed, as a condition to buying troubled assets, to receive from participating institutions that are publicly traded in the United States, warrants for nonvoting common or preferred shares in the institution (or voting shares, as to which the Treasury Secretary would waive voting rights). With respect to participating institutions that are not publicly traded in the United States, the Treasury Secretary is to receive warrants for common or preferred shares or senior debt. The participation is to provide gains on sale and interest income for the benefit of taxpayers, as well as downside protection for asset sales. The Treasury Secretary can apply a de minimis exception (not to exceed $100 million) and such other exceptions/alternate arrangements where an institution cannot, as a legal matter, issue the securities in question.
To the extent that a participating institution has issued equity pursuant to the CPP, equity participations in conjunction with sales of troubled assets presumably would be over and above the Senior Preferred and warrants issued under the CPP.
Recoupment of shortfall. Five years after the date of enactment of the EESA, the President must submit to Congress a proposal for recouping any losses incurred under TARP from the “financial industry” (early drafts of the legislation called for the burden to fall on participating institutions).
Reporting Provisions. TARP will be accompanied by reporting as well as oversight. The program is intended to have significant transparency. Among other items, the Treasury Secretary is to make available in electronic form a description, amounts and pricing of assets acquired under TARP within two business days of purchase, trade or other disposition.
For each type of financial institution that sells troubled assets, the Treasury Secretary is to determine whether such institutions’ public disclosure of off-balance sheet transactions, derivatives instruments, contingent liabilities and similar sources of potential exposure is adequate, and if not to make recommendations in respect of additional disclosure requirements to the relevant regulators. This authority appears to be focused on categories of institutions and not individual institutions, though it is yet another example of novel authority granted to Treasury, and it is unclear how broad its reach will be. Note too that the authority is not limited to evaluating the disclosure practices of US institutions.
Treasury has created seven policy teams to deal with specific elements of TARP:
- mortgage-backed securities purchases – focusing on which assets to buy, from which institutions to buy them and which mechanisms to use;
- whole loan purchases – focusing on which types of loans to buy first, how to value them and which mechanisms to use;
- the insurance program – public comment has been requested as to how best to structure the program;
- the equity purchase program – focusing on design of a program to encourage private sector participation to complement public capital;
- homeownership preservation – evaluating how best to maximize opportunities;
- executive compensation – see above; and
- compliance and oversight – focusing on establishing the structures.
A number of questions with significant implications for the success of the various initiatives remain to be answered. The markets await the TARP program guidelines and answers to a number of the questions surrounding the proposed purchase of troubled assets and the relationship between the CPP and such purchases. We identify below some of the more significant questions:
- On what basis will Treasury determine which institutions are to receive capital injections? Will participation in fact be limited to “healthy banks”?
- What criteria will be considered for buying troubled assets and what assets will be given priority? The further one moves away from the underlying mortgage assets, the more difficult the task of determining intrinsic value. To work, TARP will need to buy up the more complex assets for which there is no market or that are valued at a level wholly unrelated to intrinsic value.
- What valuation/pricing mechanisms will be addressed in the program guidelines?
- How well can the reverse auction system be expected to function – where the mortgage-backed securities market is so fragmented, where all tranches in a pool are widely held and where institutions have different values ascribed to them?
- How will asset allocations be determined?
- What data will be relied upon in executing the auctions and how will that data be made available to Treasury? As difficult as it may seem from an optics perspective, Treasury needs the assistance of the institutions themselves as they are in the best position to know what asset classes have been hit the hardest.
- Who will be able to participate? Foreign institutions, hedge funds, private equity funds, retirement accounts, SIVs? Will Treasury use some portion of TARP to assist monoline insurers?
- What troubled assets will be eligible for the program?
- Will assets be insured up to 100%? How will the level of coverage be determined?
- How will premiums be calculated? Who will perform the underwriting function to evaluate and price the risk?
- How will participating institutions be able to collect under the program?
- For the institutions themselves, how will they view sales of assets versus coverage under the insurance program? Is there an advantage to the latter as the assets will remain on the balance sheet, giving the institution the ability to benefit from appreciation in value of the assets in question?
- How will the private sector be “encouraged” to participate in TARP and invest in financial institutions (and will the private sector be encouraged to buy Senior Preferred issued under the Capital Purchase Program)?
- What is the likely impact on the market in general (and balance sheets) as new values for troubled assets are established?
