Publications

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The past several weeks have seen a number of significant developments affecting the government programs implemented to address the credit crisis.

Influential policymakers are increasingly concerned about the effectiveness of certain government actions and programs that have already been put in motion. These developments need to be analyzed in that context. For example, in separate interviews over the past several days, both Senators John McCain and Richard Shelby have expressed a reluctance to infuse additional government resources into the capital structure of certain banks, and have suggested a willingness to allow troubled banking institutions to bear the consequences of their current financial conditions. It remains to be seen how much additional political support can be mustered at this time to provide significant additional sums of government aid for the beleaguered financial industry.

In this Alert, we consider three recent developments:

• Implementation of the Term-Asset Backed Securities Loan Facility (TALF);
• Release of key provisions of the Capital Assistance Program (CAP); and
• Announcement of the Making Home Affordable initiative, including an individual homeowner modification program.

Update on TALF

On March 3, 2009, the Department of the Treasury (Treasury) and the Federal Reserve Board (Federal Reserve) announced the implementation of the TALF Program, under which the Federal Reserve Bank of New York (FRBNY) will lend up to $200 billion to eligible investors in new AAA-rated asset-backed securities (ABS), backed by recently originated auto loans, credit card loans, student loans and Small Business Authority (SBA) guaranteed small business loans. Treasury and the Federal Reserve continue to consider expanding the TALF to include commercial mortgage-backed securities (CMBS), residential mortgage-backed securities (RMBS) and other types of ABS for possible participation under an expanded TALF.

First subscriptions by investors for funding under the TALF will be accepted by the Federal Reserve on March 17, 2009, with the first disbursements thereunder scheduled for March 25, 2009. Monthly subscriptions will be scheduled on the first Tuesday of every month through December 2009, or for such longer periods as the Federal Reserve may decide if the TALF facility is extended.

TALF loans will be made only through primary dealers, will have a term of three years, will be non-recourse to the borrowers and will be fully secured by eligible ABS. The Treasury will provide $20 billion of credit protection to the Federal Reserve in connection with TALF.

The FRBNY will create a special purpose vehicle (SPV) to purchase and manage any eligible assets received by FRBNY in connection with any defaulted TALF loan. The FRBNY will enter into a forward purchase agreement with the SPV under which the SPV will commit, for a fee, to purchase all assets securing a TALF loan that are received by the FRBNY at a price equal to the TALF loan amount plus accrued but unpaid interest. The Troubled Asset Relief Program (TARP), administered by the Treasury, will purchase subordinated debt issued by the SPV to finance the first $20 billion of asset purchases. If more than $20 billion in assets are purchased by the SPV, the FRBNY will lend additional funds to the SPV to finance such additional purchases. This loan will be senior to the TARP subordinated loan and secured by all the assets of the SPV.

Credit extensions under the TALF will be in the form of non-recourse loans secured by eligible collateral. As noted, TALF loans will have a three-year term, with interest payable monthly. TALF loans will not be subject to mark-to-market or re-margining requirements. Significantly, each primary dealer that underwrites or sells an issuance of TALF securities or acts as an agent to arrange financing for a TALF borrower will agree that neither it nor its affiliates will acquire collateral from a borrower that it underwrites at a price designed to reduce or eliminate any loss that such borrower would realize on sale or enter into any other agreement or consummate any other transaction intended to have the same effect. In addition, the TALF program will prohibit issuers and sponsors from entering into any transaction designed to hedge against investor losses. These provisions are intended to ensure an independent assessment of risk by investors.

Except for SBA Pool Certificates or Development Company Participation Certificates, eligible ABS must be issued on or after January 1, 2009. Substantially all of the credit exposures underlying eligible auto loan ABS (except auto dealer floor plan ABS) must have been originated on or after October 1, 2007. Substantially all of the credit exposures underlying eligible student loan ABS must have had a first disbursement date on or after May 1, 2007. SBA Pool Certificates and Development Company Participation Certificates must have been issued on or after January 1, 2008, regardless of the dates of the underlying loans or debentures. The SBA-guaranteed credit exposures underlying all other eligible small business ABS must have been originated on or after January 1, 2008. Eligible credit card and auto dealer floor plan ABS must be issued to refinance existing credit card and auto dealer floor plan ABS, respectively, maturing in 2009, and must be issued in amounts no greater than the amount of the maturing ABS. Eligible auto loan ABS and credit card ABS must have an average life of no more than five years.

