Alert > Distressed Real Estate / Real Estate

October 30, 2008

On October 3, 2008, President George W. Bush signed the Emergency Economic Stabilization Act of 2008 (the “Act”) into law and, in the weeks that have followed, the Department of the Treasury has moved quickly to attempt to implement the Act. 

Purpose

The Act states the purpose of the legislation is to provide “immediate authority and facilities that the Secretary of the Treasury (the “Secretary”) can use to restore liquidity and stability to the financial system of the United States” and to ensure that such authority and resources are used in a manner that protect and preserve personal savings, home values, jobs and economic growth.

Although the Act provides a general framework for achieving the stated purpose of the legislation, the Act includes several broad provisions that give the Secretary great flexibility when determining how to implement the Act. During the first few weeks since the passage of the Act, we have already seen the Department of the Treasury utilize this flexibility to change the focus of some of the programs. For example, the Act was initially touted as a mechanism by which the Department of the Treasury would purchase troubled mortgages and mortgaged-backed securities from banks, but within the past few weeks, the Secretary started to move in another direction by announcing that the first round of funds available under the Act will be used to infuse cash in U.S. financial institutions by buying preferred stock in qualified financial institutions. 

Much of the flexibility granted to the Department of the Treasury results from the broad definitions of “troubled assets” and “financial institutions” found in the Act:  

• Troubled assets are defined under the Act to include any residential or commercial mortgages, and any security, obligations, or other instrument based on or related to mortgages, that were issued on or before March 14, 2008, that the Secretary determines the purchase of which will promote financial market stability, and any other financial instrument that the Secretary after consultation with the chairman of the Board of Governors of the Federal Reserve System and upon delivering notice to congressional committees, determines the purchase of which is necessary to promote financial market stability.
• Financial institutions are defined under the Act to include “any institution including, but not limited to, any bank, savings association, credit union, security broker or dealer, or insurance company, established and regulated under the laws of the United States or any state, territory, or possession of the United States, the District of Columbia, Commonwealth of Puerto Rico, Commonwealth of Northern Mariana Islands, Guam, American Samoa or the United States Virgin Islands, and having significant operations in the United States, but specifically excluding any central bank of, or institution owned by, a foreign government.”

As outlined in this article, we suspect that as the economic crisis continues and new issues arise, the Department of the Treasury may use these broad definitions to shape new programs under the Act. For example, the definition of financial institutions could be interpreted to include nearly any domestic entity and the Secretary may end up relying on this broad definition to find ways to assist domestic businesses that have not traditionally been considered to be financial institutions if the need arises. Furthermore, the Department of the Treasury may need to find new solutions to the economic crisis if the proposed plans fail to work or are inadequate to address the full scope of the problems. Some have already suggested that the Act does not do enough for average American homeowners and that further actions by the government will be required to combat declining home value and foreclosures. The Act, through its broad provisions, may serve as a means for creating new programs or initiatives designed to deal with these issues.

Establishment of Troubled Asset Relief Program

Under the framework of the Act, the Secretary created the Troubled Asset Relief Program (“TARP”) to purchase troubled assets and the Secretary created an Office of Financial Stability that will be tasked with implementing TARP. On October 6, 2008, the Department of the Treasury announced that Neel Kashkari, a former Goldman Sachs executive, will lead TARP and the newly created Office of Financial Stability.

While the Act authorized the creation of TARP, the Act did not specify many of program’s details.  Rather, the Act requires the Secretary to publish program guidelines which address:

1. mechanisms for purchasing troubled assets;
2. methods for pricing and valuing troubled assets;
3. procedures for selecting asset managers; and
4. criteria for identifying troubled assets for purchase.

The pricing and valuing of the troubled assets are critical elements to this new legislation, and the effectiveness of the Act will in part ultimately hinge on how the Secretary elects to determine the price and value of these assets. The success will also depend in part on how and which types of troubled assets the Secretary elects to purchase. The Act contemplates the Secretary using one or more methods to acquire the troubled assets including direct purchases with financial institutions, auctions and/or reverse auctions, where appropriate. These mechanisms will need to be clarified and will impact the pricing of the troubled assets.

