[House Document 110-161]
[From the U.S. Government Publishing Office]




110th Congress, 2d Session - - - - - - - - - - - - House Document 110-161

 
 OMB REPORT UNDER THE EMERGENCY ECONOMIC STABILIZATION ACT, SECTION 202

                               __________

                             COMMUNICATION

                                  from

           THE DIRECTOR, THE OFFICE OF MANAGEMENT AND BUDGET

                              transmitting

 THE FIRST REPORT OF THE ESTIMATED COST OF ASSETS PURCHASED UNDER THE 
 EMERGENCY ECONOMIC STABILIZATION ACT OF 2008, AS REQUIRED BY SECTION 
                                  202




 January 3, 2009.--Referred to the Committee on Financial Services and 
                         ordered to be printed
                 Executive Office of the President,
                           Office of Management and Budget,
                                  Washington, DC, December 5, 2008.
Hon. Nancy Pelosi,
Speaker of the House of Representatives,
Washington, DC.
    Dear Madam Speaker: Enclosed and as transmitted to the 
President of the United States is the Office of Management and 
Budget's (OMB) first report of the estimated cost of assets 
purchased under the Emergency Economic Stabilization Act of 
2008 (EESA), as required by section 202.
    OMB is required to submit this report to the President and 
the Congress no later than sixty days after the first exercise 
of authorities granted under Section 101(aa) of EESA, and 
semiannually thereafter. Consistent with the requirement to 
analyze transactions up to thirty days before publication, this 
report analyzes the cost of transactions completed by November 
6, 2008.
    OMB will continue to work closely with the Department of 
the Treasury to consider the budgetary impacts of this 
important program.
            Sincerely,
                                        Stephen S. McMillin
                                        (For Jim Nussle, Director).
    Enclosure.
    Identical letter sent to the President of the Senate.

 OMB Report Under the Emergency Economic Stabilization Act, Section 202

    The Emergency Economic Stabilization Act of 2008 (Pub. L. 
110-343) authorizes the Department of the Treasury to purchase 
and insure certain types of troubled assets for the purposes of 
restoring liquidity and stability to the financial system of 
the United States. Section 202 of the Act requires the Office 
of Management and Budget (OMB) to report the estimated cost of 
assets purchased and guarantees issued pursuant to the Act. OMB 
is required to submit the report no later than sixty days after 
the first exercise of authorities granted under Section 101(a) 
of the Act, October 6, 2008.\1\ Consistent the requirement to 
analyze transactions up to thirty days before publication, this 
report analyzes transactions through November 6, 2008.
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    \1\The appointment of Assistant Secretary of Financial Stability, 
Neel Kashkari (interim) on October 6, 2008, by the Department of the 
Treasury (Treasury) was the first exercise of authority under the 
Emergency Economic Stabilization Act.
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Purchases

    As of November 6, 2008, Treasury had purchased $115 billion 
in preferred stock and warrants for future purchases of common 
stock from eight financial institutions, as outlined in 
Treasury's first transaction and tranche reports on the Capital 
Purchase Program. The preferred stock is senior to common stock 
and pays a dividend at an annual rate of 5 percent during the 
first five years and 9 percent after five years. The stock is 
an equity transaction and therefore has no stated maturity, but 
the institution issuing the preferred stock can redeem the 
shares under certain terms. As of November 6, Treasury also had 
made a commitment to purchase $10 billion in preferred stock 
from a ninth institution. Treasury had not issued any 
guarantees of troubled assets.

Cash Flows and Impact on the Deficit and Debt

    Section 123 of the Emergency Economic Stabilization Act 
(EESA) states that the cost of Treasury purchases under the 
Troubled Asset Relief Program (TARP) are to be estimated under 
the Federal Credit Reform Act (FCRA) of 1990 (2 USC 661 et 
seq.), with discount rates adjusted for market risks. FCRA 
requires accrual budgeting only for ``direct loans'' or ``loan 
guarantees,'' as defined in FCRA. As of the writing of this 
report, Treasury's Capital Purchase Program has made equity--
not loan--purchases, and has not issued guarantees, and thus 
the cash flows are reflected on a cash basis and not on an 
accrual basis. Table 1 displays the estimated impact of these 
purchases on the deficit and Federal debt as of the writing of 
this report:

                                                            TABLE 1: CAPITAL PURCHASE PROGRAM
                                                                     [In billions*]
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                                                                                                                                                 2009-
                                                       2009     2010     2011     2012     2013     2014     2015     2016     2017     2018      2018
--------------------------------------------------------------------------------------------------------------------------------------------------------
Disbursements......................................    115.0  .......  .......  .......  .......  .......  .......  .......  .......  .......      115.0
Stock Dividends, Expected..........................  .......  .......  .......  .......  .......  .......  .......  .......  .......  .......  .........
Redemptions, and Exercised Warrants................     -3.9     -7.0     -6.5    -20.2    -19.3    -16.4    -10.4     -9.5     -8.3     -8.8     -110.4
                                                    ----------------------------------------------------------------------------------------------------
    Net Outlays....................................    111.1     -7.0     -6.5    -20.2    -19.3    -16.4    -10.4     -9.5     -8.3     -8.8        4.6
--------------------------------------------------------------------------------------------------------------------------------------------------------
*Components may not sum to totals due to rounding.

    The table shows an initial disbursement of $115 billion in 
2009 to purchase preferred stock. As stated above, this amount 
corresponds to purchases made prior to November 6, 2008. The 
table also includes the sum of estimated dividend payments that 
Treasury will receive, estimated redemptions that will occur 
each year, and estimated net proceeds from the exercise or sale 
of warrants, based on the initial disbursement of $115 billion 
dollars. The table shows that redemptions are predicated to 
increase in 2012 through 2015, when the incentives are greater 
for financial institutions to redeem shares, including the fact 
that the dividend rate on the shares will increase from 5 
percent to 9 percent after five years. It also shows that 
Treasury is expected to recover nearly all of the $115 billion 
in disbursed funds in the first ten years of the program.
    See the Alternative Valuation section of this report for an 
analysis of the cost of the Capital Purchase Program using the 
net present value of the expected cash flows.

Method for Estimating the Cash Flows of Preferred Stock

    Cash flows to and from the government occur when the 
preferred stock is purchased, when the government receives 
dividend payments, and when the preferred stock is redeemed 
(``called'') by the financial institution or sold by Treasury. 
OMB developed an analytical model to project these cash flows 
on an annual basis, incorporating the following risks 
underlying the cash flows:
     Credit risk--the risk that closure or failure of 
the institution will forestall the payment of principal (or 
value of stock sales or redemptions) and dividends to the 
Treasury. OMB takes this risk into consideration by factoring 
in the strength of the issuing firm, as evidenced by its market 
value.
     Call risk--the risk that the financial institution 
will buy back the preferred stock in scenarios where it is 
relatively cheaper for the institution to get financing in the 
open market, when market interest rates are low and therefore 
the returns on these securities are more valuable to the 
Treasury, and not buy it back in scenarios where it is not. 
Call risk derives primarily from uncertainty about Treasury 
rates and about future levels of credit risk.
     Dividend Curtailment Risk--the risk that the 
institution will stop paying dividends. The terms of the 
preferred shares prohibit the institution from paying dividends 
to common stock holders unless they pay dividends on the 
preferred stock, but companies can forgo dividends on all types 
of equity including the preferred stock.\2\ OMB takes this risk 
into consideration by factoring the strength of the issuing 
firm in its cash flow projections.
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    \2\For banks that are subsidiaries of bank holding companies 
(BHCs), dividends on the preferred stock are cumulative, meaning that a 
bank would need to pay the accumulated amount of all unpaid dividends 
on preferred stock before recommencing payment of dividends to common 
stock holders. For banks that are not subsidiaries of BHCs, dividends 
are non-cumulative, meaning that the bank would not need to make up 
past unpaid dividends before recommencing payment of dividends to 
common stock holders. The risk of dividend curtailment is substantially 
mitigated for cumulative preferred stock, although it still leads to a 
reduction in net present value due to the time value of money, and a 
higher exposure in the case of bank closure.
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    The model is probabilistic, meaning that it projects cash 
flows under a number of different scenarios and then weights 
the likelihood of the different scenarios to obtain the annual 
expected cash flow of the investment.
    The model estimates how cash flows vary depending on 1) 
current interest rates that affect the call decision; and 2) 
the strength of a financial institution's assets and net equity 
position that affect dividend curtailment or possible failure 
(credit risk).\3\ The component of the model used to determine 
the effect of interest rates builds on models used for other 
government programs with interest rate risk exposure such as 
Federally guaranteed student loan programs. The component of 
the model used to determine the effect of the financial 
institutions' strength is based on the model used to project 
bank failures in the context of Federal bank deposit insurance.
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    \3\Short-term risk-free interest rates are based on current 
Treasury yields. A firm's financial strength and ability to make 
dividend payments is estimated using a ratio of market value of the 
firm's total assets (current market capitalization plus total 
liabilities) divided by total liabilities (as recorded in the most 
recently available financial statement). The estimate of the strength 
of a firm's financial position factors in stock price volatility in its 
calculation.
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    In each of multiple scenarios, the model calculates the 
optimal call decision for each bank, the estimated dividends 
received by the Government, and the probability of each 
scenario. The result is the expected likely cash flows to the 
government from the preferred stock purchases.

