October 10, 2008
Author: , III

"To provide authority for the Federal Government to purchase and insure certain types of troubled assets for the purposes of providing stability to and preventing disruption in the economy and financial system and protecting taxpayers, and for other purposes."

So begins the Emergency Economic Stabilization Act of 2008 passed by Congress and signed into law by the President on October 3, 2008. Over the past two weeks, Blank Rome has been preparing alerts for its colleagues, clients, and contacts on the development of this legislation. This report is intended to provide a more detailed discussion of the provisions of the legislation and a look ahead to some of the issues involved in the implementation of this ground-breaking program. EESA’s purpose is "to immediately provide authority and facilities that the Secretary of the Treasury can use to restore liquidity and stability to the financial system of the United States."  Specifically, the act authorizes the Secretary of the Treasury, through a newly created Office of Financial Stability, to purchase commercial and residential mortgages and any securities related to such mortgages.

In addition, the act permits the Secretary to buy, subject to certain notice provisions, any other financial instrument the Secretary determines is necessary to promote financial market stability. Importantly, this authority extends beyond mortgages and will include some level of credit card and student loan related assets.

In the immediate aftermath of the enactment of the legislation, Secretary of the Treasury Hank Paulson announced that he will move "rapidly" and "methodically" to implement key provisions of the bill and begin the purchase of assets.  The use of those two seemingly opposing words to describe the process speaks to both the urgency and the complexity of the task at hand. Treasury officials do not anticipate any asset purchases before the November 4 election, but it is anticipated the first purchases will occur in the month of November.

Asset Purchase and Management

Under the act, the Treasury Department can use a combination of tactics to buy toxic loans, focusing on mortgages and mortgage-backed securities but also including other types of loans under certain conditions. The Treasury could purchase the bad debt through an auction process as well as by buying loans directly. The most likely approach is a reverse auction where firms would offer to sell securities at given prices, and the Treasury could buy the least expensive offer.  Institutions would presumably offer to sell at prices high enough to alleviate their woes, but not so high they would be passed over in favor of lower-priced offers.

The Office of Financial Stability is expected to have a small staff — possibly about two dozen people. This staff will assist the Department’s leadership in establishing the criteria and the process for purchasing assets, and establish the protocols for working with asset managers. Outside asset management firms will be used to manage portfolios of assets.  It is unclear how large the portfolios would be, but it appears they will be large enough so that the largest asset management firms will likely be the leading contenders to perform this function. Given that these are real estate portfolios and that asset managers will be involved in administering some of the homeowner protection provisions of this legislation, there is a potential that firms will create partnerships to ensure adequate real estate expertise and servicing capabilities are included in the asset management services. These partnerships may be facilitated by provisions in the bill that require the Secretary to develop a process for bringing minority-owned firms into the process.

We expect swift action from Treasury to begin the process of hiring asset managers. Some form of a public process is likely so that a level of transparency exists.  However, reports in the media indicate that initial discussions with major players in the asset management sector have been underway during the development of the legislation. Those firms will almost certainly have a "leg up" in the initial round of manager selections.

Many of our colleagues and clients have inquired as to the possible role of hedge funds, private equity firms, and others in this process. Our view is that Treasury, Congress and the other overseers of this program may take a dim view of these firms playing intermediary roles in this process. However, there are some ways in which such players may be able to participate. For example, after reverse auctions occur, hedge funds could purchase asset pools passed over by the federal government to the extent they believe them to be reasonable investments. Overseers will be watching carefully though to ensure the presence of hedge funds at the edge of the auction floor does not increase the cost of assets to the federal government.

In addition to the asset purchase program, the act also allows companies to participate in an insurance program, whereby Treasury may guarantee troubled assets, charging companies a premium "sufficient to cover anticipated claims." This program was inserted in the bill at the request of House Republican members who viewed it as a less intrusive alternative to the government purchase of assets. During negotiations over the legislation, Secretary Paulson made it clear he did not believe an insurance program would be an effective way to address the problems confronted by financial institutions holding toxic assets. It is unclear to what degree this program might be utilized and how energetically Treasury will promote it.

Account Insurance

Another important aspect of the bill, which the Senate added, is the temporary increase in federal insurance on bank and credit union deposits from $100,000 to $250,000 through December 31, 2009. While this provision does not directly address the core issues in this crisis, it goes to the heart of the market psychology that has been at work over the past several weeks. It is largely believed that the failure of Washington Mutual was due in large part to a run on the bank in the last two weeks of September, during which depositors withdrew more than $16 billion. Also, regional bankers from various parts of the country are reporting that customers are withdrawing funds from their accounts in excess of $100,000 and that many of them are demanding cash — i.e., not checks — when they depart. This image of people leaving banks with large satchels of cash is not one the financial sector wants to see. Raising deposit insurance is thought to be a substantial part of quelling the fears that are driving this behavior.

