[JPRT, 111th Congress]
[From the U.S. Government Publishing Office]
CONGRESSIONAL OVERSIGHT PANEL
JULY OVERSIGHT REPORT *
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TARP REPAYMENTS, INCLUDING THE REPURCHASE OF STOCK WARRANTS
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
July 10, 2009.--Ordered to be printed
*Submitted under Section 125(b)(1) of Title 1 of the Emergency Economic
Stabilization Act of 2008, Pub. L. No. 110-343
CONGRESSIONAL OVERSIGHT PANEL
JULY OVERSIGHT REPORT *
__________
TARP REPAYMENTS, INCLUDING THE REPURCHASE OF STOCK WARRANTS
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
July 10, 2009.--Ordered to be printed
*Submitted under Section 125(b)(1) of Title 1 of the Emergency Economic
Stabilization Act of 2008, Pub. L. No. 110-343
U.S. GOVERNMENT PRINTING OFFICE
50-720 WASHINGTON : 2009
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20402-0001
CONGRESSIONAL OVERSIGHT PANEL
Panel Members
Elizabeth Warren, Chair
Sen. John Sununu
Rep. Jeb Hensarling
Richard H. Neiman
Damon Silvers
C O N T E N T S
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Page
Executive Summary................................................ 1
Section One:..................................................... 4
A. Background................................................ 4
B. Understanding Warrants.................................... 5
C. Statutory and Contractual Provisions Governing Repurchase
and Warrants under TARP.................................... 7
D. Repayments of CPP and TIP Capital Investments............. 14
E. Valuing TARP Warrants..................................... 16
F. Alternatives for Disposing of TARP Warrants............... 23
G. Issues.................................................... 28
H. Conclusion--Policy Choices and Trade-Offs................. 37
Annexes to Section One:
ANNEX A: Technical Explanation of Warrant Valuation Methods.. 39
ANNEX B: Analysis of the Old National Bancorp Warrants....... 46
Section Two: Additional Views.................................... 49
A. Richard H. Neiman......................................... 49
B. Congressman Jeb Hensarling................................ 50
H. John Sununu............................................... 59
Section Three: Correspondence with Treasury Update............... 61
Section Four: TARP Updates Since Last Report..................... 62
Section Five: Oversight Activities............................... 72
Section Six: About the Congressional Oversight Panel............. 74
Appendices:
APPENDIX I: LETTER FROM CHAIR ELIZABETH WARREN TO SECRETARY
TIMOTHY GEITHNER REQUESTING INFORMATION ON THE REPAYMENT OF
TARP ASSISTANCE, DATED JUNE 12, 2009....................... 75
APPENDIX II: LETTER FROM SECRETARY TIMOTHY GEITHNER IN
RESPONSE TO CHAIR WARREN'S LETTER REQUESTING INFORMATION ON
THE REPAYMENT OF TARP ASSISTANCE, DATED JULY 1, 2009....... 79
APPENDIX III: LETTER FROM CHAIR ELIZABETH WARREN AND PANEL
MEMBER RICHARD NEIMAN TO SECRETARY TIMOTHY GEITHNER
REQUESTING ASSISTANCE WITH THE PANEL'S OVERSIGHT OF FEDERAL
FORECLOSURE MITIGATION EFFORTS, DATED JUNE 29, 2009........ 92
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_______________________________________________________________________
JULY OVERSIGHT REPORT
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July 10, 2009.--Ordered to be printed
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EXECUTIVE SUMMARY *
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\*\ The Panel adopted this report with a unanimous 5-0 vote on July
10, 2009.
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In late 2008, our economy faced an exceptional crisis, and
Congress created the Troubled Asset Relief Program (TARP) in an
effort to stabilize the financial system. Through the TARP,
taxpayers invested billions of dollars in the nation's
financial institutions.
These actions imposed an enormous risk on taxpayers. If the
TARP failed to stabilize the financial system, the entire
economy could collapse. Even if the system stabilized after
huge infusions of taxpayer funds, if some institutions were
unable to recover taxpayers could be paying the debts for
generations. While these risks were looming, then-Treasury
Secretary Henry Paulson argued that TARP assistance could be
used to rescue the economy and generate a profit for taxpayers.
When Congress authorized the commitment of $700 billion to
rescue the financial system, it decided that taxpayers should
have the opportunity to share in a potential upside if the
banks returned to profitability.
The opportunity to profit from TARP investments comes
through special securities called warrants. Banks that received
financial assistance were required to give the government
warrants for the future purchase of some of their common
shares. Simply put, warrants are the right to buy shares of a
company at a set price at some point in the future. For
example, a warrant might allow Treasury to buy shares of a bank
for ten dollars at any time in the next ten years. If the share
price rises above ten dollars, Treasury could pay less than
market value for the shares, then sell them and turn a profit.