Executive Compensation Restrictions
The Treasury announced executive compensation requirements corresponding to the three programs adopted under the EESA. These rules apply to the CEO, CFO and the next three most highly compensated executive officers (collectively, the “Senior Executives”). Any financial institution participating in the following three programs will be required to adhere to these requirements. Additional guidance has been posted on the Treasury’s web site in the form of two Treasury notices, an IRS notice and an interim final rule promulgated under the EESA.
Briefly, the requirements include the following:
- Troubled Asset Auction Program: during the term of the program, any financial institution that sells more than $300 million of troubled assets to Treasury through an auction under TARP would be prohibited from entering into new executive employment contracts that provide golden parachutes to Senior Executives. In addition, (i) the financial institution may not deduct, for tax purposes, executive compensation in excess of $500,000 for each Senior Executive; (ii) it may not deduct certain golden parachute payments made to its Senior Executives; and (iii) a 20 per cent excise tax will be levied on a Senior Executive for these golden parachute payments.
- Capital Purchase Program: for the period during which Treasury holds equity or debt securities issued by a financial institution under the CPP, a QFI must, among other things, (i) provide for a claw-back of any bonus or incentive compensation paid to a Senior Executive based on statements of earnings, gains, or other criteria that are later proven to be materially inaccurate; (ii) not make any golden parachute payment to a Senior Executive; and (iii) not deduct for tax purposes executive compensation in excess of $500,000 for each Senior Executive. Existing arrangements and agreements are to be modified or terminated before the closing of the relevant capital purchase to the extent necessary to be in compliance with, and agree to be bound by, these requirements.
- Programs for Systemically Significant Failing Institutions: the standards under this third program, which is being developed to provide direct assistance to failing institutions on terms negotiated on a case-by-case basis, are similar to those under the CPP, except that golden parachutes will be defined more strictly to prohibit any payments to departing Senior Executives. For a more in-depth description of these requirements, see our separate memorandum, available on our web site, dated October 20, 2008.
The Temporary Liquidity Guarantee Program
- The FDIC announced a program with two components: guarantees of new senior debt issued by FDIC-insured institutions and their holding companies for three years and full guarantees in respect of deposits in non-interest bearing transaction accounts.
- The debt guarantees cover eligible debt issued through June 30, 2009, and the additional deposit protection expires December 31, 2009.
- Any eligible institution that avails itself of either of the guarantees will be subject to enhanced supervisory oversight.
- The FDIC programs are independent of the CPP and participation in one does not affect the eligibility or conditions of participation in the other.
Debt guarantees. The first component of the liquidity program provides for guarantees of new, senior unsecured debt issued by FDIC-insured depository institutions, U.S. bank holding companies and financial holding companies and certain U.S. savings and loan holding companies (the “Eligible Entities”). This guarantee will cover all new senior unsecured debt issued by Eligible Entities on or before June 30, 2009, including promissory notes, commercial paper, inter-bank funding, and any unsecured portion of secured debt. The guarantee will extend only until June 30, 2012, even if the debt has not then matured.
The amount of debt covered by the guarantee may not exceed 125% of the Eligible Entity’s debt outstanding as of September 30, 2008 that was scheduled to mature before June 30, 2009. The limit applies separately to each legal entity within a group. In the event that the Eligible Entity had a zero balance outstanding as of September 30, 2008, the amount that it may issue under the program will be determined on a case-by-case basis by the FDIC and the Eligible Entity’s primary federal regulator. Eligible Entities may borrow up to the 125% limit immediately. However, the debt guarantee program may not be used as a source of cheaper financing to prepay existing long-term debt. It is the borrower that is responsible in the first instance for compliance with the 125% limit (as of September 30, 2008) rather than the lender, and as long as the lender acts commercially reasonably and in good faith and obtains representations from the borrower that the borrower is under the limit, the lender will likely be protected by the debt guarantee.
The portion of debt that exceeds the 125% limit or that matures after the threeyear cut-off date will not be covered by the debt guarantee program.
Payment under the guarantee will be triggered by bankruptcy or receivership of the Eligible Entity. The FDIC will pay the principal of the claim plus interest to the date of failure, and not to the date of payment.
Deposit guarantees. The FDIC will also offer unlimited guarantees on bank deposits that do not bear interest (i.e., in respect of small business transactional deposits) until December 31, 2009.
Coverage. All Eligible Entities will be covered by the guarantees for the first 30 days (until November 12, 2008). Thereafter, Eligible Entities must inform the FDIC whether they intend to opt-out of the guarantee programs. If an institution does not opt out from the program by November 12, 2008, it will not be able to opt-out at all. It will also be possible to opt-out just from the non-interest bearing deposit guarantee or the senior unsecured debt guarantee, while remaining covered by the other.