Homeowner Assistance

In addition to these core aspects of the Act, the EESA contains other significant provisions designed to assist American homeowners. Section 110 provides for certain modifications to some residential mortgages, including lowering interest rates and reduction of loan principal. The bill requires the Secretary of the Treasury to take steps to maximize assistance for homeowners, including encouraging servicers of the underlying mortgages to take advantage of the Hope for Homeowners Program under section 257 of the National Housing Act.

In addition to steps taken by Treasury and its asset managers pursuant to the asset purchase program, the Act directs the Federal Housing Finance Agency, the Federal Deposit Insurance Corporation, and the Federal Reserve Board to implement various measures with regard to residential loans and securities under their control in order to reduce the number of foreclosures, which could include modifying the terms of such loans.

Oversight and Accountability

The act establishes the Financial Stability Oversight Board. The board is charged with reviewing the exercise of authority under the act and keeping an eye on how the Secretary of the Treasury spends the taxpayers’ money. The FSOB will be comprised of the chairman of the Federal Reserve, the Secretary of the Treasury, the director of the Federal Home Finance Agency, the chairman of the Securities and Exchange Commission, and the Secretary of Housing and Urban Development.

No announcements have been made about how the oversight board will function. If history is a guide, the board will have a staff comprised of people "detailed" from the agencies involved. Given the magnitude of the program, there is a good chance the board would hire outside help to review the performance of Treasury and the asset managers.

The Government Accountability Office, an arm of Congress, will also be beefing up its capability in order to oversee this program. The comptroller general, who leads the GAO, is directed to report to Congress every 60 days on the activities and performance of the Troubled Asset Relief Program. In addition, he or she is required to conduct an annual audit of the TARP. The act also gives the GAO a forensics project — to report to Congress on the role leveraging and sudden deleveraging of financial institutions played in the financial crisis.

Additional oversight will be provided by a Congressional Oversight Panel. This panel will be comprised of five outside experts appointed by the House and Senate majority and minority leadership.  It is required to report to Congress every 30 days on the performance of the TARP and other compliance issues raised by the act. As with the oversight board established in the executive branch, there is a good chance this panel will need to hire a small staff and engage outside assistance to help it perform its functions.

The fourth oversight body mentioned in the act is a new Office of the Special Inspector General for the TARP. This office will conduct, supervise, and coordinate audits and investigations of the Treasury and submit quarterly reports to Congress.

With regard to accountability, the act imposed some curbs on executive compensation at firms that sell assets to the government. These include a ban on making "golden parachute" payments to departing top executives "during the period that the Secretary holds an equity or debt position in the financial institution." Companies also would be required to "claw back" past bonuses found to have been based on misleading financial statements.

The bill also allows the federal government to benefit from the improved health of institutions assisted through the TARP through the purchase of warrants for the right to acquire nonvoting common stock or preferred stock in firms benefiting from the bailout.

Additional Steps Required

On the day the EESA was enacted, the Dow Jones Industrial Average dropped by more than 150 points. Of course, a part of this drop may have been due to the old adage, "buy on the rumor, sell on the news." But analysts also believed the sell-off was indicative of a recognition that the legislation addressed only a part of the problems in the financial sector and that the deeper problems affecting the "real economy" must still be addressed.

Throughout the current credit crisis, the Federal Reserve and the Treasury Department have followed a blueprint that draws from many lessons learned during previous crises, including Japan's banking crisis in the 1990s and the Great Depression. Those lessons teach us that after allowing some institutions to fail and stopping the bleeding, attention must be paid to recapitalizing the financial sector and addressing other major economic issues that contributed to the problems in that sector.

The government response to the current credit crisis has focused heavily on emergency measures to avert a systemic meltdown, as well as actions to prop up demand in the housing and consumer markets. The Fed, Treasury, and FDIC have exercised discretion in deciding to intervene to save Fannie Mae, Freddie Mac, and AIG and to facilitate the takeovers of Bear Stearns by JP Morgan Chase, Merrill Lynch by Bank of America, and Wachovia by Citibank (although this last deal is now in abeyance due to Wells Fargo’s offer for Wachovia). They also decided to let Lehman Brothers and Washington Mutual fail, indicating that they are indeed focused on rescuing only the most essential institutions.

In the macro sense, institutions nationwide have written down massive amounts of assets involving mortgages and other securities. The result is capital has shrunk considerably for many U.S. financial firms making recent headlines. The Federal Reserve has taken many steps in an effort to inject liquidity into struggling financial institutions, including the emergency expansion of lending facilities on September 14, 2008. However, neither the Fed's nor the Treasury Department's actions, in and of themselves, directly recapitalize the financial system.

It remains to be seen what actions may be considered to provide additional capital to financial institutions, stimulate the housing market, and address other key issues affecting the economy. Congress balked at enacting a stimulus package in the final weeks of this most recent session. That package would have included traditional stimulus measures such as the extension of unemployment benefits, grants to states for Medicaid, and infrastructure grants. Congress may return to this issue after the election in a lame-duck session or early in the new year.