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The Emergency Economic Stabilization Act of 2008 and Related Initiatives

The Emergency Economic Stabilization Act of 2008 (the “Act”), authorizing a $700 billion U.S. economic rescue plan, was passed by Congress on October 3, 2008, and President Bush has signed the Act into law. Since that date, financial industry regulators have announced a number of significant initiatives designed to foster liquidity and confidence in the U.S. financial system. Key provisions of this historic legislation and related developments are outlined below.


Troubled Asset Relief Program (TARP)


The Act authorizes a troubled asset relief program (“TARP”). TARP will be administered by the Secretary of Treasury (“Treasury”) through a new Office of Financial Security (“OFS”). The OFS is to exercise its authority in consultation with the FRB, OCC, OTS and HUD. TARP expires on December 31, 2009, but is subject to extension to not later than two years from enactment.


  • Purchase Authority. Treasury has authority to purchase directly or through auction up to $700 billion in troubled assets of financial institutions, of which $250 billion will be immediately available, $100 billion will be available with Presidential certification, and $350 billion will be available for purchases only following a Presidential request and a 15-day waiting period during which Congress may object by joint resolution. Treasury is currently moving to choose advisers, issue regulations and hire asset managers for TARP.

    On October 14, President Bush announced that $250 billion of the $700 billion authorized under TARP will be used to buy shares of U.S. financial institutions. Initially, the government will purchase $125 billion in senior preferred shares of nine major financial institutions with the remaining $125 billion to be spread potentially among thousands of other financial institutions. The senior preferred shares will pay a cumulative dividend rate of 5% per annum for the first five years and will reset to a rate of 9% per annum after year five. In conjunction with the purchase of senior preferred shares, Treasury will receive warrants to purchase common stock with an aggregate market price equal to 15% of the senior preferred investment. The exercise price on the warrants will be the market price of the participating institution's common stock at the time of issuance, calculated on a 20-trading day trailing average.

  • Financial Institutions Eligible to Participate. Eligible financial institutions include banks, broker-dealers and insurance companies established and regulated under U.S. law (or state, territory or possession law) and having significant operations in the U.S. The Act includes licensed U.S. branches of foreign banks. In addition, troubled assets held by foreign banks as a result of extending financing to U.S. financial institutions that have failed or defaulted on such financing may be purchased under TARP.

  • Troubled Assets. Troubled assets eligible for purchase are residential or commercial mortgages and any securities, obligations or other instruments that are based on or related to such mortgages. However, the assets must have been originated before March 14, 2008. Other financial instruments may be classified as eligible troubled assets by Treasury following consultation with the FRB Chairman.

  • Program Implementation. Treasury has broad authority under the program. The Act references program “considerations” that include goals to minimize negative impact to the taxpayer, encourage private participation, stabilize financial markets, keep families in their homes, consider the long-term viability of sellers, and make TARP available to a wide range of financial institutions.

  • Pricing of Assets. Troubled assets are to be priced at the “lowest price … consistent with the purposes” of the Act. Treasury may use auctions or direct purchases. Treasury is to take steps to ensure that direct purchases are at reasonable prices and reflect the underlying value of the asset. However, Treasury may not purchase assets at a price higher than the seller’s purchase price, with the exception of troubled assets acquired in a merger or acquisition or from a financial institution in conservatorship, receivership or Chapter 11 Bankruptcy. Treasury has indicated that its management and operations team is working around the clock to complete the institutional and logistical framework for TARP.

  • Oversight of TARP. The program is subject to review and recommendations by a Financial Stability Board, consisting of the FRB Chairman, Treasury Secretary, Director of the Federal Housing Finance Agency, SEC Chairman and HUD Secretary. GAO will also have oversight and audit authority. An independent Office of Inspector General was established for TARP and a Congressional Oversight Panel was created.

  • Reporting. Treasury must report to Congress within 60 days of its exercise of authority under TARP and every 30 days thereafter. Treasury is required to disclose publicly all asset purchases, trades and other dispositions, including a description of the assets, amounts and pricing. In addition, Treasury is required to provide a detailed report within a week after each $50 billion is utilized that includes all transactions, terms, the pricing method and the impact of transactions on the financial system.

