The recent re-branding of the Troubled Asset Relief Program ("TARP") as the "Financial Stability Plan" ("FSP") by Treasury Secretary Timothy Geithner and subsequent roll-out of the FSP's Capital Assistance Program ("CAP") this week has done little to stem the fallout of the ongoing financial crisis. Rather than having a stabilizing effect, the lack of meaningful detail and transparency has appeared further to roil the markets. The reason, of course, is the bad assets-still there hanging like a weight on the neck of the American economy. While criticism focused on the lack of detail and direction in the FSP and a confusing rationale for the CAP, the main issue remains: there still exists a lack of consensus among industry experts on how to remove toxic assets off banks' existing balance sheets. Private equity funds and investment companies complain that until the U.S. government establishes a plan to valuate and liquidate these bad assets, there will be no purchasers willing to step forward with solutions.
While much has been written about the weaknesses of the FSP, there have been few analyses of the possible ways to address its perceived shortcomings. The most striking absence in the plan is any direction on how to resolve the bad asset problem. Clearly, this has further spooked an economy already writhing in the throes of the worst financial crisis since the Great Depression. Instead of answers to what to do next, the headlines remain fixated on where to place blame.
We all know by now that there are no easy answers and, yes, it will take time for this to be resolved; but we still do not know how it will be resolved. There have been numerous solutions put forth by national and international finance and economic experts for the bad asset problem that will allegedly guide us out of this mess. The following top ten list contains those that stand out for their promise, creativity and/or sheer audacity. While we reserve judgment for the reader on the merits of each, it is likely that one or more of the following, either alone or in tandem, may hold the keys for how to resolve the current economic crisis. In addition to addressing some of the pros/cons for each proposal, we also describe whether the proposal includes elements similar to those described in Treasury Secretary Geithner's outline for dealing with bad assets pursuant to the FSP. First, it is important to understand the "toxic asset" issue and challenges it presents.
Issue: Valuating "Toxic Assets"
Based on long-standing guidance, banks are required to carry assets at "fair value," which is the price received to sell an asset in an orderly transaction between current marketplace participants. Most of the "toxic assets" now on bank's balance sheets are real estate and mortgage-related assets, including derivative or other bundled securities backed by residential mortgages. Falling real estate values coupled with recent and continually increasing homeowner defaults and home foreclosures directly impair these assets. This has created a downward spiral as the value of these assets has plummeted and most markets for real estate-related assets have seized up. The result is that there are no willing buyers, and there is no market. And without a market, there is no "fair value." Arguably, an asset price must be over-valuated if there are no purchasers willing to pay the asking price. The net effect is that the fair value of these assets is diminished.
Under mark-to-market accounting, banks are required to mark down assets to reflect the current market or "fair value." Marking down asset values leads to further loss of investor confidence and may force institutions to sell these assets at fire-sale prices which increases banks' leverage and reduces capital ratios. Effectively this creates a spiral effect of further declining funding liquidity, further write-downs, further distressed asset sales and, potentially, additional bank failures. While the problem is clear, the challenge is how to solve it.
Top Ten Proposed Solutions
1. Seller's Auction
In Fall 2008, Federal Reserve Chairman Ben Bernanke proposed a reverse or seller's auction where financial institutions would place bids with Treasury for the sale of toxic assets at prices they deemed close to held-to-maturity values. Treasury would then purchase the offers most attractively priced to the government. Underlying this approach is the notion that, after these purchases, banks would have a basis for valuing toxic assets. Rather than using fire-sale prices, which would accelerate capital mark downs, the auction prices would provide a better gauge. Also, taxpayers would benefit to the extent that assets are purchased for a price lower than hold-to-maturity value.
Critics of this proposal pointed to the difficulty in evaluating the hold-to-maturity value, as well as allowing banks to set the prices (i.e., colluding banks could signal pricing intentions and keep prices artificially high, thus reducing the loss for such institutions). Of particular concern, if Treasury pays too much for assets, taxpayer losses could quickly mount.