In this way, the banks were repaying the taxpayers for their
investment by sharing some of their future profitability.
Currently many banks want to exit the TARP program by
repaying their financial assistance and repurchasing their
warrants from Treasury. Treasury is permitting ten of the
nation's largest bank holding companies--representing more than
one third of the nation's banking assets--to repay the
financial assistance they received eight months ago. Any exit
from the TARP system implicates an important policy question:
if the banks give up federal support prematurely, will the
economy suffer as a result? The Panel has not reached a
consensus on whether it is wise policy to release banks from
the TARP program at this time, but our June report on the bank
stress tests raised key questions about whether we know enough
about the banks' overall health.
As Treasury makes these decisions about repayment, it is
the Panel's mandate to determine whether the taxpayer is
receiving maximum benefit from the TARP. Because the warrants
that accompanied TARP assistance represent the only opportunity
for the taxpayer to participate directly in the increase in the
share prices of banks made possible by public money, the price
at which the warrants are sold is critical. To determine
whether Treasury is valuing the warrants in a way that
maximizes the taxpayers' investments in the financial
institutions, it is necessary to determine how much the
warrants are worth.
The Panel uses the most widely-accepted mathematical model,
presenting a detailed technical valuation of the warrants
Treasury holds. The assumptions employed in the use of any
model are crucial, and the report offers a range of estimates
based on high, low and best estimate assumptions for certain
key variables. The Panel was aided in its valuation efforts by
three renowned finance experts, Professor Robert Merton,
Professor Daniel Bergstresser, and Professor Victoria Ivashina,
all of the Harvard Business School. The professors reviewed
both the technical valuation model and the assumptions that
were built into the model; they concluded that the approaches
reported here were reasonable and that they produced reliable
estimates.
Eleven small banks have repurchased their warrants from
Treasury for a total amount that the Panel estimates to be only
66 percent of its best estimate of their value. If the warrants
had been sold for their market value, taxpayers would have
recovered $10 million more.
Treasury has to date sold warrants only from smaller banks.
In those sales, liquidity discounts are likely to be a major
factor in a way that they are not likely to be for large
publicly-traded institutions. If, however, liquidity discounts
or any other rationales are accepted as a reason for taking
only 66 percent of market value for the full group of warrants
Treasury holds, the shortfall to taxpayers could be as much as
$2.7 billion.
It is possible that policymakers may conclude that other
objectives should override the goal of maximizing taxpayer
returns. For example, Treasury has said that it wants to allow
banks to operate again without TARP assistance as soon as they
are strong enough to do so.
Because warrant valuation is a difficult task, the Panel
explores the possibility that Treasury should leave it to the
markets by selling the warrants in an open, public auction.
This has the benefit of stopping any speculation about whether
Treasury has been too tough or too easy on the banks that want
to repurchase their own warrants. It also permits the banks to
bid for their own warrants--in direct competition with
outsiders.
The report describes key provisions in the Treasury
contracts with the banks and statutory provisions that govern
warrant purchases. The Panel notes that Treasury is constrained
in some ways by the provisions of the contracts governing the
TARP investments in the banks.
It should be noted that Treasury is just beginning its
warrant repurchase program. Banks have bought back only a
fraction of one percent of all warrants issued, and the prices
paid thus far may not be representative of what is to come. As
always, it is critical that Treasury make the process--the
reason for its decisions, the way it arrives at its figures,
and the exit strategy from or future use of the TARP--
absolutely transparent. If it fails to do so, the credibility
of the decisions it makes and its stewardship of the TARP will
be in jeopardy.
SECTION ONE
Ten of the nation's largest financial institutions, and
some smaller institutions, have repaid the amounts they
received under the TARP by redeeming the preferred shares
Treasury received when the assistance was provided. Their
redemption of the preferred shares entitles them to buy back
the warrants to purchase their common shares that Treasury also
received at that time.
The preferred shares and pending warrant repayments raise
important questions about the TARP:
the extent to which repayment of TARP
assistance is yet appropriate, and if so, on what terms
and timing, in light of the still uncertain economic
recovery;
the appropriate circumstances for repayment;
the extent to which the relationship between
the strength of individual institutions and the
strength of the financial system should govern timing
of repayment;
the price at which Treasury should dispose
of the warrants it holds, and the way it should do so;
the statutory and contractual obligations
that affect Treasury's ability to set a price for
warrant repurchase;
the fair market value of the warrants; and
the policy considerations that should govern
the price that Treasury accepts for its warrants.
In its past reports, the Panel examined questions about the
policy, strategy and execution of the TARP's approach to bank
assistance. This report begins an effort to evaluate the
details of the exit strategy from the TARP that are emerging
from the actions Treasury and the Federal Reserve Board are now
taking.