Method for Estimating the Cash Flows of Warrants

    While the call option of the preferred stock benefits the 
institution, the warrants for common stock that Treasury 
received as part of the transaction benefit Treasury. OMB 
values and projects the cash flows of the warrants using a 
commonly applied option-pricing approach based on the current 
stock price and its volatility. By using the same volatility 
parameters as used for the preferred stock model, the model 
maximizes consistency between the estimates of the downside 
risks associated with the preferred stock and the upside 
potential associated with the warrants.

Alternative Valuation

    Although OMB is reflecting the equity purchases on a cash-
basis, this report also shows the cost of the preferred stock 
purchases under the Capital Purchase Program using the net 
present value (NPV) of the expected cash flows.\4\
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    \4\While the term of the preferred stock is perpetual life, the 
projected cash flows are truncated at thirty years for the NPV 
calculations.
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    NPV is calculated under two alternative discount rates. The 
first alternative discounts the expected cash flows using 
current Treasury yields as of the time of preparing this 
report, which reflect the government's cost of borrowing. The 
single effective discount rate for these purchases is 3.84 
percent.\5\ The second alternative view of the cost of TARP 
purchases uses a market-risk adjusted rate, as outlined in 
Section 123 of EESA. It reflects the higher rate of return that 
private investors would demand to compensate for the risk that 
future cash flows may be lower than expected due to higher than 
expected default rates. The single effective discount rate with 
the market risk adjustments is estimated to be 8.79 percent.\6\
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    \5\A single effective discount rate is a weighted average of the 
rates used to discount the cash flows over multiple periods. Under 
FCRA, for example, cash flows are discounted using a ``basket of 
zeros'' approach where each period's cash flow is discounted using the 
yield of a Treasury zero-coupon bond of a similar maturity. The single 
effective discount rate is the one discount rate that generates the 
same subsidy cost as the basket of zeros.
    \6\It should be noted that these discount rates are based on a 
snapshot of current Treasury rates as of the time of preparing this 
report, and are not the rates that would be used to value preferred 
stock purchases if they were evaluated under FCRA. Under FCRA, the 
discount rates for credit transactions executed in fiscal year 2009 are 
based on the economic assumptions used to prepare the 2009 Budget, 
released in February 2008.
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    Table 2 shows the estimated cost of the preferred stock and 
warrants:

               TABLE 2: ESTIMATED COST OF EQUITY PURCHASES
                             [In billions*]
------------------------------------------------------------------------
                                            NPV at the
                                           USG's cost of   NPV with risk
                                             borrowing      adjustments
------------------------------------------------------------------------
Expenditure.............................          115.0           115.0
Present Value of Preferred Stock........         (115.7)          (81.9)
Present Value of Warrants...............          (11.8)           (7.6)
                                         -------------------------------
    Net Cost (Gain).....................          (12.6)           25.5
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*Components may not total due to rounding.

    This table shows that under the first alternative 
(calculating NPV at the Government's cost of borrowing), the 
estimated value of the preferred stock and warrants represents 
a net gain of $12.6 billion or 11 percent of the initial 
disbursement. This means that Treasury is estimated to receive 
on average a rate of return on its investment that exceeds the 
Government's cost of borrowing, reflecting an estimated overall 
net gain to the Government in an average scenario. Under the 
second alternative (calculating NPV with adjustments for market 
risk), the estimated value of the preferred stock represents a 
net loss of $25.5 billion or 22 percent of the initial 
disbursement. This means that the estimated average return on 
Treasury's investment will not equal what a typical private 
investor would demand for an investment facing similar risks 
given the private investor has a higher cost of borrowing. 
Thus, the return on the investments would represent a net loss 
compared with what would typically be demanded by a private 
investor.

Future OMB Reports

    Section 202 of the Emergency Economic Stabilization Act 
requires OMB to submit a recurring report at least semi-
annually. OMB may satisfy this requirement in 2009 and future 
years through reporting in the Budget and Mid-Session Review.

                                  
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