TARP Capital Purchase Program

The Department of the Treasury revealed its first large-scale plans for TARP on October 14, 2008 when it announced its plan to use the first $250 billion of the bailout money to purchase preferred stock in certain qualifying financial institutions through the Capital Purchase Program, a new voluntary program created by the Secretary under TARP. This announcement made it clear that the Department of the Treasury is willing to rely on the broad definition of troubled assets when implementing the Act and that the Department of the Treasury is initially focusing on purchasing preferred stock instead of purchasing troubled mortgages or mortgaged-backed securities from financial institutions.

Although purchasing preferred stock in financial institutions may fall outside the scope of troubled assets which many initially envisioned, the Secretary and others working within the Bush administration on the economic crisis are moving quickly to invest the $250 billion in equity positions of major financial institutions in hopes that it would help to stabilize the capital  markets and encourage lending activities. Under the Capital Purchase Program, the Department of the Treasury is acquiring preferred stock in qualifying financial institutions in an amount that is worth no less than 1 percent and no more than 3 percent of risk-weighted assets (subject to a $25 billion cap). Each investment receives a cumulative dividend at a rate of 5 percent per annum for the first 5 years and at a rate of 9 percent per annum for each year thereafter. Although these basic return requirements are attractive compared other alternatives, some financial institutions have been reluctant to accept this capital infusion due to Department of the Treasury required conditions. The deadline for financial institutions to apply for the Capital Purchase Program is November 14, 2008.

Insurance Program for Troubled Assets

In addition to authorizing the creation of TARP, the Act provides for an insurance program whereby the Secretary may, upon the request of a financial institution, guarantee the timely payment of principal and interest on troubled assets, and, in return, the financial institution will pay a premium in an amount to be determined by the Secretary. The Secretary is required to publish the methodology it uses for setting the premiums and may take credit risks into consideration when determining the premiums for particular troubled assets. The premium rates and underwriting criteria established by the Department of the Treasury will play an important role in determining whether the Act is effective in helping to stabilize the financial markets.

All fees collected by the Secretary under this insurance program are to be deposited into a new fund called the Troubled Assets Insurance Financing Fund, and the amounts held in this fund are to be used by the Secretary to fulfill payment obligations under the guarantees provided to the financial institutions for troubled assets. It is unclear at this point what role the insurance program will have in the overall economic recovery plans implemented by the Department of the Treasury.

Spending Power

Upon its enactment, the Act provided the Secretary with $250 billion in troubled asset purchasing authority. As previously noted, the Department of the Treasury has already indicated that it will use this $250 billion to purchase preferred stock in troubled financial institutions under the Capital Purchase Program. The President of the United States may increase the purchasing authority by an additional $100 billion at any time by submitting a written certification to Congress that states the Secretary needs such additional purchasing authority. After the purchasing authority has been increased to $350 billion, if there is a need for additional purchasing authority, the President must submit a written report to Congress outlining the plan for the additional funds and, unless Congress enacts a joint resolution within 15 calendar days of receiving the report, the purchasing authority shall be increased to $700 billion. To the extent that the Secretary elects to guarantee troubled assets under the insurance program described above, the amount of the Secretary’s purchasing authority shall be reduced by the amount of the outstanding obligations covered by the guarantees. In addition, these limits relate to the amount of troubled assets that the Secretary may hold and/or guarantee at any one time. Therefore, if the Secretary reaches the purchasing authority limits, it would not prevent the Secretary from selling troubled assets and then purchasing new troubled assets for the same or a lesser amount.

Term of Programs

Pursuant to the Act, the Secretary’s powers under TARP and the program of insuring troubled assets expire on December 31, 2009, unless the Secretary extends the term of the programs by submitting a written certification to Congress. Such an extension by the Secretary can be for no more than two years from the date of the enactment of the Act.

