Given the rapid pace of change in the financial markets these past few weeks along with a barrage of information that makes it difficult to distill what information matters most, we have created this key insights overview of the Emergency Economic Stabilization Act of 2008. Importantly, please note that the observations that follow are meant to provide a brief overview for executives at our member organizations based upon an initial review of the DRAFT Act. Our interpretation of the Act's implications may change as we review the final version of the act and we review more commentary on it by regulators and policy makers. You should not rely on this information as legal or tax advice.
Eight Things You Should Know Even if You Are Not a Financial Institution
1. Broad Power to Stabilize the Financial Markets. While a large portion of the Act's 110 pages go to oversight, the Treasury Secretary has broad, sweeping power under the Troubled Asset Relief Program ("TARP”)-probably broader than any government minister has had in modern history-to stabilize the US financial markets.
2. Potential Suspension of FAS 157. The Act (Sec. 132) gives the SEC authority to suspend FASB Statement 157 (i.e., the mark-to-market accounting requirement) for any issuers or any class or category of transaction; given the SEC's actions to prohibit short selling and loud complaints in the press about mark-to-market requirements, the SEC is likely (at least a 50% chance) to exercise this authority to some degree.
3. Purchases of Troubled Assets from Retirement Funds. The Act authorizes the Treasury Secretary to purchase Troubled Assets from retirements as defined by clauses (iii), (iv), (v), and (vi) of the Internal Revenue Code of 1986 (excluding non-qualified deferment plans as defined by clause of section 402(c)(8)B) for corporations with retirements funds whose value has been substantially compromised by investments-even indirect-in Troubled Assets, this provision MAY provide an avenue for relief depending on the Treasury Secretary's plan and purchase priorities; at this time, it is unclear how the Act's provisions providing the Treasury with an equity or debt interest in participating financial institutions and limitations on executive compensation would apply in these instances.
4. Not All Financial Institutions May Benefit from the Act. Don't assume that your bank or financial partner is inherently stronger as a result of the TARP program; financial institutions don't have the right to participate; for example, the Treasury Secretary can choose to exclude a financial institution that doesn't have strong prospects for long-term viability; overall, the Treasury Secretary is charged with deploying a scarce (albeit large) set of funds and to take into account the "net present value to the tax payer” of the purchases and guarantees made, which likely means the funds won't be spread peanut butter thin and, most likely, we will see many more financial institutions fail.
5. US National Debt Will Increase Sharply and Potentially Permanently. Despite provisions giving the Treasury warrants, preferred stock, or senior debt obligations in participating financial institutions, nothing in the Act requires TARP to NOT increase the national debt; the deficit will increase dramatically in the short term and the national debt ceiling was raised to $11.315 trillion; the President is required to submit legislation 5 years hence proposing how to recover from financial institutions any shortfall, but there is no guarantee such legislation will pass or that a feasible method of recovery will exist.
6. Frequent Shocks to the Financial System May Persist. The Act creates a number of incentives that favor auctions and open-market transactions for Troubled Assets over direct purchases (e.g., different executive compensation limits for participating institutions, less burdensome reporting and oversight for the Treasury Secretary, and direction in the Act to the Treasury Secretary) and the Treasury will need to issue large amounts of debt to finance TARP; the former transactions periodically and suddenly will create new pricing information that may change substantially (i) the valuation of assets in mark-to-market models and (2) investor assessment of the health of individual institutions, the financial system, and the housing market; the latter Treasury auction may produce substantial swings in interest rates and dollar exchange rates, as well as highly correlated commodity prices (e.g., crude oil prices). Additionally, much like the Federal budget, the program requires continuing acts of Congress (authority under the Act sunsets in December 31, 2009 and may be extended briefly by the Secretary for up to 2 years from the passage of the Act) which may create uncertainty.
7. Early Look at Potential Broad Executive Compensation Changes. The Act provides an early look at how the next administration and Congress may consider reshaping executive compensation more broadly than just financial institutions participating in TARP, especially regarding tax deductibility; limits include:
(1) restrictions on golden parachutes (either prohibition of payment or the ability to create new ones);
(2) limits on incentives that threaten the value of the financial institution; (3) provisions for the recover of compensation based on earnings/gains that later prove materially inaccurate; and (4) tax deductibility limits with the $1 million cap falling to $500k and golden parachutes even more likely to be treated as non-deductible (if it is even possible). Note that the executive compensation limitation draws a line between companies that participate via direct sales of assets and those that participate via open auctions; clearly favoring the latter. The motivation of lawmakers in drawing this distinction is unclear to us at this time (beyond a bias toward using market mechanisms for the purchase of assets).
