Publications

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The past several weeks have brought significant developments on the regulatory, legislative, accounting and international fronts in the US government’s response to the credit crisis.

Addressing the crisis across several fronts, these developments elaborate on programs and initiatives already in place: the Public-Private Investment Program, (and its Legacy Loan and Legacy Securities initiatives), the Capital Assistance Program, the Troubled Asset Relief Program (TARP) and the Term Asset-Backed Securities Loan Facility (TALF).

Among the developments:

THE REGULATORY FRONT

Results of the stress tests: Identification of banks and financial institutions that require additional capital and expected courses of new investment. Last week’s release of the results of the US Treasury’s stress tests of the 19 largest bank holding companies largely confirmed the market’s hope that these institutions will be able to weather a significant recession, without the need for additional funding beyond that already authorized by the US Congress. The analysis of the banks’ condition, as revealed by the stress tests, was released by the Treasury on Thursday, May 7, and confirmed the financial industry’s expectations while potentially forming the basis for future financial regulation and legislative proposals by the Administration.

Those banks whose reserves were judged insufficient were being given up to six months to obtain additional private capital, before being obligated to accept government funds through the Treasury’s Capital Assistance Program. Treasury officials are determined not to allow any such significant bank to fail. Healthy banks will be allowed, if they so choose and if they meet certain financial strength standards, to repay funds previously borrowed from the US government, allowing such institutions to avoid encumbrances, including constraints on executive compensation, that relate to such Treasury funding.

Under these stress tests, 10 of the 19 bank holding companies deemed “too big to fail” by the Treasury will be required to raise additional capital. But these 10 banks will have to raise much less capital than the amount predicted by many analysts several weeks ago. Citigroup will be required to raise $5.5 billion in new capital, in addition to converting $45 billion in preferred stock acquired by the US government with TARP funds into ordinary common stock. As a result, the US government will own 36 percent of Citigroup’s common equity. Similarly, Bank of America will be required to raise $34 billion in new equity, but may avoid having to convert the US government’s preferred stock position into ordinary voting shares. Instead, Bank of America is expected to raise new capital by selling some of its smaller banking divisions, and, if need be, raising additional equity without government assistance through the capital markets. There were no recommendations made to dismiss any officers of the bank holding companies as a result of the stress tests as reported in the US Treasury’s official summary, and US Treasury officials strongly asserted that most, if not all, of the new capital required would be available from private sources, with the US government available as the investor of last resort to ensure the continued viability of the banks in question.

Click here to read the US Treasury press release and stress test report.

The Federal Reserve announced that it is making its TALF Program available to finance newly issued commercial mortgage-backed securities (CMBS). Under this new program, announced on May 1, investors will be eligible to receive low-cost, non-recourse loans, with either three-year or five-year terms, to buy qualifying CMBS. The five-year term for the loans in question is a significant extension of the three-year term provided for investors to acquire previously authorized securities backed by eligible vehicle debt, credit-card debt and other consumer and small business loans.

To qualify as eligible collateral for a TALF loan, the CMBS in question must have been issued after January 1, 2009, be rated not less than the highest investment-grade rating from the required TALF CMBS-eligible rating agencies and be backed by eligible commercial mortgage debt originated on or after July 1, 2008 and secured by properties located in the United States. Each CMBS must evidence an interest in a trust fund consisting of fully funded, first-priority mortgage loans that are current in payment at the time of securitization. A three-year TALF loan will bear interest at a fixed rate per annum equal to 100 basis points over the three-year Libor swap rate; a five-year TALF loan is expected to bear interest at a fixed rate per annum equal to 100 basis points over the five-year Libor swap rate.

The collateral haircut for each CMBS with an average life of five years or less will be 15 percent, meaning that the Federal Reserve will lend up to 85 percent of the value of the CMBS. For average lives beyond five years, collateral haircuts will increase by one percentage point for each additional year of average life beyond five years. No CMBS may have an average life beyond ten years. TALF loans are made through the Federal Reserve’s primary dealer network. Investors interested in qualifying for TALF loans must establish an account relationship with a primary dealer and enter into a so-called Customer Agreement that will govern the TALF loan process.

Additional notifications to be issued in the future are expected to clarify the application of TALF to so-called Legacy Securities. Click here to review the Terms and Conditions and here to read Frequently Asked Questions pertaining to the CMBS program.

Developments relating to the Legacy Loan and Legacy Securities Programs. The Public Private Investment Programs includes the Legacy Securities Program administered by the US Treasury and the Legacy Loans Program administered by the Federal Deposit Insurance Corporation. Under the Legacy Securities Program, the US Treasury will contribute equity and debt capital, alongside equity capital raised by selected fund managers, in Public-Private Investment Funds that will then purchase certain Legacy Securities from financial institutions. Entities that were interested in participating as fund managers for Public-Private Investment Funds under the Legacy Securities Program were required to submit applications by April 24. We understand that more than 100 applications were submitted.