Conversely, if Treasury pays too little for the assets, the auction could accelerate an already difficult pricing situation. If institutions sell securities at fire-sale prices, rather than at or near hold-to-maturity prices, banks holding similar assets would be forced to write down their values to match the auction price. This could speed up bank failures, erode banks' capital base and further restrict the ability of banks to borrow and lend.
This plan was ultimately abandoned for a number of reasons, including (i) that the bundled assets are too diverse with little available comparative information; (ii) determining an optimal price was too difficult; (iii) the government was unwilling to risk inaccurately valuating these assets; and (iv) the reliability of the auction method itself was questioned.
2. Additional Capital Infusions
Infusing capital into troubled financial institutions has the very obvious positive effect of increasing banks' available capital. However, as the public recently discovered, increasing banks' capital does not necessarily increase available credit, nor does it do anything immediately or directly to address how to resolve the toxic assets still sitting on banks' balance sheets. The first round of TARP funds were directly invested in financial institutions with few conditions on the use of such funds. As a result, TARP I has been criticized as failing to encourage banks to use infused capital to extend loans to businesses and consumers.
Advocates of capital infusion for the second round of TARP funds ($350 billion) emphasize attaching strings to the grant of such funds to prevent the same failed result. The House of Representatives passed a bill in January 2008 which implemented accountability and transparency by restricting use, requiring reporting and monitoring by regulators, allocating funds to particular types of businesses and small financial institutions, among others. Although it is unlikely to be considered by the Senate, the bill has had a significant influence on Secretary Geithner's FSP.
The CAP component of Geithner's FSP contains a capital infusion element with the following conditions:
Banks desiring TARP II funds must undergo a "stress test" to determine the extent to which they require additional capital.
Banks receiving TARP II funds must submit initial "intended use" plan and monthly use reports which are available to the public.
Recipients of TARP II funds must participate in mortgage foreclosure mitigation programs, and are restricted from (i) paying excess dividends, (ii) repurchasing privately-held shares until TARP II funds are repaid, (iii) acquiring healthy firms in cash deals, and (iv) various executive compensation arrangements.
At the heart of the new CAP is the notion that banks requiring additional capital will have six months to raise it from private sources. Those unable to do so will receive federal government funding with all the strings attached. The problem, of course, is that banks with capital holes are not particularly attractive investments. It is difficult to understand why private investors would put a dime in an institution that has a big capital hole. More fundamentally, it is questionable that a savvy investor would put any money in an institution that has a capital hole, particularly if the federal government appears ready to fill that hole six months from now. And certainly investors will want to know what the hole is before making any investment - that may be the greatest challenge.
At the same time, Congress has made it clear that it expects taxpayers to receive an upside for their investment of TARP funds in banks via an increase in available credit. It remains to be seen whether these conditional capital infusions will fix the credit crunch. The track record so far is not particularly optimistic.
3. Suspending Mark-to-Market Accounting
Many bank executives and banking groups advocate suspension of mark-to-market accounting temporarily or permanently. On the up-side, this would stop the spiral of marking down assets, reducing investor confidence, and lowering available capital.
On the down-side, this invites speculative valuation by substituting the internal valuation of a subjective management team for an illiquid market price. It also provides less transparency and potentially widely varying valuations by institutions for the same underlying assets. This plan has been rejected by most governmental regulators because the consequences appear too undesirable. More fundamentally, diverging from mark-to-market accounting creates a financial system structure not subject to the same rules as the markets and industries it serves.
4. Write Down and Fire-Sale
Many Wall Street traders and analysts suggest that banks should write assets down and add capital, no matter what the costs. This would require banks to disgorge their toxic assets for whatever price they can get, even if this means selling for pennies on the dollar. Bank analyst Meredith Whitney recommended this approach in mid-2008. Shortly thereafter, Merrill Lynch sold to Loan Star Funds over $30 billion worth of collateralized debt obligations for the bargain price of $6.7 billion, or 22¢ on the dollar, compared with the 36¢ valuation Merrill Lynch had for these assets the preceding quarter.
The benefits of this approach include removing toxic assets as quickly as possible, and providing the opportunity for banks to begin restoring their capital. This is an obvious favorite of private equity investors since they stand to gain the most benefit from implementation of this plan. The difficulties lie in finding buyers with sufficient capital who are sophisticated enough to assess and buy the toxic assets. Credit extensions are increasingly difficult to come by so private funding is necessary.