8. Criminal Enforcement like the Post-Enron Period. The Act tightens up fraud provisions around use of FDIC protection claims and directs key players to co-operate fully with the FBI in investigations related to the financial crisis. Executives should expect far reaching investigation (if not charges) that extend not just to financial institutions, but also to their advisors, customers, and partners who helped create mortgaged-back securities (e.g., accounting firms, law firms) or transacted in them (e.g., pension funds, corporate treasuries).
Other Things You May Want to Know About the Act
What TARP Encompasses
* Section 101 of the Act empowers the Treasury Secretary to purchase Troubled Assets (basically any residential or commercial mortgage-related assets) held by financial institutions originated on or before March 14, 2008, or others as determined the Secretary after consultation with the Fed Chairman.
* Instead of purchasing those assets, Section 102 allows the Treasury Secretary to issues guarantees for the interest and principal of Troubled Assets (not to exceed 100%) held by financial institutions in return for a premium paid by those institutions; the premiums must at a "level necessary to create reserves sufficient to meet anticipated claims, based on an actuarial analysis, and to ensure that taxpayers are fully protected”; the premiums are managed in the Troubled Assets Insurance Financing Fund.
* The Treasury Secretary has authority immediately to tap up to $250 billion, which the President can increase to $350 billion; the Treasury Secretary can increase that authorization up to $750 billion upon sending a notice and plan to Congress, so long as Congress doesn't disapprove of the plan through a joint resolution within 15 days of receiving the plan.
* The Act encourages the Treasury Secretary to place special emphasis on supporting institutions that lend to lower-income borrows as well as small financial institutions that were well capitalized prior to the government placing Fannie Mae and Freddie Mac into conservatorship.
* The Treasury Secretary has broad power to manage the purchased Troubled Assets, including sell them and create securities based on them.
* Note also that there are a number of provisions throughout the act designed to assist financial institutions negatively affected when the government placed Fannie Mae and Freddie Mac into conservatorship (e.g., treatment of gains/losses of preferred stock in those institutions as ordinary income) and to prevent incidental penalties to companies like J.P. Morgan Chase who purchased financial institutions and assets as part of broader efforts to shore up the financial markets.
Efforts to Reduce Foreclosures
* The Treasury Secretary must create a plan designed to reduce the number of foreclosures; to that end, the Secretary can change the terms of residential mortgages in purchased Troubled Assets.
* Fannie Mae and Freddie Mac must issue plans designed to encourage lenders to participate in the HOPE program (the July 2008 law aimed at stemming the US foreclosure rate), although it remains voluntary and its efficacy to date in shoring up the housing market is questionable.
Protection of Taxpayers
* The Act directs the Treasury Secretary to establish policies and otherwise act to prohibit participants in TARP from unjust enrichment, which largely means that the Secretary shouldn't pay more for Troubled Assets than they cost the person from whom they are purchased; there are potentially important exceptions for current owners and conservators of Fannie Mae, Freddie Mac, Bear Stearns, Lehman Brothers, and Washington Mutual.
* The Treasury Secretary takes a warrant in publicly traded companies for non-voting common stock or preferred stock in those companies who sell Troubled Assets under the program; non-publicly traded companies must provide senior debt instruments instead; the Treasury Secretary determines the terms and conditions and will include anti-dilution provisions; the Treasury Secretary can establish de minimis exceptions where the aggregate purchase from the institution is under $100 million.
* Costs of purchased and guaranteed Troubled Assets will be determined in accordance with the Federal Credit Reform Act of 1990 (2 USC 661 et. seq.).
* The Act creates an Office of Financial Stability, headed by an Assistant Secretary of the Treasury (Presidential appointment, with Senate confirmation).
* The Treasury Secretary must consult with the Board of Governors of the Federal Reserve, the FDIC, the Comptroller of the Currency, the Director of the Office of Thrift Supervision, and the Secretary of Housing & Urban Development; note, though, that consultation typically doesn't have a lot of teeth.
* The Act also creates a Financial Stability Oversight Board consisting of the Fed Chairman, the Treasury Secretary, the Director of the Federal Home Finance Agency, the SEC Chairman, and the Secretary of Housing & Urban Development; the Chair of the Board is selected by its members, but it can't be the Treasury Secretary; it meets monthly and has the power to create a Credit Review Committee to evaluate the Treasury Secretary's exercise of purchase authority.
* The Comptroller General has oversight of TARP, basically to evaluate the efficacy of the program and its implementation as well as to monitor controls; it can only report and recommend changes; the Comptroller General also is charged with creating a big "what happened, who is responsible, and what should we do about it” report by June 1, 2009.
* The Act creates a Special Inspector General also to oversee TARP.
* The Act also creates a Congressional Oversight Panel.