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10.06.2008 | Legal Update

The Emergency Economic Stabilization Act of 2008 was signed into law by the President on October 3.

Among other things, the law provides funding to the administration to purchase troubled loans and other financial assets, temporarily increases the deposit insurance limit to $250,000 per account, requires the federal agencies to avoid residential mortgage foreclosures, authorizes the SEC to suspend mark-to-market accounting, authorizes the Federal Reserve to immediately begin paying interest on reserves, and provides tax relief to banks that suffered losses on FNMA and FHLMC preferred stock.

1.  General Purposes

The law’s general purposes are to provide authority and specific facilities to the Secretary of the Treasury (Secretary) to “restore liquidity and stability to the financial system” and to ensure that the authority and facilities are used in a manner that “protects home values, college funds, retirement accounts, and life savings; preserves home ownership and promotes jobs and economic growth; maximizes overall returns to the taxpayers of the United States; and provides public accountability for the exercise of such authority.”

2.  Treasury Authorized to Buy or Guarantee Troubled Assets

The law authorizes the Secretary to establish the Troubled Asset Relief Program (TARP) to purchase “troubled assets” from “financial institutions” and, if the TARP is established, to establish a Troubled Assets Insurance Financing Fund to guarantee the payment of principal and interest on troubled assets on the books of participating financial institutions.  The authority will terminate on December 31, 2009 unless the Secretary extends the program until October 3, 2010.

• “Troubled Assets”

The term “troubled assets” is defined to include residential and commercial mortgage loans originated on or before March 14, 2008, as well as securities or other instruments based on or related to those types of loans (such as mortgage backed securities) issued on or before that date, the purchase of which the Secretary determines “promotes financial market stability.”  The Secretary may include any and all other “financial instruments” after consulting with the Federal Reserve and reporting to Congress.

Nutter Notes:  The law does not require that the asset being purchased be non-performing, impaired, past due or “troubled” by any customary measure.  There is no objective standard included in the law as to when an asset becomes “troubled.”  An asset is a “troubled asset” only if the Secretary determines that it would have an adverse effect on financial market stability.  Treasury Department rules implementing the program may more precisely define the term.

• “Financial Institutions”

The term “financial institution” means “any institution” including but not limited to any bank, savings association, credit union, securities broker or dealer, or insurance company, whether organized under state or federal law, “having significant operations in the United States” but not including any central bank of, or institution owned by, a foreign government.

Nutter Notes:  Commercial companies as well as non-profit entities could be included.  Treasury Department rules implementing the program may more precisely define the term.

• $700 Billion Authorized in Increments

The authority of the Secretary to purchase troubled assets is limited initially to $250 billion.  If the President certifies to Congress at any time that the Secretary needs additional funding, the overall limit automatically increases to $350 billion.  An additional $350 billion would be available following a written report by the President to Congress detailing the need unless Congress within 15 days by a joint resolution denies the request.

• Troubled Assets Insurance Financing Fund

If the Secretary establishes the TARP, the law requires the Treasury Department to establish a Troubled Assets Insurance Financing Fund (Fund) to guarantee up to 100% of the payment of principal and interest on troubled assets on the books of participating financial institutions.  Financial institutions that opt to participate in the Fund would pay premiums established by the Secretary sufficient to create a reserve to meet anticipated claims.  Premiums would vary according to the credit risk associated with the troubled assets that would be guaranteed.

• Program Guidelines

The Secretary must publish program guidelines by November 16 unless purchases of troubled assets are made before that date in which case program guidelines must be issued within two business days after the first purchase.  The guidelines must include mechanisms for purchasing troubled assets, criteria for identifying troubled assets for purchase, methods for pricing and valuing troubled assets, and procedures for selecting asset managers.

• Factors Required to Be Considered in Exercising Authority

The Secretary must consider eight factors in exercising authority to purchase or guarantee troubled assets including, among others, providing financial assistance to institutions with under $1 billion in assets that were well capitalized or adequately capitalized as of June 30 but that suffered capital declines as a result of losses on FNMA or FHLMC preferred stock, and ensuring that all financial institutions regardless of charter type, size, location, or amount of troubled assets are eligible to participate in the program.

Nutter Notes:  The requirement that the Secretary ensure that all financial institutions regardless of size or the amount of troubled assets on their books be eligible to participate appears inconsistent with the definition of “troubled asset” which is premised on risk to the financial system as a whole.

• Minimizing Long-Term Costs

The Secretary must minimize long-term costs to taxpayers by, among other means, holding assets to maturity or for re-sale until such time as the Secretary determines that “the market is optimal for selling such assets,” and by selling assets at prices that will maximize the return on investment.  The Secretary must “encourage the private sector to participate in purchases of troubled assets, and to invest in financial institutions.”  The Secretary is required to make use of “market mechanisms” including auctions and reverse auctions where appropriate, but may also make direct purchases of troubled assets from financial institutions.

• Maximizing Investment Return

The Secretary is prohibited from purchasing any troubled asset unless the selling institution – if its securities are traded on a national exchange – provides a warrant giving the Secretary the right to receive non-voting common stock or preferred stock, or voting stock with respect to which the Secretary determines not to exercise voting power, as appropriate.  The Secretary is prohibited from purchasing any troubled asset from any other institution unless it provides a warrant for common or preferred stock, or a senior debt instrument.  The Secretary may establish an exception for relatively small purchases provided that the rules above must apply to any selling institution that engages in aggregate sales in excess of $100 million.