This plan severely impacts banks and their existing equity holders. Banks would suffer meaningful asset impairments and forego any upside recovery (i.e., lost opportunities of holding to maturity). For many institutions this is not a viable option since doing so would make them instantly insolvent. Losses under this approach are borne by the banks and their equity holders, and would generally avoid taxpayer losses (barring taxpayer assistance).
5. Government Guarantees and Insurance
In the fall of 2008, Britain announced that it would insure its banks against the worst losses on their toxic assets. The U.S. government has also implemented various forms of additional guarantees and insurance. First, the FDIC raised federal deposit insurance levels to $250,000 for individual accounts and, pursuant to its Temporary Liquidity Guarantee Program ("TLGP"), eliminated a maximum coverage cap for corporate accounts. Also as part of the TLGP, the FDIC is providing guarantees of certain senior unsecured debt of depository institutions and their holding companies. In addition, Treasury has back-stopped certain systemically important banks' losses in connection with assets assumed in assisted acquisitions (e.g., Bank of America's purchase of Merrill Lynch).
An interesting variation of this theme is the federal government's use of net worth certificates, similar to those used to infuse capital into sick or failing thrifts during the thrift crisis of the late 1980s. While that program was subject to significant criticism, it did enable many institutions to work through relatively serious difficulties. While it is not a permanent solution for a capital-strapped bank with significant troubled assets, it would permit an institution to issue certificates to the FDIC in exchange for "full faith and credit" notes issued by the FDIC that such banks could count as capital on their balance sheets. In effect, this would enable the bank to restore its capital so that it could resolve the troubled assets that appear on its balance sheet over a longer time horizon.
The benefits of a guarantee-type approach include the immediate impact of a program that can be implemented with virtually one announcement that grabs investor and depositor attention. It also keeps assets at the institutions that originated and have the most familiarity with them.
The drawbacks include the historically weak impact of such announcements on overall public confidence, as well as the unknown liability that the government assumes. Under this approach, it is not possible to quantify the extent of potential loss to the government and taxpayers, thereby creating a significant economic disincentive. In addition, significant concerns have been expressed that retaining bad assets on bank balance sheets, even though guaranteed, will discourage private capital from investing in such institutions.
Secretary Geithner's FSP also includes a Small Business and Community Bank Lending Initiative that seeks to increase the availability of SBA loans by increasing the guarantee of such loans from 75% to as high as 90%. The plan does not preclude further guarantees and insurance implemented at a later date. Again, guarantees and insurance ultimately subject taxpayers, rather than banks and their equity holders, to potential loss, often without any tangible upside since there is generally no compensation for the level of risk assumed by the government.
6. Bad Bank or Fencing Off
A much discussed concept is for the government to create a central "bad bank" (or several bad banks) that purchase the toxic assets from banks. This approach has been utilized in isolated situations in the U.S. and was implemented broadly, with limited success, in Japan to save its troubled banks during the 1990s. For this approach to be effective there must be a clean break between the existing financial institution and the bad assets. The objective is to enable the institution to unburden itself of severely impaired assets so it can resume normal lending activities, as well as capital raising and deposit-taking activities.
A hybrid version of the bad bank and guarantee approaches is the so-called fencing off approach in which toxic assets on a bank's balance sheet are sold and/or guaranteed to neutralize their impact on the institution.
Critics of the bad bank plan point out that such a program would invariably politicize the buyout process of toxic assets, which could lead to potentially enormous losses to taxpayers for poor purchasing decisions, conflicts of interest, political corruption, interference from interest groups, poor management by governmental officials, and other inefficiencies typically related to government transactions (time, money, centralized decision-making, etc.).
These types of government-oriented solutions also lack competitive aspects that promote an effective market mechanism, including the efficiencies of true private "at-risk" capital investments and the participation of knowledgeable private "for-profit" managers. This approach also fails to solve the issue of asset valuation and loss allocation (i.e., taxpayers or bank equity holders) because it has the same problem as a seller's auction; namely, pay too little and hurt the banks, pay too much and hurt the taxpayers.