Fees. Fees for these guarantees will be waived for the first 30 days. Thereafter, an annualized fee of 75 basis points will be charged for the debt guarantee and a 10 basis point surcharge will be added to the existing risk-based deposit insurance premium for any amount in the deposit accounts in excess of the existing limit of $250,000 (or, if applicable, in excess of any other pass-through coverage on the account). An Eligible Entity remaining in the debt guarantee will not be charged the 75 basis points if it does not issue any new senior unsecured debt under the program. The 75-basis point fee will be applicable to commercial paper issued under the CPFF.
Fees received under the program will be kept separate from the existing FDIC Deposit Insurance Fund and will be used to pay defaults under the program. Any deficiency will be recovered by a special assessment on all FDIC-insured banks, even on the banks that choose to opt-out of the program. The special assessment will be based on a bank’s liabilities rather than its assets.
Commercial Paper Funding Facility
Structure. The CPFF will become operational on October 27, 2008 and purchases will continue until April 30, 2009. It will be structured as a credit facility made available to a special purpose vehicle (“SPV”). The Federal Reserve Bank of New York (the “New York Fed”) will lend to the SPV on a recourse basis and will be secured by all assets of the SPV. The SPV will purchase from eligible issuers eligible commercial paper through the New York Fed’s primary dealers. The SPV will hold the paper until maturity and will use proceeds from maturing paper and other assets of the SPV to repay its loan. The SPV will not purchase commercial paper from investors. However, issuers are permitted to repurchase outstanding commercial paper from investors and finance those repurchases by selling commercial paper to the SPV.
Eligible issuers. Issuers of commercial paper organized under the laws of the United States or the individual States and territories, including those with a foreign parent, are eligible to participate.
Eligible paper. The commercial paper must be unsecured or asset-backed, have a three-month maturity, be U.S. dollar-denominated, and be rated at least A-1/P-1/F1. Interest-bearing commercial paper and commercial paper with an extendable maturity will not be eligible for purchase by the SPV.
Registration and fee. Eligible issuers must register with the CPFF by no later than October 23, 2008 to access the facility by October 27, 2008. Thereafter, issuers will be required to register two business days in advance of their intended use of the CPFF. At the time of the registration, the issuer will have to pay a 10-basis point facility fee based on the maximum amount of its commercial paper the SPV may own. Issuers not intending to access the CPFF need not register.
Maximum amount. The maximum allowable amount for each issuer is the greatest amount of U.S. dollar-denominated commercial paper the issuer had outstanding on any day between January 1 and August 31, 2008, as certified by the issuer to the Federal Reserve at the time of registration.
Price. The price of the purchased commercial paper will be discounted based on a rate equal to a spread over the three-month overnight index swap (OSI) rate on the day of purchase. The spread for unsecured commercial paper will be 100 basis points per annum and the spread for asset-backed commercial paper will be 300 basis points per annum. For unsecured commercial paper, an additional 100 basis points per annum unsecured credit surcharge must be paid on each trade execution date. After November 12, 2008, issuers who remain protected under the FDIC's debt guarantee pursuant to the Temporary Liquidity Guarantee Program will not be subject to the unsecured credit surchage on the commercial paper covered by such guarantee (but will be subject to the FDIC's 75 basis points charge). The daily lending rates under CPFF will be posted on the New York Fed website at 8:00 am (EST) and via Bloomberg screen.
Temporary Guarantee Program for Money Market Funds
On September 29, 2008, Treasury announced the details of its Temporary Guarantee Program for Money Market Funds, which was established in response to growing concern about the health of the money market industry. Under the program, Treasury will guarantee the share price of eligible money market funds that apply to the program and pay a fee to participate. The program provides coverage to shareholders for amounts held in participating money market funds as of the close of business on September 19, 2008. The guarantee will be triggered if a fund’s net asset value, or NAV, falls below $0.995 per share, which is commonly referred to as “breaking the buck.” Funds that broke the buck before September 19, 2008 are not eligible for the program. Following an initial three-month term, the Treasury Secretary will have the option to renew the program for an additional period up to September 18, 2009.