Any US company that owns eligible collateral may borrow from TALF, provided that the company maintains an account relationship with a primary dealer.

Eligible collateral for a particular borrower must not be backed by loans originated or securitized by the borrower or by an affiliate of the borrower.

Of special note is the fact that participants in the TALF program will not be required to abide by the restrictions on executive compensation made applicable by the Emergency Economic Stabilization Act of 2008, as amended (EESA).

For more information about TALF from the Federal Reserve, please click here.

Key Provisions of the Capital Assistance Program

In late February, Treasury announced the terms and conditions for the Capital Assistance Program (CAP), a critical element of the US government’s Financial Stability Plan. It was designed to complement and succeed to the previously existing Capital Purchase Program (CPP) established under TARP, whereby the US government invested in numerous US banks and financial institutions in the form of preferred stock positions.

Under CAP, federal banking regulators will conduct forward-looking assessments, or “stress-tests,” based on challenging economic assumptions. Should additional capital buffers be warranted, banks will have the opportunity to turn to private sources of capital; failing to obtain sufficient resources through private capital raising, these banks will be able to turn to CAP for those amounts that may be necessary to provide sufficient capital to these banks.

Eligible US banking organizations with assets in excess of $100 billion on a consolidated basis will be required to participate in these assessments or tests, and may access CAP immediately in order to establish any necessary buffer; those institutions with assets under $100 billion may also participate on a voluntary basis. The precise terms and conditions set forth for participation in this program include the following:

Terms

• Capital will be provided in the form of preferred stock that is convertible into common equity at a 10 percent discount to the price prevailing for such equity on February 9, 2009;
• Preferred securities will provide for a 9 percent dividend yield and will be convertible at the issuer’s option (subject to regulatory approval);
• After 7 years, the securities would automatically convert into common equity if not redeemed or converted before that date;
• With supervisory approval, banks will be able to request capital under the CAP facilities in addition to their existing CPP preferred stock; and,
• With supervisory approval, banks will also be allowed to exchange the existing CPP preferred stock for the new CAP preferred securities.

Conditions

• Recipients of capital under the CAP will be subject to the executive compensation requirements provided under the terms of the Emergency Economic Stabilization Act of 2008, as amended, including the guidance that Treasury announced on February 4, 2009 as well as the restrictions imposed by the American Recovery and Reinvestment Act of 2009. It is expected that Treasury will be promulgating regulations as required by this legislation;
• As part of applying for CAP funding, banks must submit a plan setting out how these resources will strengthen their lending capacity--such plans to be made publicly available;
• Banks participating in the CAP facility will be required to prepare and submit monthly reports on their lending activities to Treasury; and
• Participating banks will be subject to restrictions on paying common stock dividends, repurchasing shares and pursuing cash acquisitions.

Restrictions on Executive Compensation

Until Treasury promulgates rules and regulations regarding the executive compensation restrictions under CAP, it remains uncertain how it will rectify some of the inconsistencies between the stimulus bill and its guidance issued on February 4, 2009. (To read our overview of those issues, please click here.) What is known is that any institution receiving assistance under CAP will be subject to a litany of executive compensation limitations, including the following:

• Prohibitions on payment of bonuses, retention awards and incentive compensation to a graduating scale of officers and employees (depending on the amount of government financial assistance), except those paid in the form of restricted stock that meets certain terms and conditions;
• Clawback requirements for any bonuses, retention awards and incentive compensation paid to the top five senior executive officers and any of the next 20 most highly compensated employees based on statements of earnings, revenues, gains or other criteria later found to be materially inaccurate;
• Prohibitions on golden parachute payments to any of the top five senior executive officers and any of the next five most highly compensated employees;
• Annual “say-on-pay” shareholder votes;
• Establishment of a “luxury policy”; and
• Annual compliance certifications from the chief executive officer and the chief financial officer.