7. Home Owners' Loan Corporation
An often discussed, but apparently not seriously considered option is recreating the Home Owners' Loan Corporation ("HOLC") which was employed by the federal government as one of the programs to pull America out of the Great Depression. The program involved the HOLC purchasing mortgages at a discount and renegotiating the terms with the existing homeowner to keep them in their homes at payments levels they could afford.
A number of experts have spoken strongly in support of this approach, particularly since it accomplishes the objective of removing troubled mortgages from bank's balance sheets and out of underperforming mortgage-related securities, while also preventing foreclosures.
The drawbacks are the staggering costs and massive scale likely needed for this type of program, as well as the difficulties in establishing a mechanism for determining which assets would be purchased by HOLC. As with a seller's auction, pricing would be a particularly challenging issue, as would servicing and/or monitoring the mortgage loans and real estate-related assets held by HOLC. Finally, there are additional challenges with how to administer the program in a manner that is open to all potential sellers, and potential mark-to-market issues as soon as the federal government begins to buy mortgages and mortgage-related assets.
8. Private Equity Participation in "Tarpics" or Government Fund
An idea popular among private equity investors is to make private capital the centerpiece of any bailout. Partnering private capital with government funds to buy banks' toxic assets may be accomplished through a broad group of newly capitalized secondary financial institutions, called TARP Investment Companies ("Tarpics"). In fact, this is a variation of the FSP's CAP.
Generally, this involves the government contributing capital along with private equity firms to establish these Tarpics. This approach is targeted at jump-starting the closed secondary asset markets, which would lead to faster and more efficient asset valuation. In addition, it is envisioned that this would offer banks a greater range of liquidity options and expand the overall availability of credit.
Proponents claim this would be much more beneficial than continuing to pump even more capital into existing primary institutions that are failing or spiraling towards failure. Executed properly, it could reduce both the amount of taxpayer funding and the duration of the rescue.
By some estimates, there is over $400 billion of private capital currently available in private equity funds and other entities and institutions waiting to capitalize on the distressed loan markets. However, these funds and institutions are waiting for bargain sale prices that banks are not yet ready to offer. If the government offered to match (on a one-to-one or other basis) the equity capital contributed by reputable managers interested in forming and operating these Tarpics, it could make up the difference in the price valuations of potential buyers and banks, thus freeing up the current stalemate. It could also prevent the spiraling mark-down issue for non-selling banks, because a private/public funded market value would help establish a more reasonable valuation than fire sale prices.
This approach has worked for the Small Business Administration which has for many years partnered with private equity managers to deploy capital to small businesses through Small Business Investment Companies, or SBICs. Procedural protections used in the SBIC program, such as capital commitment fees, redemption periods and capital priority levels, could be incorporated into the Tarpic program if needed.
Instead of numerous Tarpics, some proponents suggest establishing a single centralized fund in which private equity contributors could invest. This would encourage consistency in price valuation among banks and potentially more transparency in buyout actions if the government actively manages or operates the institution. However, this model may fail to incentivize buyers by eliminating the ability of private managers to operate their own restructuring transactions. There could also be inefficiencies generally related to governmental institutions.
The FSP incorporates the latter take on private equity investment through a Public-Private Investment Fund. This fund would be financed with public and private capital to purchase toxic assets. Treasury statements suggest that public financing would leverage private capital on an initial scale of up to $500 billion with the potential to expand to $1 trillion.
9. Nationalizing Banks
In recent weeks, the merits of nationalizing U.S. banks, or at least several of the largest systemically important banks, have been hotly debated. Notwithstanding the inherent distrust of nationalization and the perceived irony of a U.S.-backed nationalization effort, many argue this has already happened to a certain degree in the banking industry. Clearly, this was the case when the U.S. government took over Fannie Mae and Freddie Mac.
Bank nationalization was successfully executed by Sweden in 1992, which was eventually privatized at a profit to the Swedish government. However, the general view is that the Swedish experience would not be easy to duplicate in the U.S., in large part because of size of the U.S. banking system, its much greater role in the world economy, and the overall size of several of the largest systemically important U.S. banks.