Eligibility. The program is open to publicly offered money market mutual funds that are registered with the SEC and regulated pursuant to Rule 2a-7 under the Investment Company Act of 1940. This includes both retail and institutional funds and taxable and tax-exempt funds. To be eligible, a fund must have had an NAV per share of at least $0.995 as of September 19, 2008. The program does not cover funds that broke the buck prior to that date (such as The Reserve Fund’s Primary Fund, which fell to 97 cents per share on September 16, 2008 as a result of its holdings of securities issued by Lehman Brothers Holdings Inc.). The guarantee program is open to funds that have a policy of maintaining a stable share price of $1.00, as well as funds that maintain a per share price of more than $1.00.
The enrollment deadline was October 8, 2008 for funds with a policy of maintaining a $1.00 per share price and October 10, 2008 for funds that maintain a higher per share price. Investors are not permitted to enroll in the program directly.
Coverage. The coverage of the Treasury program is based on the number of shares held at the close of business on September 19, 2008. Specifically, the guarantee covers the lesser of (i) the number of shares held on September 19, 2008 and (ii) the number of shares held at the time of a “Guarantee Event” (defined as the initial date on which the NAV per share falls below $0.995, unless promptly cured). Any increase in the number of shares held after September 19, 2008 will not be covered. The guarantee will cover shares that are sold and repurchased. For example, if an investor held 100 shares as of September 19, subsequently sold 50 shares and later repurchased 25 shares, the investor would be covered for 75 shares.
Upon the occurrence of a Guarantee Event, a participating fund must be liquidated within 30 days, at which time shareholders will receive $1.00 per covered share, subject to the overall amount available to all funds under the program. The program will be funded by Treasury’s Exchange Stabilization Fund, which currently has approximately $50 billion in assets. The guarantee program is not otherwise backed by the full faith and credit of the U.S. government.
Term. The guarantee program is initially available for a three-month term ending on December 18, 2008. Treasury may extend the program in its sole discretion for any additional period up until September 18, 2009.
Fees. Participating funds are required to pay a fee for the initial period of 1 basis point if the fund’s NAV per share is greater than or equal to $0.9975 and 1.5 basis points if the fund’s NAV per share is less than $0.9975 but greater than or equal to $0.995. Any extension of the program beyond the initial three month term will require additional payments by participating funds.
The Money Market Investor Funding Facility
On October 21, 2008, the Federal Reserved announced that, as a complement to the CPFF, it will support a private-sector initiative to restore liquidity to U.S. money market investors. Under the MMIFF, the New York Fed will establish a credit facility to provide senior secured funding to a series of SPVs established by the private sector (“PSPV”) to facilitate the purchase of eligible assets from eligible investors.
Structure. Each PSPV will purchase, at amortized cost, eligible assets from eligible investors using proceeds of borrowings from the MMIFF and from the issuance of asset-backed commercial paper (“ABCP”). The PSVPs will issue to the seller of eligible assets ABCP equal to 10% of the asset’s purchase price. The ABCP will have a maturity equal to the maturity of the asset and will be rated at least A-1/P-1/F1 by two or more rating agencies. The New York Fed will commit to lend to each PSVP 90% of the purchase price of each eligible asset until its maturity. The loans will be senior to the ABCP, with recourse to the PSVP, and secured by all assets of the PSVP. The operational documents of each PSVP will designate ten financial institutions from which it may purchase eligible assets. Each of these designated financial institutions must have a short-term debt rating of at least A-1/P-1/F1 from two or more rating agencies. A concentration limit will be imposed on each PSVP: at the time of the purchase, the eligible assets of any one financial institution may not exceed more than 15% of the assets of the PSPV.
Eligible assets. Eligible assets include U.S. dollar-denominated certificates of deposit, bank notes, and commercial paper with a remaining maturity of 90 days or less issued by the financial institutions designated in operational documents of the PSPVs.
Eligible investors. U.S. money market mutual funds may participate, other money market investors maybe permitted to participate in the future.
Downgrade or default of eligible assets and termination. If eligible assets of an institution held by the PSVP are downgraded, then the PSVP must cease all purchases from that institution until all of the PSVP’s assets issued by that institution have matured. If there is a default of any of the assets held by PSVP, the PSVP must cease all asset purchases and repayments on outstanding ABCP. Upon maturity of the assets, the proceeds will first be used to repay the New York Fed and any remaining available cash will then be used to repay principal and interest on the ABCP.
PSVPs will continue purchasing assets until April 30, 2009. On April 30, 2009, PSVPs will enter into a wind-down process during which the proceeds from the maturation of the assets of the PSVPs will be used first to repay principal and interest on the New York Fed's loans and then to repay principal and interest on the ABCP. A small fixed amount of any excess spread remaining in the PSVP after completion of the winddown process or upon repayment of the Fed and the ABCP after a default will be allocated proportionally among investors in its ABCP. Then the New York Fed will receive any remaining excess spread.
