The US Senate is expected to confirm Tim Geithner as the Secretary of the Treasury later today. The clear anticipation is that the new team at Treasury will move quickly with appointments and programmatic decisions on the future of the TARP program. Mr. Geithner fielded many questions both at his confirmation hearing and in written questions posed afterward and while he certainly laid out many of the options that Treasury and the Obama Administration are considering, he did not confirm a specific course of action. While there have been numerous press reports about the likely next steps for TARP, no formal decisions have been made yet by the Obama Administration regarding exercising its authority under the Emergency Economic Stabilization Act of 2008 (EESA). Nonetheless, we thought it would be helpful to provide our clients a review of the various options apparently being considered.
As soon as specific decisions are confirmed, we will update you accordingly.
I. TARP Policy Options for Troubled Illiquid Assets
It is quite clear that the Obama Administration is concerned about the fact that troubled assets continue to poison the balance sheets of financial institutions. Although institutions that have participated in the Capital Purchase Program (CPP) would not have had their financial conditions improved were it not for those investments, the degradation of value of the assets remaining on those institutions' balance sheets have resulted in further write-downs and further pressure on the institutions affecting their ability to expand the offering of credit to their customers and the economic system. Below are three policy options that are reportedly being considered by the Obama Administration:
1) Return to the original TARP program - When the Congress passed the EESA, the original game plan was to have the Treasury buy hundreds of billions of dollars of “troubled assets” ( basically, either whole loans or MBS/ABS securities) from a broad range of financial institutions. The original design was to have Treasury obtain those assets either by auction or some other valuation mechanism and then hold and manage them until the assets could be sold into the market at what was hoped to be a profit. This original plan, as well as a House Republican plan to guarantee assets against certain losses, were quickly side-tracked due to difficultly in valuing the troubled to be purchased or guaranteed. Not only did it prove difficult to determine an accurate market/economic value, but it was also clear that there was a conflict between the interests of the taxpayers to get the best lowest price and the needs of the financial institution to get the best highest price. Within weeks, European governments began making equity investments in their financial institutions. It was after such moves that the Treasury developed the CPP program and turned its attention away from purchasing troubled assets. Returning to this original concept will prove to be difficult because the same valuation issues remain. However, part of the infrastructure necessary to acquiring and managing these asset purchases had begun in October 2008 with the awarding of some contracts for custodial, accounting and legal services. A problem with going back to the original plan is that half of the original $700 billion of TARP money has already been spent on the CPP and other purposes and $40-100 billion is expected to go to home foreclosure avoidance. That leaves slightly more than $200 billion for such asset purchases and absent a mechanism to leverage these funds, this amount seems insufficient to make a real dent in the problem.
2) Creation of an aggregator bank (“bad bank”) - This proposal is getting the most attention. Rumored for weeks to be the subject of serious consideration by the Obama Administration, it began to get much more attention recently when FDIC Chair Sheila Bair began talking publicly about this idea. The idea of a “bad bank” or “aggregator bank” (Aggregator Bank) is not a new one. A similar approach was used during the S & L crisis in the early 90s, where the Resolution Trust Corporation was created to buy troubled real estate assets. In today's version, an aggregator bank would be created, capitalized using TARP funds, and quickly begin purchasing the bad assets of financial institutions. Since a leveraged usage of the remaining TARP funds is clearly needed, the idea is that this institution would have the authority to issue its own special form of debt, likely with some sort of full or quasi U.S. government guarantee. There are reports that the Obama Administration is considering, as part of its policy options, allowing the aggregator bank to thus have a fairly leveraged balance sheet so that it might purchase up to $1 trillion of troubled assets. An aggregator bank would be faced with the same challenge as the original TARP program as it relates to valuing the troubled assets to be purchased from financial institutions. Whether such assets are subject to an auction or not, there is the conflict of whether to provide the maximum capital to the financial institutions or getting the very best deal for the taxpayer. It is not clear whether the priority is to “beef up” financial institutions capital levels or to clear the slate of troubled assets from their balance sheets even if it forces them to sell quality assets. Given the current condition of some of the major financial institutions in the US, this sudden de-leveraging could cause many institutions to further reduce their lending activities. Lastly, it would have to be determined how the assets in the bad bank would be managed and ultimately sold. For example, they could be bought and held to maturity. Alternatively, the assets could be securitized (or resecuritized as CDOs) and then resold into the marketplace as asset backed securities issued by the aggregator bank. Such a security could carry with it an implied or even explicit Federal guaranty. While there are many issues to address in the potential creation of an aggregator bank, this idea is reportedly being seriously considered.