Warrants and Debt Instruments

Any financial institution that sells troubled assets to the Secretary must, depending on the situation, give the Secretary either a warrant to receive common or preferred stock or a debt instrument. The Act provides the Secretary with broad discretion to determine the percentage of equity the warrants will represent and the Secretary has the right to sell, exercise, or surrender warrants, at any time that it is in the interest of taxpayers to do so. For the Capital Purchase Program, the Department of the Treasury released a term sheet that indicates it will require warrants with a term of 10 years to purchase shares of common stock in the participating financial institution equal to 15 percent of the aggregate market price of the senior preferred stock on the date of the investment (subject to future reductions in certain instances). It is unclear at this point what the Department of the Treasury will require for other programs created under the Act.   

Policy Considerations

When implementing the Act, the Secretary is required to take several items into consideration including the interests of taxpayers and the stability of the financial markets. In addition, the Secretary is required to consider the long-term viability of a financial institution before determining whether or not to purchase troubled assets from such financial institution in order to ensure the most effective use of funds under the Act. Presumably, this provision is designed to prevent the Secretary from investing funds in financial institutions where the assistance is not sufficient to prevent a failure.

Given the depth of troubles and concerns facing American homeowners including declining home values and high foreclosure rates, and the impact of falling home prices on the economy as a whole, the Secretary is facing financial and political pressure to more directly deal with this issue in its implementation of the Act.  Since the Act does contain measures specifically designed to help American homeowners directly such as provisions that require the Secretary, the Federal Housing Finance Agency as conservator of Fannie Mae and Freddie Mac, and the Federal Deposit Insurance Corporation (“FDIC”) to implement plans to maximize assistance to homeowners to use their authority to encourage servicers of mortgages to minimize foreclosures, more may need to be done to support the economic recovery. Some are already questioning how TARP will adequately address the issues facing American homeowners. In the coming weeks and months, the Secretary and the Administration (with involvement of the Congress) will have to face these concerns and determine how to best address these issues. 

Management of Troubled Assets and Selection of Asset Managers

Under the Act, the Secretary is authorized to immediately begin managing and exercising any rights received in connection with troubled assets that are purchased under the Act. The Secretary may also sell or enter into other financial transactions related to the purchased troubled assets. The Department of the Treasury will have to determine its approach in dealing with property owners: where whole loans are involved the question is whether assets will be sold or worked out on an individual basis. The challenges will of course differ depending on the type of asset (single family, multi-family or commercial) and the borrower.

This approach becomes much more complicated when dealing with asset-backed securities where investors hold only a fractional share of the interests in the mortgages. Considerable thought and structuring (and perhaps additional legislative action) may be necessary to effectively deal with these underlying assets and enhance values. This process will be complex and fraught with issues relating to ownership rights of the holders of securities not purchased or held by Treasury.

Any proceeds or revenues received from the purchased troubled assets are to be paid into the general fund of the Treasury to reduce the public debt. When it comes to hiring contractors or advisors as necessary to implement the Act (e.g., to serve as asset managers or otherwise), the Secretary is authorized to waive specific provisions of the Federal Acquisition Regulations if there is an urgent and compelling reason to do so. The Act also provides that the FDIC is eligible and shall be considered in the selection of asset managers for residential mortgages and residential mortgage-backed securities.

The Secretary is also required to issue regulations or guidelines regarding conflicts of interest that may arise during the implementation of the Act including conflicts of interests arising out of the hiring of asset managers and the management of troubled assets. As another sign that the Secretary is moving swiftly to implement the Act, on October 6, 2008, just three days after the Act was signed into law, the Department of the Treasury released interim conflicts of interests guidelines and a set of procedures outlining how the Department of the Treasury will select asset mangers for the portfolios of troubled assets expected to be purchased. These procedures provide that separate asset managers will be selected for mortgaged-backed securities and for whole loan assets. For example, asset managers tasked with mortgaged-backed securities will handle prime, Alt-A and subprime residential mortgaged-backed securities, while asset managers tasked with whole loans will handle residential first mortgages, home equity loans and commercial mortgage loans.