  • Government to Receive Warrants or Debt Instruments – Subject to $100 Million “De Minimis” Exception. A government stake in a participating financial institution may be required. Treasury may not purchase any troubled assets without receiving non-voting common or preferred stock warrants from public institutions or senior debt instruments from other institutions. Warrants are to provide reasonable participation by Treasury for the benefit of taxpayers in equity appreciation and debt instruments are to provide a reasonable interest rate premium. However, a “de minimis” exception may be applied to all transactions relating to troubled assets purchased from any one financial institution for the duration of the program not exceeding $100 million. In addition, if there is a shortfall in TARP after five years, “recoupment” from the financial industry may be required.

  • Executive Compensation and Golden Parachutes. If Treasury purchases assets directly from a financial institution, the institution must observe executive compensation and corporate governance standards to be established by Treasury so long as Treasury holds a debt or equity position in the financial institution. These standards include limits on incentives to take unnecessary and excessive risks, prohibitions on golden parachutes and claw-back provisions to recover bonuses or other incentives based on earnings or other criteria that are later found to be materially inaccurate. When assets are purchased at auction, an institution that has sold more than $300 million of assets may not enter into any new contract with a senior executive officer that provides golden parachute payments in the event of an involuntary termination, bankruptcy, insolvency or receivership. This prohibition applies while the Act is in effect. The Act also amends section 162(m) of the Internal Revenue Code to limit annual deductible compensation to $500,000 in any year that the Act continues in effect for a covered executive (CEO, CFO, or one of the three most highly compensated officers) of a financial institution that has sold more than $300 million of assets. The Act imposes the 20% golden parachute tax, as well as the loss of a corporate tax deduction, on certain severance payments received by covered executives of institutions participating in TARP.


Mark to Market Accounting Subject to Suspension


The SEC may suspend the application of mark to market accounting as provided in Statement No. 157 of the Financial Accounting Standards Board (“FASB”). The SEC, FRB and Treasury are required to study mark to market accounting and report back to Congress within 90 days.


On September 30, 2008, the SEC and FASB jointly issued guidance on determining the fair value of securities under SFAS No. 157. The guidance acknowledges that determining fair value in the current environment is particularly challenging. Prices for securities resulting from disorderly transactions should not be considered necessarily indicative of fair value. When the market for a security is inactive, the guidance points out that other multiple inputs from various sources may be used to determine fair value. The guidance further cautions that companies should place less reliance on quotes that do not reflect actual transactions.


FDIC Deposit Insurance Temporarily Increased


From the date of enactment of the Act through December 31, 2009, the FDIC will insure deposits up to $250,000 per account ($100,000 per account prior to the increase).


In addition, the FDIC announced on October 14 that under its new Temporary Liquidity Guarantee Program, any participating depository institution will be able to provide full deposit insurance coverage for non-interest bearing deposit transaction accounts, regardless of dollar amount. The FDIC stated that this coverage would mainly pertain to payment-processing accounts, such as payroll accounts used by businesses which frequently exceed the current maximum limit of $250,000. However, this new coverage is temporary and will expire at the end of 2009.


The FDIC announced that all FDIC-insured institutions will be covered under the Temporary Liquidity Guarantee Program for the first 30 days without incurring any costs. After that initial period, however, institutions no longer wanting to participate must opt out or they will be assessed the additional fee for future participation. A 10-basis point surcharge will be added to a participating institution's current FDIC insurance assessment in order to fully cover its non-interest bearing deposit transaction accounts.


Interest on FRB Reserves


Beginning October 1, 2008, the FRB is authorized to start paying interest on reserves and adjust the size of required reserves. On October 6, 2008, the FRB announced that it will begin paying interest on required and excess reserve balances.


Foreclosure Mitigation and Residential Loan Modifications


Treasury, FRB, FHFA, FDIC and federal property managers must attempt to mitigate residential mortgage foreclosures. Homeowner assistance provisions contemplate residential loan modifications.


