October 16, 2008



THE GLOBAL CREDIT CRISIS
AND THE GLOBAL RESPONSE

Coordinated International Response: European Developments

Since the date of our last update, the United States, as well as a multitude of nations in Europe and Asia, has acted to implement programs designed to restore confidence in the banking systems of the global economy. The Group of 7 and the Group of 20, along with senior representatives of key countries in the European Union, have met to establish a coordinated effort by the principal central banks and governments in the affected economies to bolster the solvency of their significant constituent international banks. The programs and proposals, in the main, have three common elements: (1) investment in the affected banks; (2) support and facilitation of inter-bank lending; and (3) guarantee of banking deposits.

These actions include:

  • In the United Kingdom, the British Government announced its decision to invest in major UK banks and building societies, acquiring a 63 percent stake in Royal Bank of Scotland in exchange for a 20 billion pound investment, and investing 17 billion pounds in the combined HBOS/Lloyds TSB merged entity. Other banks and financial institutions will receive comparable investments from the Government; under the terms of this proposal, the UK Government will take affirmative steps in contributing to management of the financial institutions in question by designating representatives to the supervisory boards of the institutions involved. This investment policy was implemented along with a government guarantee program designed to stabilize inter-bank lending;
  • In Germany, as in England, a financial market stabilization fund was established, designed to buy preferred stock or other financial instruments in an amount of up to 80 billion Euros. This fund has been structured to act along with the provision of a guarantee of up to 400 billion Euros of debt and deposits issued by financial institutions;
  • In Spain, the Spanish Government has implemented a 100 billion Euro fund whose objective is to support inter-bank lending among Spanish financial institutions;
  • In France, a 320 billion Euro program has been announced, with the intention of providing guarantees of direct obligations and deposits of French banks; this program is complemented by a 40 billion Euro facility providing for direct investment in selected banks and financial institutions;
  • In Italy, a 20 billion Euro program was established, providing for investment by the Italian Government in Italian financial institutions;
  • In the Netherlands, an inter-bank guarantee program was established with the amount of 200 billion Euros, coupled with a proposal to fund capital injections in selected Dutch banks in an aggregate amount of 20 billion Euros;
  • In Belgium, all banks and financial institutions are the beneficiaries of Government support behind interbank lending; and
  • In Ireland, the Government continues with its policy of guaranteeing all banking deposits and obligations, as well.

In a more general vein, Icelandic banks remain in receivership, causing complications for the world financial system as a result of the freezing of their funds in the United Kingdom. Despite funding received in the form of a loan from Russia in the amount of $5 billion, no immediate resolution of the banking crisis in Iceland appears imminent.

Despite the stated intention of the European governments in question to invest in the affected banks, a critical question has arisen in the minds of the banks’ management regarding the viability and desirability of such investment alternatives. Specifically, members of management are concerned that availing themselves of the option to have the governments in question effectuate the capital investments anticipated by these programs could place such bank under the “stigma” of requiring such special support and emergency relief, causing potentially additional doubts about the viability of the bank. Coupled with fears that accepting such investments could lead to limitations on the compensation of banking officers and key executives, as well as giving the governmental investor an excessive say over bank policies and management, there is some doubt as to the likelihood that many banks and financial institutions will participate in these relevant programs. It should be noted that the US Government solved the “stigma” problem by, in essence, forcing each of the largest US banks to accept the investment by the US Government, while undertaking to receive non-voting securities that would prevent the Government from influencing the management of the bank in question. It is to a consideration of this program, and related developments, that we now turn.

US Government Actions Under the Emergency Legislation and Related Programs

In the United States, the Government has continued to implement aspects of the legislative program established by the Emergency Economic Stabilization Act of 2008 (EESA), but in a manner that represents a dramatic departure from the original focus of the legislation, which emphasized the purchase of mortgages and mortgage-related assets. In taking this new direction, the US Treasury was cognizant of developments in Europe (most specifically, in the United Kingdom) which accentuated a direct investment in banking institutions as the preferred means to recover the loss of faith in the world’s banking system. In so acting, the US Treasury hoped to restore confidence in the US banking system, while at the same time not allowing US banks to be at a disadvantage, by having less capital at their disposal than their European counterparts.