Advocates of this approach point to elimination of both the need to valuate toxic assets and compensate bank shareholders. Most importantly, it would restore public confidence, again particularly at systemically important banks, and free up lines of credit. The losses would be born by bank equity holders and creditors rather than taxpayers. Variations of this theme include partial nationalization (taking out equity holders, but protecting creditors) and temporary nationalization (government control for a designated period of time).
Not surprisingly, there are numerous and vocal critics to this approach. As a threshold matter, opponents cite the demise of free enterprise and efficient lending if the government interferes or takes over the operations of troubled institutions. Historically, nationalized banks have not been particularly adept at the efficient allocation of credit compared to private banks, and some suggest it would take many years before such institutions could be "re-privatized."
Even if the government merged or sold off banks rather than actually operating nationalized banks, there are many critics of such forced consolidations. The criticism includes that acquiring banks invariably get an outrageously good deal at the expense of the taxpayer; a lack of accountability and transparency on behalf of governmental officials taking over the failed bank (possibly leading to conflicts of interest or favoritism); and an adverse impact on competitiveness after the crisis.
The recent statement by Treasury and the federal banking agencies on the details of the CAP's stress testing program suggests that tests will be conducted to determine the overall exposure of institutions under various economic scenarios. Apparently, the government will tailor its proposed investments in the 25 largest institutions subject to the stress testing based on the projected vulnerability of the institutions to the economic factors utilized in the stress tests. The statement indicated that Treasury will provide capital to these institutions in exchange for convertible preferred securities. Generally, the investments would be converted to common stock if/when an institution taps into such funding.
Some view this as a version of incremental nationalization, and this approach retains the possibility of full nationalization and/or taking over a troubled bank. The plan suggests that Treasury views some banks as too important to fail and may effectively take almost all necessary actions to prevent a systemic failure. In part, this approach is likely driven by the catastrophic effects of the failure of Lehman Brothers in the fall of 2008. Given the extent of these institutions' participation in the payment system and the large counter-party risks these institutions present, ensuring the continued viability of these largest systemically important banks benefits the overall banking system as much as it does the particular banks themselves.
10. Debt-to-Equity Conversions
Another proposed solution is to have the government institute mandatory debt-to-equity conversions with or without wiping out existing equity holders. This would involve converting existing bank debt, in inverse order of seniority, into stock (either preferred or common shares). Unlike a capital injection, which lowers a bank's leverage ratio by raising equity without affecting debt, a mandatory conversion would lower the leverage ratio by both lowering debt and raising equity. The total size of the balance sheet (debt plus equity) increases in a capital injection but would remain unchanged in a mandatory debt-to-equity conversion. In the late 1980s, Citigroup used this approach in Chile by converting then existing debt to equity.
This type of conversion provides creditors an opportunity to regain the equivalent of debt and interest in the form of dividends and capital gains on the stock of the bank. Although creditors may ultimately receive less than the debt owed to them, having a troubled debtor avoid bankruptcy - or in the case of a bank, FDIC receivership - avoids completely wiping out creditors' interests. Although this approach is dilutive of existing shareholders' interests, it may be utilized to avoid completely wiping out existing debt holders and shareholders.
As proponents point out, this plan decisively places the bulk of the financial losses on bank equity holders. This is viewed as appropriate, particularly since investors received the gains when financial institutions were doing well. Effectively, a mandatory debt-to-equity conversion would act like a high-speed bankruptcy, forcing banks into a financial restructure. From a policy perspective, this approach also operates to discourage reckless lending and investments in the future.
The downside, of course, is that a certain amount of losses will be imputed instantaneously to both equity holders and creditors upon a debt-to-equity conversion. This is not a desirable proposition for any bank.
Existing Regulatory Scheme
Notwithstanding the various solutions that have been discussed and debated in recent months, some experts continue to argue that the existing regulatory scheme is adequate to address the toxic asset problems of the banking industry. Institutions that have too many bad assets and are unable to work their way out of the problem should be taken over. Proponents argue this will strengthen the remaining banks and bolster the economy without the need for injecting capital or implementing new plans.