Treasury has indicated that it hopes to announce the selection of an initial group of approximately five fund managers on May 15. Many in Washington are encouraging the US Treasury to expand the selection of fund managers to encompass a broader group of smaller fund managers.

In contrast, the Legacy Loans Program is intended to remove legacy loans from US bank and thrift balance sheets by individual Public-Private Investment Funds that will capitalized by private investors and Treasury on a dollar-for-dollar basis and by debt financing to be guaranteed by the FDIC. The FDIC requested comment from banks, investors and the general public on how the Legacy Loan Program should best be structured. That comment period ended on April 10 and more than 400 comments have been posted to the FDIC’s web site.

The market is anxiously awaiting word on this program and how it will be structured. Recent press reports indicate that the FDIC and the US Treasury may be considering an option that would allow the formation of Legacy Loan funds without requiring an equity investment by the US Treasury. Such a result would reduce the uncertainties and concerns expressed by potential private investors that the US Treasury could change the rules applicable to these funds if it participates as a co-investor. Similar concerns have been expressed regarding the TALF and the Legacy Securities Program.

Additional regulatory guidance regarding executive compensation arrangements and related restrictions. The US Treasury will be issuing further regulatory guidance to clarify the regulation of compensation that may run afoul of the standards set forth in the American Recovery and Reinvestment Act of 2009.

Under the provisions of this legislation and the Emergency Economic Stabilization Act, recipients of TARP funds were required to limit certain officers’ annual salary and bonus payments. (For a summary of these restrictions, click here.) It is expected that strict limitations will remain on the nature and amount of compensation awarded these affected employees. While many recipients of TARP funds may wish to avoid the consequences of such restrictions, their ability to repay these amounts will be significantly limited--both by the practical requirement that such firms raise additional capital to replace the TARP funds, and by the proviso recently announced by US Treasury that the US government would find the anticipated repayment of such to be in the national economic interest.

Anticipated extension of TARP to life insurers that are bank holding companies or that own a thrift institution. Applying TARP to a broad class of insurance companies would very significantly extend the scope of this program. However, indications exist that the initial determination by the US Treasury and other pertinent regulatory agencies will be to make the TARP initiative applicable to life insurance firms already registered as bank holding companies. Of course, entities newly registered as bank holding companies are also addressing activity and capitalization constraints that they may well be finding onerous. Additional extensions of the TARP initiative to cover other insurance vehicles not registered as bank holding companies are possible—and, of course, will be subject to further scrutiny should they occur.

THE LEGISLATIVE FRONT

Passage by the US House of Representatives of a bill curbing "excessive compensation" at financial firms, and applicable to recipients of funds from the US government under TARP. The proposed legislation’s fate in the US Senate is uncertain. Should it be enacted into law, it would impose significant additional limitations on the payment of executive compensation to key officers of financial institutions that have received TARP funds. Many observers note that increasing numbers of such firms have become anxious to return TARP funds in order to avoid these and other entanglements with the US government in their business operations. As discussed above, the legislation may be overtaken by new Treasury guidance on the subject that will apply to institutions in which the government holds long-term equity positions.

Passage by the House of Representatives of the Mortgage Reform and Anti-Predatory Lending Act, which attempts to regulate both the standards and practices as well as the methodologies of origination of mortgages aimed at consumers. The scope of the bill, and its potential to impose liability on the base of broad and, at times, ambiguous standards, has caused concern among market participants. Among the key provisions are the following:

• A prohibition on all fees paid to loan officers that are tied to the interest rate of the mortgage or the type of the loan.
• Creation of mandatory minimum national quality standards for all mortgages. The rules would encourage lenders to make fully documented 30-year, fixed-rate loans with prevailing market rates, as opposed to loans with higher-risk features such as adjustable payments and negative amortization. The bill would also impose federal “duty of care” standards requiring loan officers to offer applicants terms and rates that are "appropriate" to their income and ability to repay.
• Authorization on the part of borrowers who are put into mortgages that violate the new law to seek legal redress through cancellation of the loan contract, refund of all payments and fees and compensation for legal costs.
• Prohibition on borrowers who lied or committed fraud on their loan applications to obtain such legal recourse in the event that the lender violates one or more of the standards under this proposed legislation. The bill would also extend liability for rule violations to third-party firms who buy loans for repackaging and securitization through the issuance of mortgage-backed bonds. Originators of all but fully documented 30-year, fixed-rate loans would be required to retain at least a 5 percent stake in the loan until final maturity, although recent legislative developments appear to provide regulators with greater flexibility in the application of these requirements. If the loan goes into default, such originators would retain some economic stake in the related losses.
• Action coincides with a vote in the US Senate defeating Senator Dick Durbin’s proposed mortgage cramdown legislation; as a substitute to this bill, Senator Chris Dodd has introduced mortgage legislation which would not include cramdown provisions and which would establish a safe harbor for servicers that modify a loan consistent with the Obama Administration’s new proposals on mortgage relief or with the terms of the Hope for Homeowners loan program.