In the period leading up to the credit crisis, significant criticism was leveled at mark-to-market accounting standards, many viewing the accounting standards under both US GAAP and IFRS as a contributing factor to the crisis. In response to concerns, various actions have been taken, both in the United States (by the SEC and the FASB) and in the EU (by the IASB).
In the United States, the EESA directed the SEC to study the mark-to-market standards under US GAAP, contained principally in Statement of Financial Accounting Standards No. 157 (Fair Value Measurement) (“SFAS 157”).
SFAS 157 establishes a single definition of fair value and a framework for measuring fair value under US GAAP and expands disclosure about fair value measurements. The standard defines fair value as the “price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.” As such it focuses on “exit price” rather than on “entry price” or management’s good faith assessment. The standard establishes a hierarchy to rank the evidence to be relied upon in measuring fair value (Level 1 through 3), distinguishing between evidence based on market data (observable inputs, which could be Level 1 or 2) and evidence based on a reporting entity’s own assumptions (unobservable inputs, which are Level 3). The standard defaults in favor of observable inputs (at the highest level) wherever possible.
Shortly after enactment of the EESA, the SEC and the FASB issued guidance in respect of applying SFAS 157. Thereafter, the FASB issued additional guidance. The SEC also issued guidance in respect of hybrid securities and, separately, in the EU the IASB issued amendments to the IFRS fair value accounting standards. These initiatives are described below.
The IASB and FASB have also announced that they will create a global advisory group, which will help ensure that reporting issues arising from the global economic crisis are considered in an internationally coordinated manner.
FASB FSP 157-3. On October 10, 2008, the FASB staff issued FASB Staff Position No. FASB 157-3. FSP 157-3 is intended to clarify by example how companies should apply SFAS 157 to value financial assets that have no active market. The guidance responds to specific concerns that reporting entities are unsure how their own assumptions (i.e., expected cash flows and appropriately risk-adjusted discount rates) should be considered when observable inputs do not exist, how observable inputs in inactive markets should be considered and how market quotes should be considered when assessing the relevance of observable and unobservable inputs.
Among other things, FSP 157-3 clarifies:
- That even in times of market dislocation, it is not appropriate to conclude that all market activity represents forced liquidations or distressed sales. However it is also not appropriate to automatically conclude that any transaction price is determinative of fair value.
- The use of a reporting entity’s own assumptions about future cash flows and appropriately risk-adjusted discount rates is acceptable when relevant observable inputs are not available. In some cases, the entity may determine that observable inputs (Level 2) require significant adjustment based on unobservable data and thus would be considered a Level 3 fair value measurement.
- Broker quotes are not necessarily determinative if an active market for a financial asset does not exist. In weighing broker quotes as an input, less reliance should be placed on quotes that do not reflect the results of market transactions. Whether a quote is an indicative offer or a binding offer should also be considered.
SEC position on perpetual preferred securities. The assessment of declines in fair market value of perpetual preferred securities (“PPS”) (which are structured in equity form but possess significant debt-like characteristics) has also presented challenges in the current market, as Statement of Financial Accounting Standards No. 115 (Accounting for Certain Investments in Debt and Equity Securities) (“SFAS 115”) does not address the impact, if any, of debt-like characteristics on the assessment of other-than-temporary impairment.
In response, on October 14, 2008, the Office of the Chief Accountant (“OCA”) of the SEC, after consultation with and concurrence of the FASB staff, concluded that with respect to PPSs it would not object to an issuer applying an impairment model (including an anticipated recovery period) similar to a debt security. In reaching this conclusion the OCA noted that it had no objection to such treatment provided there has been no evidence of a deterioration in credit of the issuer and that it would expect an issuer to provide adequate disclosure about its PPS holdings in situations where the cost exceeds the current fair value as required by FSP 115-1/124-1 (The Meaning of Other-Than- Temporary Impairment and Its Application to Certain Investments). This no-objection position is effective until SFAS 115 can be formally addressed by the FASB.
IASB amendments. On October 13, 2008, the IASB amended IAS 39 to permit financial instruments, which had previously been measured at fair value to be reclassified to a different accounting basis, thereby permitting reclassifications for previously held trading assets, other than derivatives. In connection with this change, the IASB also amended IFRS 7 (Financial Instruments: Disclosures) to require additional disclosure about instruments that are reclassified out of fair value or reclassified from available for sale to loans and receivables. As published, the amendments permit the reclassification of some financial instruments out of the fair-value-through-profit-or-loss category and out of the available-for-sale category, which introduce into IFRS the same possibility of reclassifications that is already permitted under US GAAP.