• Conflicts of Interest

The Secretary must issue rules or guidelines to address conflicts of interest that arise in connection with the administration of the program including those arising in the hiring of contractors or advisers including asset managers.

• Executive Compensation Limits

If the Secretary purchases troubled assets from an institution, the institution automatically becomes subject to limits on executive compensation.  In the case of direct purchases of troubled assets (as opposed to purchases at auction), the Secretary must require that the selling institution meet “appropriate standards” for executive compensation and corporate governance.  Those standards must include provisions for recovering bonus or incentive compensation paid to any senior executive officer of the selling institution based on statements of earnings, gains or other criteria that are later proven to be materially false, as well as a prohibition against making any golden parachute payments to any senior executive officer during the period that the Secretary holds an equity or debt position in the institution.  Golden parachutes triggered by involuntary termination, bankruptcy and insolvency are also limited for institutions that sell over $300 million in troubled assets to the TARP through a combination of sales at auction and direct sales.  The tax laws are amended to limit annual deductible compensation to $500,000 in any year the law is in effect for the chief executive officer, chief financial officer, and the next three most highly compensated senior officers of an institution that has sold more than $300 million of troubled assets.  Section 280G of the Internal Revenue Code is also amended to add adverse tax consequences for certain severance payments.

• Recovering Losses from the “Financial Industry”

If there is a shortfall in the TARP on October 3, 2013, the President is required to submit to Congress a legislative proposal that recovers from the “financial industry” an amount “equal to the shortfall” in order to ensure that the TARP “does not add to the deficit or the national debt.”  The term “financial industry” is not defined in the law.

3.  Temporary Increase in Deposit Insurance Coverage

The law temporarily increases FDIC insurance coverage to $250,000 per account.  The increase in coverage is effective through December 31, 2009.  The temporary increase may not be taken into account by the FDIC in setting assessments.  To support this additional coverage, the law temporarily eliminates limits on the FDIC’s borrowings from the Treasury.  Any borrowings by the FDIC from Treasury to support the additional coverage would need to be paid back through industry assessments.

Nutter Notes:  In Financial Institution Letter 102-2008 (October 3, 2008), the FDIC advised FDIC-insured financial institutions that, effective October 3, 2008, FDIC deposit insurance temporarily increased from $100,000 to $250,000 per depositor through December 31, 2009.  The letter states that insured institutions “may post the above statement, or affix a sticker with the above statement, next to the official FDIC sign (teller station sign).  Banks may use their own materials in any format for this purpose, or order stickers with this language using the procedures on the FDIC’s web site.”

4.  Losses on FNMA and FHLMC Stock

The law allows “applicable financial institutions” to deduct losses on FNMA and FHLMC preferred stock owned on September 6, 2008 or sold between January 1, 2008 and September 7, 2008 as ordinary income losses for tax purposes.  The term “applicable financial institution” is defined to include any bank, savings association, cooperative bank, bank holding company, savings and loan holding company, any small business investment company, and any business development corporation, but does not expressly include subsidiaries of such entities.  The Secretary may write such guidance, rules or regulations as are necessary to carry out the purposes of the law.

5.  SEC Authorized to Suspend Mark-to-Market Accounting

The law allows the Securities and Exchange Commission to temporarily suspend mark-to-market accounting rules for any public company.  The SEC must study mark-to-market accounting in consultation with the Federal Reserve and Treasury Department and report to Congress within 90 days.

6.  Money Market Mutual Fund Guarantees

The law requires the Secretary of the Treasury to reimburse the Exchange Stabilization Fund for any funds that are used to guarantee investments in money market mutual funds, and prohibits the Secretary from using the Exchange Stabilization Fund again for the establishment of any future guarantee program for money market mutual funds.

Nutter Notes:  The Secretary has established a program to insure the holdings of eligible money market mutual funds that participate in the program.  Under the Temporary Guarantee Program for Money Market Funds, which began on September 29, the Secretary will guarantee the repayment to investors of the full value of their principal investment in participating money market mutual funds as of the close of business on September 19.  The Secretary will make payments required under the program from the Exchange Stabilization Fund, which was established by the Gold Reserve Act of 1934 to deal in gold, foreign exchange, and other instruments of credit and securities to promote international financial stability.

7.  Foreclosure Mitigation

The Secretary must implement a plan that seeks to maximize assistance for homeowners and “use the authority of the Secretary to encourage the servicers of the underlying mortgages . . . to take advantage of . . .” various programs including the HOPE for Homeowners Program to minimize foreclosures.  The Secretary may use loan guarantees and credit enhancements to facilitate loan modifications to “prevent avoidable foreclosures.”  The Secretary must consent, where appropriate, on receiving any request under existing investment contracts, to “reasonable requests for loss mitigation measures,” including term extensions, rate reductions, and principal write downs.

8.  Interest on Reserves

The Federal Reserve is authorized to begin paying interest on reserves on October 1, 2008 instead of on October 1, 2011 as authorized by the Financial Services Regulatory Relief Act of 2006.

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