3) Providing financial institutions a “second loss” position on mortgage related assets - This lesser discussed approach, which is based on the authority added to EESA by House Republicans, was utilized by the Paulson team at the end of 2008 as a way to provide additional support and stability to so-called systemically significant financial institutions (SSFIs). Citigroup, AIG and more recently Bank of America have all been beneficiaries of this program which is formally called the “asset guarantee program” (AGP). This program was actually announced in early December and was discussed at length in a Report delivered to Congress on December 31, 2008. In that filing, the Treasury indicates that the program “provides guarantees for assets held by systemically significant financial institutions that face high risk of losing market confidence due in large part to a portfolio of distressed or illiquid assets.” This program first came to light in November 2008 when the Treasury and the FDIC announced that they would provide Citigroup protection against the possibility of unusually large losses on their asset pool of over $300 billion of loans and securities backed by residential and commercial real estate and other assets. Those assets, under this program, remain on Citigroup's balance sheet. A Treasury/Fed/FDIC joint press release issued at that time explained that “as a fee for this arrangement, Citigroup will issue preferred shares to the Treasury and FDIC. In addition and if necessary, the Federal Reserve stands ready to backstop residual risk in the asset pool through a non-recourse loan.”
In connection with the action to support Citigroup in November 2008, Treasury committed $5 billion of TARP money, the FDIC $10 billion and the Federal Reserve providing the backstop credit through the issuance of a non-recourse loan. While the AGP is expressly limited to SSFIs, such coordinated actions by the Treasury, the Federal Reserve and the FDIC are reportedly being closely looked at as a possibly way to leverage both the TARP funds and the Fed's balance sheet to guarantee assets that could remain on the balance sheets of financial institutions. Again, there remain valuation issues because in determining the amount of any guarantee, a valuation would have to be agreed upon between the financial institution and the U.S. government. Once again, there exists a conflict, potentially to a lesser degree than actual asset purchases, between the interests of the institution and those of the taxpayer.
II. Next Steps for Capital Purchase Program and Status of Nationalization
The Paulson Treasury Department allocated $250 billion to fund the Capital Purchase Program (“CPP”). To date, over $190 billion of investments have been awarded and there are still hundreds of applications pending before Treasury and the various other financial regulators. Although it is surely anticipated that the pending applications will continue to work through the system, it should be pointed out that the Treasury Department certainly has the authority to change this program. Given all of the criticism of the CPP program from the Congress, the Geithner Treasury Department will at the very least ensure that future awards are based on sound and conservative judgments and analysis and that all of the restrictions and oversight in the TARP program, particularly the executive compensation limitations, are adhered to strictly.
There may be consideration of proposals to expand the CPP program to include a broader array of financial institutions. While there are no firm plans that have been officially surfaced, it is clear that the Bush/Paulson Treasury had been looking at TARP/CPP expansions to include assistance to mortgage insurers and monoline bond insurers. It is uncertain how the Obama Administration will view such proposals. There has also been talk, but no hard evidence, that the Paulson Treasury Department had considered expanding the TARP/CPP program to the insurance sector and possibly to US subsidiaries of non-US based financial institutions.
While government nationalization of the most deeply wounded financial institutions remains a last resort option, such a heavy government intervention is appearing increasingly unpopular on the Hill and with the new Administration. Recent momentum towards the aggregator bank seems to have shifted analysts focus and fears away from nationalization. Nevertheless, under the CPP program, the new Treasury Department could continue to take greater equity stakes in the weakest financial institutions, and while avoiding the specter of nationalization, achieve a result that is still tantamount to nationalization. While such an option does not appear to be on the table early this week, our team continues to gather and assess relevant intelligence on point in order to keep you apprised.
III. Potential Expansion of Federal Reserve Liquidity Facilities
As provided in Chairman Frank's TARP reform bill, there is increasing talk about expanding the Federal Reserve's liquidity facilities to inject funds into a wider array of markets. This would supplement the extensive lists of facilities the Fed/Treasury created to benefit the market for corporate commercial paper, asset backed securities (TALF), Fannie/Freddie residential mortgage backed securities, money market mutual funds and other securities. The specific markets being talked about most frequently and intensely include the municipal securities market and the market for commercial mortgage backed securities, which is suffering from investor concerns over large debt roll overs in the next few months and about current market difficulties facing the commercial real estate market as a result of the recession. We anticipate that the Treasury and the Federal Reserve will move quickly on decisions to expand these liquidity programs.
We hope this review and analysis is useful.
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