REGULATORY REFORM DEVELOPMENTS

Who will oversee regulatory actions? A likely outcome is the requirement that hedge funds be registered with an appropriate host regulatory body, while more uniform and increased capital requirements may be required as a result of coordinated action by a college of national supervisors. An expanded and critical role is also foreseen for the International Monetary Fund, resulting from an infusion of approximately $750 billion in additional contributions available for diverse country programs in various sectors of Europe, Asia, Africa and Latin America.

Such developments are consistent with standards and proposals for increased regulatory oversight articulated in recent remarks by US Treasury Secretary Geithner, who called for regulation depending on the economic function provided by the financial institution in question and not as a unreflective result of the legal form taken by the entity under consideration.

The principal issues under consideration in such a regulatory revision include the following:

• Credit cards. Following a much-publicized meeting between President Obama and representatives of the major credit card issuers, the US House of Representatives passed a bill with broad bipartisan support, including the votes of more than 100 Republicans, with a number of significant amendments to toughen its standards. A key provision would require cardholders to obtain customers’ permission before charging them over-the-limit fees. Another would limit college student card accounts to $500 or 20 percent of the student’s annual income, whichever is higher. Other amendments would require teaser promotional rates to be offered for at least six months and payments to be applied to the highest-rate balances first. The Senate is expected to vote on its version of a credit card bill this month; its bill, which has passed committee vote, calls for a nine-month implementation; the House bill for one year from approval, or by July 2010, whichever comes first.
• Unwinding failing firms. The Obama Administration has sent Congress draft legislation to empower the government to seize and unwind large, failing financial firms that are not banks. No clear procedure for doing this now exists. A seizure would require approval of the US Treasury, the Federal Reserve and the FDIC, in consultation with the White House. The Treasury and FDIC would decide whether to offer financial aid to the seized firm or to put it into conservatorship. The House Financial Services Committee plans to hold hearings on the legislation in May.
• Systemic risk regulator. Treasury wants a single, independent regulator to oversee systemically important firms and critical payment and settlement systems, but has not said which agency should get this job. No agency formally does it now. Some in Congress favor giving the job to the Federal Reserve, but others are skeptical, noting that the Federal Reserve may be too extended at present, given its current responsibilities in monetary policy and bank holding company supervision. Alternative legislation has been introduced in Congress to establish an inter-agency council on financial stability.
• Executive pay. The House has approved a bill to curb "excessive" employee pay at firms getting government bailout funds. It would let the Treasury block compensation and bonuses that are not based on performance standards. This new legislation would apply to all employees, not just executives, at bailed-out firms. Some analysts expect passage of a modified version that exempts some forms of compensation and applies only to future bonuses.
• Hedge funds, private equity. Treasury has recommended that all advisers to hedge funds, private equity funds and venture capital funds, whose assets under management exceed a not-yet-determined level, must register with the Securities and Exchange Commission. The recommendation imposes investor and counterparty disclosure requirements on funds' SEC-registered investment advisers. The SEC would share the reports it gets from funds with the systemic risk regulator, which would decide whether any hedge fund poses a systemic threat and should be subjected to higher standards for systemically important firms. Such developments would mirror proposals for hedge fund regulation being considered in the European Union. To this end, Mary Schapiro, the chair of the SEC, has proposed that the SEC be given additional jurisdiction to regulate the nature of those investments that hedge funds can effectuate and the amount of indebtedness that they can incur. Ms. Schapiro noted that it might not be enough simply to have these funds register with the SEC; affirmative limitations and constraints on investment strategies and leverage may also be necessary, requiring additional disclosure and inspections/examinations by SEC staff. This call for action follows criticism from President Obama and others directed against hedge funds that failed to agree to terms in the recent proposed Chrysler restructuring, which may have triggered that company’s bankruptcy. The SEC may go so far as to require public disclosure by hedge funds of their short-sale positions, impose restrictions on excessive borrowing and restrict the nature of the investments that hedge funds may make.
• Short selling. The SEC is requesting public comment on various proposals, which include reinstituting the uptick rule, allowing short selling in anticipation that a stock will fall only when the last sale price was higher than the previous price.

We are monitoring the US government’s responses to the financial crisis for their import and applicability to the financial services industry. To learn more and to discuss the ways the government’s moves affect your business, please contact:

Richard Coll

Rusty Conner

Andrew Eskin

James Kaplan

Megan Kraai

David Krohn

Michael Reed