A number of executive compensation limitations require further clarification or implementation of rules and regulations from Treasury. These include:

• Setting a possible cap of $500,000 on annual compensation for the top five senior executive officers;
• Determining which officers and employees are covered by the executive compensation limitations (that is, defining how “compensation” will be determined year to year to identify the mostly highly compensated officers and employees);
• Clarifying the types of bonuses, retention awards and incentive compensation that are prohibited and/or subject to clawback requirements;
• Determining the limits on executive compensation that exclude incentives for senior executive officers who take “unnecessary and excessive risks” that threaten the value of the institution;
• Setting standards for “independence” with respect to the directors on an institution’s compensation committee; and
• Setting forth the type of compensation plan provisions which “encourage” manipulation of reported earnings to enhance officer and employee compensation.

To read the Treasury press release on this subject, please click here.

Modification of the Temporary Liquidity Guaranty Program

On March 4, 2009, the Federal Deposit Insurance Corporation (FDIC) published an Interim Rule to include certain issuances of mandatory convertible debt (MCD) in the Temporary Liquidity Guarantee Program (TLGP).

The TLGP had been adopted by the FDIC in October 2008 as part of a coordinated effort with the Treasury and the Federal Reserve to address disruptions in the credit markets by guaranteeing deposits in insured institutions and the issuances of short term debt instruments by these entities. The Interim Rule expands the TLGP by removing a provision that prevented the use of the guarantee for “convertible debt.” In its stead, this Interim Rule allows eligible entities to apply to have the FDIC guarantee newly issued senior unsecured debt with a feature that mandates the conversion of the debt into common stock of the issuing entity at a specified date, which shall be no later than the expiration date of the FDIC’s guarantee (currently June 30, 2012).

No FDIC-guaranteed MCD may be issued without the FDIC’s prior written approval; and the MCD must be newly issued on or after February 27, 2009. Because the issuance of the debt that is convertible into common stock could raise control issues upon the disposition of such debt or upon the conversion taking place, an applicant seeking to issue FDIC-guaranteed MCD must provide confirmation that the applicant has submitted to its appropriate federal banking regulator all applications and notices required under applicable federal banking law.

To read the FDIC Interim Rule, please click here.

The Making Home Affordable Initiative

On March 4, 2009, Treasury announced a series of guidelines designed to enable servicers to begin modifications of eligible mortgages. Under this initiative, servicers will follow predetermined steps in order to reduce monthly payments on qualifying mortgages to a debt to income percentage (DTI) equal to no more than 31 percent of a borrower’s gross monthly income.

Treasury will share with the lender/investor the cost of reductions in monthly payments from 38 percent DTI to 31 percent DTI. In addition, the initiative will include incentives for extinguishing second liens on loans modified under this facility. Modifications may be effectuated only once under the program, which will be in effect through December 31, 2012. Servicers that modify loans according to the guidelines will receive an up-front fee of $1,000 for each modification, plus additional success fees on still-performing loans equal to $1,000 per loan per year.

These are the key eligibility requirements for reducing the loans under the terms of this program:

• The mortgage loans must have originated on or before January 1, 2009;
• The loans must represent first-lien loans on owner-occupied properties with an unpaid principal balance of less than $729,750;
• Borrowers must fully document their income, through the use of pertinent Treasury forms, pay stubs and tax returns, and must execute an affidavit of financial hardship; and
• Borrower credit reports and other documentation will be needed to verify borrower occupancy of the property in question: no investor-owned, vacant or condemned properties will be eligible.

These are the steps to follow in order to obtain the modifications:

• The modification sequence calls for first reducing the interest rate (subject to a rate floor of 2 percent ) and, if necessary, expanding the term or amortization of the loan up to a maximum of 40 years, with forbearance of principal if required;
• Monthly payment must include principal (unless waived), interest, taxes, insurance, flood insurance and homeowner’s association and/or condominium fees;
• Monthly income includes wages, salary, overtime, fees, commissions, tips, social security, pensions and all other income;
• Servicers will have until December 31, 2009 to enter into the program agreements and amendments in question.

To read the Treasury press release on this subject, please click here.