Tax Deduction for Fannie Mae or Freddie Mac Preferred Stock


The Act contains a provision allowing banks that experienced losses on their investments in Fannie Mae or Freddie Mac preferred shares to deduct their losses as ordinary losses for tax purposes. Gain or loss from the sale or exchange of such preferred stock will be treated as ordinary income or loss. The provision only applies to preferred stock in Fannie Mae or Freddie Mac that was held by the institution on September 6, 2008, or was sold or exchanged by the institution on or after January 1, 2008, and before September 7, 2008.


Federal Reserve Emergency Lending


The FRB must report any use of its emergency lending authority under Section 13(3) of the Federal Reserve Act to Congress within seven days. Congress is permitted to keep this information confidential.


Regulatory Modernization and Study of Leverage and Margin


Treasury must deliver a regulatory modernization report and recommendations to Congress by April 30, 2009. The report must include the results of Treasury’s review of the financial markets and existing regulatory system, including regulations governing the over-the-counter swaps market and whether there should be regulatory enhancements. The Act also calls for a GAO study of the role of leverage in the financial crisis.


Tax Provisions


Tax provisions include extensions of renewable energy tax incentives and exemptions related to college tuition and disaster victims, a renewal of the research and development tax credit and a measure to prevent alternative minimum tax expansion until 2009.


FDIC Temporary Liquidity Program


On October 14, the FDIC announced a new program, the Temporary Liquidity Guarantee Program (“TLGP”). The purpose of TLGP is to strengthen confidence and encourage liquidity in the banking system. The FDIC will guarantee specified newly issued senior unsecured debt of banks, thrifts and certain holding companies.


Under TLGP, certain newly issued senior unsecured debt issued on or before June 30, 2009, would be fully protected in the event the issuing institution subsequently fails, or its holding company files for bankruptcy. The FDIC noted that covered debt could include promissory notes, commercial paper, inter-bank funding and any unsecured portion of secured debt. Coverage would be limited to June 30, 2012, even if the maturity exceeds that date. Participants will be charged a 75-basis point fee to protect their new debt issues.


Federal Reserve Board To Purchase Commercial Paper


The FRB announced additional information on October 14 about its Commercial Paper Funding Facility (CPFF). The FRB noted that it would begin funding purchases of commercial paper under CPFF on October 27, 2008. CPFF is intended to “improve liquidity in short-term funding markets and thereby increase the availability of credit for businesses and households.”


Under CPFF, the Federal Reserve Bank of New York will finance the purchase of unsecured and asset-backed commercial paper from eligible issuers. However, CPFF will finance only highly rated, U.S. dollar-denominated, three-month commercial paper. The maximum amount of a single issuer’s commercial paper that CPFF may own at any time will be limited to the greatest amount of U.S. dollar-denominated commercial paper the issuer had outstanding on any day between January 1 and August 31, 2008.


CPFF will cease commercial paper purchases on April 30, 2009, unless the FRB extends the program. However, the Federal Reserve Bank of New York will continue to fund CPFF after April 30, 2009, until CPFF’s underlying assets mature.


Internal Revenue Service Eases Limitations Related to Unrecognized Losses of Acquired Banks


The IRS recently issued Notice 2008-83, which should provide significant relief from rules that limit the ability of an acquiring bank to use certain losses of an acquired bank to offset income. For example, if a profitable bank acquires a bank with significant bad loans and shortly thereafter disposes of those loans at a price less than the tax basis of the loans, some or all of that loss would have been limited under section 382 of the Internal Revenue Code. Under Notice 2008-83, the IRS will not apply the typical section 382 limitation with respect to losses of acquired banks which were unrecognized by them prior to a change in ownership. Rather, the IRS will treat a loss from the disposition of the bad loans as a post-acquisition loss that is not subject to the section 382 limitation, thereby allowing the acquiring bank to offset income against the loss.


It is important to note that section 382 limitations will still apply to tax losses already recognized by acquired banks before the ownership change. Therefore, banks desiring to make an acquisition should continue to carefully consider the impact of section 382 and consult with their accountants and tax attorneys before negotiating the terms of the acquisition.


Questions about TARP, other features of the Act and related regulatory measures may be directed to our Banking and Financial Companies Team.

October 15, 2008

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