Credit Default Swaps
In late September, the SEC Chairman, following the lead of New York State, turned his attention to credit default swaps (“CDS”) and other credit derivatives and urged Congress to provide the SEC with the authority to regulate these instruments. The Governor of New York announced that New York State would regulate CDS, at least to the extent that the buyer of the CDS protection owns the underlying reference security. In these cases, the seller of the protection would be deemed to be selling insurance and required to be licensed in the State of New York under the New York State Insurance Law. These requirements would not apply where the buyer, at the time the swap is entered into, does not hold, or reasonably expect to hold, a “material interest” in the reference obligation (as contemplated by guidelines issued by the New York State Department of Insurance in Circular No. 19 (“Best practices for financial guaranty insurers”)).
Industry participants are in discussions with the NYS Insurance Department regarding a range of issues relating to implementation of the proposed regulation of covered CDS, including whether it will be prospective only and what other instruments might be brought within the scope of the initiative. How individual State initiatives will mesh with possible Federal action, as well as voluntary industry action, remains an open question.
In the meantime, the SEC has called for authority to mandate trade and position reporting by dealers, and position reporting for market participants with significant holdings.
There have also been proposals for the creation of a central counterparty of the CDS market, which would seek to address (and thus reduce) counterparty risk and, thus, mitigate the potential systemic impacts of counterparty defaults. Risk could be reduced by novating CDS trades to the central counterparty, thereby eliminating the counterparty risk of the original protection seller and reducing risks related to collateral flows by netting positions in similar instruments and netting gains and losses across different instruments. The SEC has been in discussions with the Federal Reserve, the New York Fed, the Commodity Futures Trading Commission (“CFTC”) and industry participants to create such a central counterparty.
At this point it is unclear how, and by whom, the U.S. CDS market will be regulated. There is likely to be regulatory oversight (though that oversight could be by the SEC or the CFTC). Oversight is likely to be combined with some form of reporting. This regime is likely to exist in parallel with one or more central counterparty arrangements.
The U.S. announcement of the CPP followed a flurry of activity in Europe, including an announcement of a three-pronged rescue package in the United Kingdom. The U.K. plan includes a £50 billion Tier 1 capital facility to be made available to U.K. financial institutions in the form of preference shares or other permanent interest bearing shares, half to be available for eight designated institutions and the other half available upon application. As a first step in implementation of its program, Britain provided £37 billion in new capital to three of its banks, with controlling stakes taken in each.
To reopen the medium-term funding market for participating institutions that raise appropriate amounts of Tier 1 capital, the U.K. government is making available a government guarantee of short and medium term debt issuances to assist in refinancing maturing, wholesale funding obligations as they fall due. The program envisages the issuance of senior unsecured debt instruments of varying terms of up to 36 months. The announcement of the plan stated that the government expects the take-up of the guarantees to be in the range of £250 billion and will keep this amount under review.
In addition, the Bank of England will make available under its “Special Liquidity Scheme” at least £200 billion in short term liquidity. The Bank of England also announced new emergency overnight borrowing facilities designed to ease pressure in the money markets. A “discount window facility” will provide liquidity insurance in the event of stress to otherwise financially sound banks, giving them the ability to borrow government securities against a wide range of collateral. It is set to run concurrently with the Special Liquidity Scheme.
In Germany, a rescue passage has been enacted that provides €500 billion in total aid to the country’s financial markets, with up to €400 billion earmarked for lending guarantees for banks, €80 billion for recapitalization of the banks and, if necessary, for the purchase of risky assets, as well as €20 billion in back-up guarantees.
The French government announced that it would make available €10.5 billion in capital to its six largest banks in the form of subordinated loans repayable after other debts, non-dilutive to existing shareholders, and not requiring a change in dividend policy. This followed an earlier announcement by the French government that it would guarantee up to €320 billion of inter-bank loans and commit up to €40 billion in the form of capital injections.
Austria, Belgium, Italy, the Netherlands, Portugal, Spain and Sweden have also committed capital for guarantees and capital injections. Switzerland agreed to provide a cash infusion to, and take troubled assets off the balance sheets of, one of its banks, while a second Swiss bank declined and accessed capital from third parties.