These key elements have included the following actions:

  • Equity Purchase program—preferred stock: $250 billion will be made available to financial institutions as a capital infusion, with the US Treasury receiving non-voting preferred stock that pays cumulative dividends of 5 percent per year for the first five years and 9 percent after that. The program will be available to qualifying US-controlled banks, savings associations, and those savings and loan holding companies that elect to participate. The minimum subscription amount available to a participating institution is one percent of risk-weighted assets. The senior preferred shares will qualify as Tier 1 capital, and will rank senior to common stock and pari passu with existing preferred stock (other than junior preferred shares). For as long as any of this preferred stock is outstanding, no dividends may be declared or paid on any junior preferred shares, preferred shares ranking pari passu with the senior preferred, or common shares. The preferred shares will be callable at par after three years, and will not be subject to any restrictions on transfer.
  • Equity Purchase program—warrants; deadline: In addition, as a condition of effectuating such preferred stock investment, the Government also will receive a related warrant being issued equaling common stock in the amount of 15% of the amount of the loan provided. The warrants will be immediately exercisable, in whole or in part. Should the issuing institution not have sufficient authorized shares to reserve for issuance upon exercise of the warrant, such entity will call a meeting of its shareholders and take such other steps as are necessary to have such shares ready. Among the other consequences of making such an investment is that select executives of the organizations issuing the preferred stock become subject to constraints on executive compensation, as more fully described below. Nine banks have already agreed to accept an aggregate investment of $125 billion, with the balance of the program being made available to small and medium-sized financial institutions. The deadline for a financial institution to apply to participate in this program is November 14, 2008;
  • Limitations on Executive Compensation: As noted above, it is a condition of participating in the capital infusion program described directly above that the financial institution in which the investment has taken place must: (1) ensure that incentive compensation for senior executives does not encourage unnecessary and excessive risks that threaten the value of the financial institution; (2) require 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; (3) prohibit the financial institution from making any golden parachute payment to a senior executive in contravention of applicable constraints on such payments arising under the Internal Revenue Code; and (4) agree not to deduct for tax purposes executive compensation in excess of $500,000 for each senior executive. For purposes of these provisions, the term “senior executive” is generally meant to be one of the top five “named executive officers” whose compensation arrangements must be disclosed under applicable reporting standards, as well as to their counterparts in privately held institutions. Despite their terms, it is not expected that these considerations alone would render the capital investment program inappropriate for many potential banking institutions, particularly for smaller and medium-sized banks for which the terms of the preferred stock issuance remain attractive when compared against prevailing market conditions. In many cases, the private capital markets will simply be unavailable at this time for these institutions, rendering the Government’s program highly desirable for this reason, among others;
  • Guarantee Programs: The Secretary of the Treasury, in consultation with the President and upon the recommendation of the boards of the Federal Deposit Insurance Corporation (FDIC) and the Federal Reserve, has invoked the systemic risk exception of the FDIC Improvement Act of 1991, providing the FDIC with the ability to extend a complete guarantee for newly issued senior unsecured debt and non-interest bearing transaction deposit accounts at FDIC-insured institutions. The FDIC will guarantee all newly issued senior unsecured debt issued by eligible entities on or before June 30, 2009, in amounts that do not exceed 125 percent of debt that was outstanding as of September 30, 2008, and that was scheduled to mature before June 30, 2009. For eligible debt issued on or before June 30, 2009, coverage would only be provided for three years beyond that date, even if the liability has not matured. It is expected that this aspect of the FDIC program could aggregate upwards of $1.5 trillion. Separately, the FDIC will guarantee funds in non-interest bearing transaction deposit accounts held by FDIC insured banks until December 31, 2009. It is anticipated that this part of the program could represent sums to be guaranteed of approximately $500 billion. The guarantee fees would equal 75 basis points in the case of the senior unsecured debt, and 10 basis points for the deposit accounts. Eligible entities for purposes of this program consist of FDIC-insured depositary institutions, US bank holding companies, US financial holding companies, and US savings and loan holding companies;
  • Commercial Paper Purchases: Beginning October 27, 2008, the Federal Reserve will begin purchasing dollar-denominated commercial paper of three-month maturity from high-quality corporate issuers, improving liquidity, “…in short-term funding markets and thereby increas[ing] the availability of credit for businesses and households.” This will be effectuated through the establishment of a credit facility to be extended to a special purpose vehicle (SPV), which will serve as the funding backstop for the issuance of the eligible commercial paper. The Federal Reserve Bank of New York will commit to lend to the SPV on a recourse basis, secured by the assets of the SPV. The SPV will purchase from eligible issuers three-month US dollar-denominated commercial paper through the New York Fed’s primary dealers. The SPV will only purchase commercial paper that is rated at least A-1/P-1/F1 by a major nationally recognized statistical rating organization, and will be limited to the greatest amount of US dollar-denominated commercial paper the issuer has outstanding on any day between January 1 and August 31, 2008; and
  • Designation of Agents: The Government announced that the firm of EnnisKnupp would act as investment advisor to the Treasury in connection with the troubled asset program established by EESA, while Bank of New York Mellon was selected to serve as custodian for the assets in question. At this point, further guidance is expected from the Treasury on the mechanics and process to be followed in the designation, purchase and eventual sale of the mortgages and mortgage-related and other assets that are the focus of the Troubled Assets Relief Program. It is anticipated that, after the designation of the initial $250 billion funding available under EESA for the capital investment program described above, an additional amount of $100 billion will become available upon the certification by the President to Congress of the need for such authority. This additional sum would be available for purposes of purchasing the requisite troubled assets described above.