The most powerful tool currently available to banking regulators is the ability to take over troubled institutions with too many bad assets and placing them into receivership or conservatorship. This process has been conducted by the FDIC many times since the beginning of the current recession. When the FDIC takes over a failing bank, it replaces management, restructures the bank by merging or selling all or part of the assets, reassures insured depositors, and typically wipes out the equity holders. Although a disruptive and painful process, it is useful to clear out banks that may never be again productive lending entities, no matter how much capital is injected.
Experts call for stronger supervision, regulatory monitoring and action, again using the existing regulatory scheme, by requiring banks to develop business plans, raise additional capital, or engage in other activities to restore their balance sheets. The tools currently available to regulators are very powerful and, according to some, more than sufficient to resolve the current crisis.
Others suggest regulators should ease certain existing rules to assist banks. One theory is to cut minimum capital requirements, which would permit many banks to continue to meet the revised requirements and, in some cases, upgrade their existing rating. Regulators have been easing rules to some extent. For example, high-yield interest rate caps were recently lowered to permit less than well-capitalized institutions to offer higher deposit interest rates and, thus, attract new depositors.
Certainly, relying on the status quo is appealing since it avoids Congressional action, which could involve a painful process for the industry given various political agendas and potentially significant time delays. However, it is amply evident that the regulators have limited resources, including too few examiners to exercise effective industry supervision, overseeing troubled banks under their watch, and taking over failing institutions. If existing regulatory action was sufficient, of course, it is likely that the current crisis would have been resolved by now. Also, given the public desire for action and change, maintaining the status quo does not appear to be favored by the government and other law and policy makers.
Geithner's FSP incorporates elements to bolster current regulatory actions. For example, the CAP's new bank stress test will combine the efforts of Treasury, the bank supervisors, the SEC and accounting standards setters to improve bank disclosures and transparency. It also describes a coordinated effort to assess exposures:
All relevant financial regulators - the Federal Reserve, FDIC, OCC, and OTS - will work together in a coordinated way to bring more consistent, realistic and forward looking assessment of exposures on the balance sheets of individuals.
While additional details on this concerted effort were recently released, they appear to have raised more questions than answers. In any event, it is clear that, at least for the time being, the current regulatory scheme will be retained and increased regulatory actions and guidance will continue to be emphasized.
These top ten solutions to address the toxic asset issue have been proposed and discussed by economic and financial experts around the world. Of course, there are additional variations to many of these proposals, including recommendations for combinations of one or more of the above. The FSP contains a combination of several of the proposals set forth above, including #2 (Conditional Capital Infusion Plan), #5 (Increased SBA Loan Guarantees), #8 (Private Equity Investment in Government Fund) and, of course, certain aspects of the status quo (Increased Regulator Actions).
The lack of details in the FSP and CAP continue to worry economic experts and the financial world because it highlights and leaves unanswered the main issue of the economic crisis: how to deal with the substantial losses of the devalued toxic assets. There is still no consensus on whether bank creditors and investors, or taxpayers will bear the losses and continued risk of loss from these assets as mortgage (and other loan) defaults continue to escalate. For now, the government appears unwilling to place the risks associated from these assets solely on investors and creditors. Rather, the risks are being shared and absorbed by taxpayers via the provision of government assistance, including capital and increasing guarantees.
Efforts to attract private equity highlight opportunities for significant upside, as well as spreading and diluting the existing risks to investors. More importantly, the involvement of private capital will expedite the valuation of mortgage and mortgage-related assets currently sitting on the books of most banks. It is not clear which of the various proposals show the most promise to fix the ongoing economic crisis. Whatever the solution, the challenge for the government remains finding ways to restore the lending and credit markets to get the economy running again.
Clearly, the world is watching and waiting to hear more details on this most critical aspect of the Administration's FSP. Until further guidance is forthcoming, most credit markets will likely remain stalled and the toxic assets will continue to sit on institutions' balance sheets.
Kevin Petrasic is a former special counsel of the OTS and senior associate in the Banking and Financial Institutions Group at international law firm Paul Hastings, resident in the firm's Washington, D.C. office. Nicole Ibbotson is an associate in the firms' Banking & Financial Institutions Group, resident in the Atlanta office.