Financial institutions can be designated as asset managers, and such asset managers will be considered financial agents of the United States who have a fiduciary agent-principal relationship with the Department of the Treasury and thus a responsibility to protect the interests of the United States. Separate notices will be issued for mortgage-backed securities asset managers and for whole loan asset managers. Three such solicitation notices were posted on the Department of the Treasury’s website on October 6, 2008, all of which had a response deadline of October 8, 2008, and within days of the response deadline the Department of the Treasury announced one of the contracts had been awarded to Bank of New York Mellon, which was selected to serve as the custodian for the implementation of TARP.¹ 

These three solicitations indicated that the Department of the Treasury was initially looking for major financial institutions that met the following criteria:

1. financial institutions interested in providing whole loan asset management services:

• must have been continuously engaged as a principal business in managing whole loan assets for the last 5 years; and
• must either (i) currently manage a portfolio of at least $25 billion in mortgage loans or (ii) provide “clear and credible evidence” that it can scale its capacity to manage a portfolio of this size.

2. financial institutions interested in providing securities asset management services:

• must be registered investment advisors under the Investment Advisers Act of 1940;
• must have at least $100 billion in dollar-denominated fixed income assets under management;
• must have been continuously engaged as a principal business in managing portfolios of dollar-denominated MBS for the last 5 years;
• must have received an unqualified auditor’s opinion for the last 5 years; and
• must have a primary portfolio manager to assign to Treasury’s account with at least 10 years of experience in managing fixed income assets.

3. financial institutions interested in providing custodian, accounting, auction management and other infrastructure services:

• must have at least $500 billion in domestic assets under custody.

In addition, all financial institutions selected through these solicitations must covenant to disclose any potential conflicts of interest and to avoid or mitigate any such conflicts identified by the Treasury, and must be able and willing to work and coordinate with the Treasury and other governmental and non-governmental entities when the Treasury determines it to be in the government’s best interest. These solicitations also noted that the major financial institutions wishing to be considered for these contracts must be willing to partner with other smaller and minority- and women-owned financial institutions selected by the Department of the Treasury to serve as sub-managers. This requirement stems from language in the Act that requires the Secretary to develop and implement standards and procedures that ensure the inclusion and utilization of women- and minority-owned businesses.

Furthermore, all financial institutions selected to be asset managers are expected to enter into a Financial Agency Agreement with the Department of the Treasury. The notice posted by the Department of the Treasury clearly states that a financial institution’s willingness to enter into the standard Financial Agency Agreement will be a factor considered when selecting asset managers.

It is unclear when the Department of the Treasury will release additional solicitations for asset managers and/or sub-managers; however, the Department of the Treasury has indicated that it will issue separate notices for smaller and minority- and women-owned financial institutions. Financial institutions interested in being appointed as an asset manager and/or sub-manager should monitor the Department of Treasury’s website (www.ustreas.gov), which is where notices will be posted to solicit prospective financial agents.

Oversight

As the implementation of the Act continues, there will be several layers of oversight including the Financial Stability Oversight Board (the “Oversight Board”) which is tasked with reviewing TARP, other programs developed under the Act, and the policies adopted by the Secretary and the Office of Financial Stability, and determining the effect of such actions on American families and taxpayers. The Oversight Board will also make recommendations to the Secretary regarding the use of authority under the Act and will monitor fraud, misrepresentations, or malfeasance for TARP. The Oversight Board will begin to meet monthly once the troubled assets purchasing authority under the Act is first exercised by the Secretary and it will report directly to Congress on no less than a quarterly basis.

