September 24, 2008



UPDATE: THE GLOBAL CREDIT CRISIS AND
THE US GOVERNMENT’S RESPONSE

Today the financial markets received the welcome news that investor Warren Buffett, acting through Berkshire Hathaway, Inc., is planning to invest $5 billion in Goldman Sachs. The proposal, coupled with an additional capital raise by Goldman announced today, is being seen as a favorable indication of faith in the viability of the country’s financial
system.

Today’s update provides further information on issues discussed in our Client Alert of September 21, “Implications of the Global Credit Crisis and the US Government’s Response,” and Monday’s Update, as well as recent events. These include:

  • Summarizing developments concerning the legislative program proposed by the US Treasury, and also reviewing certain critical points in the proposals for comparable legislation under consideration by the US Senate Banking Committee and the US House of Representatives Banking Committee;


  • Outlining calls by the Securities and Exchange Commission, as well as by the New York State Insurance Department, to establish mechanisms to enhance the regulatory oversight for the massive credit default swap industry; and


  • Analyzing regulatory actions recently undertaken relating to the crisis, most notably the policy announced by the Federal Reserve on Monday, September 22 dealing with passive investments in banks and bank holding companies.

Legislative Developments

The US Congress is resisting the Treasury’s troubled assets proposal. After extensive periods of questioning of Secretary Henry Paulson and Chairman Ben Bernanke, concerns abound regarding the enormous cost of the proposal and the structures it would put in place to provide the program with appropriate oversight.

Alternative proposals being considered by the Banking Committees of the Senate and of the House of Representatives, as set forth in our earlier Update, focus on a number of critical areas. The greatest amount of debate and controversy in the consideration of these legislative proposals by Congress is concentrated on these areas of dispute. The proposals most under scrutiny and contention are the following:

Placing limitations on the extent of executive compensation paid to officers of companies receiving assistance. The Senate proposal would exclude incentives for executives to take risks determined to be excessive, would establish a clawback for compensation based on gains that prove to be inaccurate and would impose constraints on the payment of severance compensation. These provisions are echoed in the House version of the legislation, with the additional timing requirement that these conditions be followed for a period of two years after an institution participates in the purchase program. The proposals on these points are quite broad and general in nature, reflecting the open-ended terms of the language used in the proposed legislation. Under either the House or Senate version, the Secretary of the Treasury would be given extensive discretion to apply these concepts in specific settings, as well as to define further by regulation the precise meanings of these terms.

Providing for additional assistance to individual mortgage holders in the form of bankruptcy relief. Both the House and Senate versions of the legislation would allow bankruptcy courts to modify residential mortgages; the Senate bill would provide for the Federal Deposit Insurance Corporation to forestall foreclosures through modifications and utilization of the HOPE for Homeowners refinancing program established under prior law. The House version of the legislation also directs the Secretary of the Treasury to encourage use of the HOPE for Homeowners program, and to apply loss mitigation measures that might allow homeowners to remain in their residences.

Calling for Treasury to acquire options on stock in the companies being assisted through the purchase program. The Senate version of the legislation calls for the Treasury to receive contingent shares from institutions that participate in the purchase program, with these shares vesting in an amount equal to 125 percent of any loss experienced by the Treasury on the purchase and subsequent sale of troubled assets from the entity in question, divided by the average share price for the entity’s stock (calculated as the average over the fourteen business days prior to such calculation). There is no comparable provision in the House bill.

Establishing numerous oversight boards, reporting requirements and administrative officials to oversee the operations of the Treasury under the purchase program. The Senate bill calls for
the creation of an Office of Financial Stability, under the Department of the Treasury, to implement the purchase program, and an Emergency Oversight Board, consisting of the Federal Reserve chairman and the chairs of the Federal Deposit Insurance Corporation and of the Securities and Exchange Commission, as well as two appointees designated by the Senate and House respectively. In addition, the Senate bill sets forth the obligation to provide annual reports, while the House version requires an initial report to be submitted within sixty days of the first purchase of troubled assets, with subsequent periodic reports every ninety days thereafter.

In addition, a further alternative was proposed by Senator Chuck Schumer yesterday, raising the possibility that the reduced amount of $150 billion might be authorized at this stage for the purchase program, with additional amounts to be considered in the new session of Congress to commence in January 2009.

We note that the President spoke to the nation this evening and outlined the gravity of the situation and the importance of passing legislation on these topics, recognizing the need to resolve the foregoing issues. The presidential candidates have proposed a collaborative approach to the pending legislation in an effort to assure its passage by the weekend deadline.