Coordinated Regulatory Activity in Furtherance of the Legislative Mandate

The above actions are in consonance with certain other significant regulatory steps previously announced that are designed to support and augment the effects of the emergency stabilization programs set forth under EESA. These other regulatory actions include decisions in the following significant areas:

  • Short-selling: The Securities and Exchange Commission (SEC) had issued its ban on short-selling under the condition that it would be of limited duration. Although the SEC had the authority to extend its prohibitions, or to issue a new order in this regard, it announced upon the passage of EESA that it would allow the ban on short-selling in financial companies to expire at 11:59 PM (EDT) on the third business day after enactment of the legislation. Accordingly, the SEC’s prohibitions on short-selling were allowed to lapse on October 8, 2008. The obligation to report short-selling continues in effect until August 2009. In this regard, we also note that comparable prohibitions remain in effect by virtue of the mandate of the Financial Services Authority in the United Kingdom;
  • Mark-to-market accounting: The SEC provided guidance on September 30, 2008, with respect to this controversial program, with the intent of ameliorating the application of these standards in cases where markets are limited in their applicability and efficacy. The fair-value rule, set forth in SFAS 157, provides for a variety of valuation techniques. The first valuation methodology derives the fair market value of the security based on its quoted trading price. If there is no active market, the next valuation methodology to be used is based on prices of similar securities; if neither of these valuation methodologies is available, a specific model of value may be applied in the absence of a usable market price. By providing this guidance on disorderly transactions in the nature of distressed sales, the SEC’s guidance may make it more possible to move from rigid application of a forced sale price to applying a model approach more reflective of long-term value. In light of the controversy that this rule has fostered between participants in the financial services community, on the one hand, and members of the accounting profession, on the other, it is not clear whether the SEC’s guidance will be effective in giving market participants confidence that the values attributed to these types of securities are accurate;
  • Tax liberalization: The Internal Revenue Service (IRS) announced rulings providing for more favorable tax treatment for parties affected by the credit crisis. These new interpretations on additional lending flexibility for Controlled Foreign Corporations (CFCs), concerning investments in US properties, allow a CFC to exclude certain obligations of the US properties held by the CFC from the definition of the term “obligation” for purposes of Internal Revenue Code provisions that, absent such relief, would tax the CFC in the current tax year on its share of any income from these obligations. Similarly, the IRS liberalized the treatment with respect to the loss limitations arising under Section 382 of the Internal Revenue Code by making clear that deductions may be properly allowed with respect to losses on loans or bad debts after bank ownership change dates, notwithstanding limitations that might otherwise be applicable. Likewise, the acquisition of securities issued by Fannie Mae and Freddie Mac will not be subject to loss carryover rules that might otherwise limit the availability of losses incurred in connection with the ownership of these securities as being deductible. Relief was also provided for certain securities lending transactions and for lenders who use collateral retained for defaulted securities loans, permitting such collateral to be used for the acquisition of securities that are substantially identical to the defaulted securities, and allowing such securities the benefits of tax-free exchange treatment;
  • More favorable rules for bank investments: The Federal Reserve and other banking regulators issued interpretations permitting greater leeway on the part of investors seeking to contribute new amounts of capital to banks and their affiliates without requiring full banking applications. It did so by permitting investors to acquire up to 15% of the voting securities of a bank or financial institution, and up to 33% of the total contributions to equity of the bank or institution in question. At the same time, these investors would be allowed up to two representatives on the board of directors of the entity, assuming that such representation is proportional (as a percentage of the total number of directors), to the amount of equity held by the investor, and further assuming, in all events, that no other factors exist suggesting the existence of a controlling influence on the part of such investor. The banking regulators also provided greater potential benefits to investors in banks by issuing a determination on the characterization of “goodwill” for purposes of the calculation of a bank’s overall capital, making it possible for a lesser quantity of such amount to be deducted from a bank’s capital upon the acquisition of such institution. These provisions may allow private equity funds or other strategic investors to consider more aggressively investments in the financial services industry, leading to greater amounts of capital formation in this troubled sector.