The Comptroller General shall also have ongoing oversight responsibilities related to the activities of TARP and TARP agents, and other entities or programs created by the Secretary under the Act. Specifically, the Comptroller General will monitor foreclosure mitigation, cost reduction, whether taxpayers are being protected and whether the programs have increased stability or prevented disruption in the financial markets and banking system.

In addition, the Act establishes the Office of the Special Inspector General for TARP. This office is tasked with conducting, supervising, and coordinating audits and investigations of the purchase, management and sale of assets under TARP and the troubled assets insurance program.

The Act also establishes a Congressional Oversight Panel which will monitor the financial markets, the regulatory system and the use and impact of the Secretary’s authority under this Act.

Executive Compensation and Corporate Governance

Any financial institution that directly sells any of its troubled assets to the Secretary under the terms of the Act must satisfy certain new executive officer compensation requirements. These include limits on executive officer compensation, the recovery of any bonus or incentive-based compensation paid to a senior executive officer based on a statement of earnings, gains or other criteria that later proved to be materially inaccurate, and the prohibition of golden parachute payments to senior executive officers. These requirements will bind the financial institution for as long as the Secretary holds an equity or debt position in the financial institution.

In situations where the Secretary purchases troubled assets from a financial institution through an auction purchase, the financial institution shall be prohibited from entering into any new employment contract that provides a golden parachute in the event of an involuntary termination, bankruptcy filing, insolvency or receivership.

In addition, on October 14, 2008, the Department of the Treasury released guidelines related to executive compensation for financial institutions that elect to participate in the Capital Purchase Program. These guidelines provide that financial institutions participating in the Capital Purchase Program must:

• refrain from using incentive-based compensation for senior executives in a way that encourages unnecessary and excessive risks that threaten the value of the financial institution;
• require clawback of any bonus or incentive compensation paid to senior executives based on statements of earnings, gains, or other criteria that are later proven to be materially inaccurate;
• prohibit golden parachute payments for certain senior executives; and
• agree not to deduct for tax purposes executive compensation in excess of $500,000 for senior executives.

Additional Changes and the Future Political Landscape

In addition to the matters described in this article, the Act includes several other statutory changes such as the temporary increase of the FDIC coverage from $100,000 to $250,000 until the end of next year and the addition of several new tax provisions. It also permits the Securities and Exchange Commission to suspend mark-to-market accounting if it determines it is necessary or appropriate. We are happy to field any questions you may have about these sections or the elements of the new legislation discussed in this article.

We continue to follow the daily changes to the legislative and regulatory landscape related to the current financial market issues. As evidenced by the comments made by Federal Reserve Chairman Ben Bernanke earlier this month, additional actions will likely be required to deal with the current economic climate. We suspect this will involve additional actions on the part of the Federal Reserve, the Department of the Treasury, the FDIC, the SEC, other governmental agencies and Congress. 

To some extent, we have already begun to see this with the introduction of the Temporary Liquidity Guarantee Program by the FDIC and the introduction of the Money Market Investor Funding Facility by the Federal Reserve. Under the Temporary Liquidity Guarantee Program, the FDIC is able to provide a 100 percent guarantee for newly-issued senior unsecured debt and non-interest bearing transaction deposit accounts (e.g., payroll accounts) at FDIC-insured institutions. Initially, all eligible institutions are covered by this program for 30 days free of charge. If eligible institutions do not want to participate they must opt-out during the first 30 days. Additional fees will apply for the coverage after the initial 30-day period. Under the Money Market Investor Funding Facility, (for more information click here) the Federal Reserve will provide funding to help facilitate the purchase of certain certificates of deposit and commercial paper issued by highly rated financial institutions from money market mutual funds (and over time may include other U.S. money market investors). This Federal Reserve program is designed to compliment other initiatives already in place which are intended to improve liquidity in short-term debt markets and thereby increase the availability of credit. 

If you have questions or would like more information, please do not hesitate to contact:

Kenneth Lore, Partner
k.lore@bingham.com
T. 212.705.7535
T. 202.373.6281