As of this writing, we expect that some form of this legislation will be enacted, probably no later than this coming weekend, albeit by a close margin in the House and a somewhat larger affirmative vote in the Senate. It is also expected that the legislation will, at minimum, include some caps on executive compensation described above, as well as oversight provisions; conceivably, as a more contentious matter, it may also include the bankruptcy “cram-down” provisions noted, despite some opposition from the Republican members of Congress for this relief provision.

We also expect that a Continuing Resolution will be passed at the same time, providing for funding critical to the ongoing operation of the federal government. In addition to the Department of Defense appropriations necessary for national security and the overseas war efforts, Congressional Democrats may seek to add to this Resolution assistance for the automobile industry as well as hurricane relief. It is thought by Congressional Democrats that passage of such a Resolution, linked to national security expenditures, would render such legislation virtually “veto-proof,” and would obviate the need for a lame duck Congressional session after the November election.

Expect New Regulations on the Credit Derivatives Market

In an unprecedented move, New York Governor David Paterson has indicated his intention to regulate credit derivatives.

In recent days, state regulators have considered the role of credit derivatives in the recent financial crisis. The most commonly traded credit derivative is a credit default swap (CDS), a derivatives transaction which allows one counterparty, the buyer, to purchase protection against losses and defaults (on underlying indebtedness or debt instruments) from a financial institution or insurance company, the seller.

Regulators have begun to voice concerns that CDS allows buyers to bet against the outstanding indebtedness of US businesses and institutions, while taking on little or no risk to the underlying debt. These buyers are synthetically speculating against third-party debt.

This CDS market has been the fastest growing derivatives market worldwide in the last two years. The sellers of CDS protection are often Insurance companies, and the risk of loss to sellers (in the event reference indebtedness is not repaid in accordance with its terms) increases exponentially. This arguably increases systemic risk to the financial markets.

Governor Paterson has therefore attributed the financial crisis, in part, to the proliferation of credit derivatives and CDS transactions. The SEC has also indicated it will interview hedge fund managers, broker/dealers and institutional investors with significant positions in CDS to assess their impact on financial markets. Global over-the-counter (OTC) market participants will eventually be forced to deal with a major sea change, as state and federal regulators are likely to impose new regulations on the credit derivatives market.

Comments on the Policy Modifications Created to Bolster Financial Institutions

Since the proposed Treasury legislation does little to enhance directly the capital position of the nation’s banks, both the Federal Reserve and other significant banking regulators have adopted proposals designed to bolster the capital position of such financial institutions.

As noted in our earlier Update, the Federal Reserve announced on September 22 a modification to its policies on passive investments. While the language in this statement is general in its terms, it permits increased ownership interests of an additional 8 percent (and in the aggregate less than a 33 percent interest) of the total equity of the bank or bank holding company in question and less than a 15 percent position in the voting equity. The policy also significantly liberalizes the requirements concerning designation of board representations, expanding the previous ability to appoint one director in those cases in which an investor held 15 percent or less of the voting rights in a bank.

Under the new policy, the holding of two board seats is generally accepted, provided that such right is not in excess of the proportionate amount of capital held by the investor in the entity in question, such representation does not exceed 25 percent of the voting members of the board and another equity holder controls the bank or the bank holding company. The Federal Reserve took this action in the context of interpreting Section 1841 of the Bank Holding Company Act, which defines “control” of a bank to exist in those cases where an investor holds more than 25 percent of the class of any voting securities.

It is important to note that these guidelines are subject to the overall facts and circumstances of the investment and the existence of any factors that might evidence a finding of influence (such as veto rights, management overlaps or contractual constraints impairing the unfettered management of the bank or entity in question). In these cases, a finding of control may occur notwithstanding a technical structure that comports with the overall percentages on ownership described above. We recommend a detailed review of the entire policy as announced by the Federal Reserve. As previously noted, the banking regulators recently requested public comment on an interagency notice of proposed rulemaking that would permit a banking organization to reduce the amount of its goodwill deduction from tier 1 capital by any associated tax liability. The proposed rule would provide that the regulatory capital deduction for goodwill would be equal to the maximum capital reduction that could occur as a result of a complete write-off of the goodwill, which is a sum equal to the amount of goodwill reported on the bank’s balance sheet as calculated under generally accepted accounting principles, less any associated deferred tax liability. The effect of this amendment is to lessen the amount of the goodwill deduction, thereby increasing bank regulatory capital. We attach a link to this proposal as well.

We will continue to monitor these and other legislative and regulatory developments concerning actions or interpretations of significance for the issues raised by the credit crisis.