Key Topics for Decision and Next Steps

As noted in the description of the above programs, in many cases both the legislative language, as well as the regulatory guidance, contain terms and concepts that are extremely general in nature. Significant open questions remain in the detailed implementation of these programs. For example, it remains unclear how much funding will be available for the purchase of mortgages and related securities, and what procedures will be followed by the US Treasury, or its advisors, in cases of the acquisition by the US Government of these mortgages and mortgage-related assets (including securities) from financial institutions whose balance sheets are burdened by these investments. In addition, as noted, the effectuation of investments in the equity of the banks and institutions in question by the US Government has subjected these financial entities to provisions in EESA governing executive compensation.

Questions for interpretation with respect to these rules include:

  • How will financial institutions define excessive risk-taking by corporate officers, so as to limit the amount of compensation in these types of instances?
  • Are executives disadvantaged as a result of the prohibitions on the deductibility of compensation in excess of $500,000 per specified officer per year, or will this be a burden carried by shareholders relating to the ban in question in those cases where deductibility is not allowed?
  • When will golden parachute arrangements be deemed excessive for purposes of the constraints arising under the provisions of EESA?
  • Will the claw-back of compensation paid to executives, who facilitated or permitted incorrect or false earnings, be broadly interpreted to apply to all failures of reporting standards regardless of the direct responsibility of the officer involved?

It is unclear whether there will be detailed regulations that will provide definitional clarity on these topics, whether on the precise calculation of impermissible executive compensation, the methodology of bidding and selling troubled mortgage assets, or the precise calculation of warrant amounts to be issued in connection with contributions of capital by the Government to the equity of selected financial institutions. Even more fundamental, as market uncertainties continue to be pronounced, and as the scope and tenor of inter-bank lending remains unduly restrictive, it remains to be determined whether even these dramatic and coordinated actions by the constituent nations will produce, in the near term, the positive consequences desired for remedying the crisis so profoundly affecting the international banking system.

Whether banks are operating in the US or in Europe, the credit crisis is predicated on the inability of banks to lend to one another and to receive credit from each other, due to the uncertainties caused by the troubled assets many banks possess, and the resulting instability in their capital positions. To remedy the freezing up of credit, most governments (including the US Government) have proposed to strengthen the capital position of their respective national banks, while undertaking to guarantee the shorter-term obligations of the institutions involved. In addition, a purchase of the troubled assets held by these banks will hopefully lead to greater clarity in the capital position of these entities by establishing a more realistic price for these assets, as well as a market for the purchase and sale of at least a portion of this universe of troubled loans and securities. To be effective in this objective, governments must move quickly to invest on terms and conditions that allow some reasonable possibility of recovery, to implement effective guarantee programs that market participants may access with confidence, and to establish bidding and auction processes whereby the underlying assets can be bought and sold. In this way, the financial services industry will be supported in its efforts to move from a reliance on public-sector investment alternatives to an eventual return toward traditional capital market opportunities.

As in the days of nuclear deterrence and mutual assured destruction, the financial security of the world rests upon a three-legged “triad” of these complementary programs, each of which must be funded adequately, defined carefully, managed effectively and executed successfully in order to reach the overall goal of restoring global economic confidence to the global financial system. The next several weeks will be critical, both in the US and in Europe, for the development of each leg of this three-legged stool. Fortunately, as events have already demonstrated, countries are able to learn from the successes and failures of other nations who are also seeking to resolve their problems; for example, the US Government emulating the United Kingdom in moving rapidly after the passage of EESA to organize a capital infusion program. We will continue to monitor legislative, executive and regulatory activity to keep you fully advised of developments on these topics at this most critical time.