In doing so, the Panel recognizes that repayment of TARP
assistance and disposition of TARP warrants raise different,
albeit related, issues. The former is the foundation of the
government strategy for stabilizing the nation's financial
system. The warrants represent only 15 percent of the value of
Treasury's investment in the banks that have received
assistance (at the time of that investment). But Congress
required institutions receiving TARP assistance to issue the
warrants to permit the public to share in the increase in share
values that investment of billions of dollars of the public's
money made possible. Thus examination of issues relating to
both repayment and warrants can shed light on Treasury's
objectives and strategy during what appears to be a critical
phase in the implementation of the TARP.
A. Background
Between October 14, 2008 and June 26, 2009, Treasury
injected more than $240 billion into over 600 of the nation's
bank holding companies (BHCs) and independent banking
institutions through the TARP in exchange for preferred shares
and warrants to buy common shares of each institution
involved.\1\ These capital injections appear to have
contributed to stabilizing, or at least softening, last year's
severe downturn in the U.S. financial system, although as the
Panel has noted elsewhere, it is not entirely clear what
positive effects TARP assistance has had on the availability or
terms of credit.\2\
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\1\ U.S. Department of the Treasury, TARP Transactions Report for
the Period Ending June 30, 2009 (July 2, 2009) (online at
www.financialstability.gov/docs/transaction-reports/transactions-
report_070209.pdf) (hereinafter ``July 2 TARP Transactions Report'').
The injections were part of Treasury's Capital Purchase Program (the
``CPP''), except for two $20 billion transactions that were part of
Treasury's Targeted Investment Program (the ``TIP'').
\2\ See Congressional Oversight Panel, April Oversight Report:
Assessing Treasury's Strategy: Six Months of TARP at 27-35 (April 7,
2009) (online at cop.senate.gov/documents/cop-040709-report.pdf)
(hereinafter ``Panel April Report''); Congressional Oversight Panel,
May Oversight Report: Reviving Lending to Small Businesses and Families
and the Impact of the TALF (May 7, 2009) (online at cop.senate.gov/
documents/cop-050709-report.pdf) (hereinafter ``Panel May Report'');
Congressional Oversight Panel, June Oversight Report: Stress Testing
and Shoring Up Bank Capital at 135-139 (June 9, 2009) (online at
cop.senate.gov/documents/cop-060909-report.pdf) (hereinafter ``Panel
June Report'').
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During the winter and spring of this year, the Federal
Reserve Board oversaw the Supervisory Capital Assessment
Program (the ``stress tests'' or ``SCAP'') that was the subject
of the Panel's June report.\3\ The stress tests' results,
released on May 7, 2009, determined that ten of the nation's
nineteen largest BHCs must raise an additional capital buffer
totaling $74.6 billion in all, to meet capital requirements
that the Federal Reserve Board has set in light of current
economic conditions.\4\
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\3\ Id, at 6-56.
\4\ Board of Governors of the Federal Reserve System, The
Supervisory Capital Assessment Program: Overview of Results (May 7,
2009) (online at http://www.federalreserve.gov/newsevents/press/bcreg/
bcreg20090507a1.pdf).
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On June 17, ten of the nation's largest BHCs repaid the
TARP capital infusions they received eight months ago, spending
a total of $68.2 billion to redeem their preferred shares from
Treasury (with the approval of Treasury and the Federal Reserve
Board). The institutions, and amounts repaid, included:
JPMorgan Chase ($25 billion), Morgan Stanley ($10 billion),
Goldman Sachs ($10 billion), US Bancorp ($6.6 billion), Capital
One Financial ($3.5 billion), American Express ($3.4 billion),
BB&T ($3.1 billion), Bank of New York Mellon ($3 billion),
State Street ($2 billion), and Northern Trust ($1.6 billion).
In addition, as of July 2, 2009, repayments have been made by
22 small and private banks, for a total of $1.9 billion. All
told, $70.2 billion in Capital Purchase Program (CPP)
assistance has been repaid. The systemic risks posed by BHCs
with $100 billion or more in assets are different than those
posed by other BHCs or smaller community banks, but the issues
raised in this report--the relationship of the return of
capital assistance to the size and health of a bank, the
policies that should govern approval of return of assistance,
and the value of the warrants held by Treasury in the bank,
apply equally to both.
In May 2009, Treasury issued ``FAQs on Capital Purchase
Program Repayment,'' which included a general statement of the
policy used in determining whether to approve TARP repayments;
on June 1, 2009, the Federal Reserve Board issued more detailed
guidelines on the criteria for approval for the stress-tested
BHCs.\5\
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\5\ See infra note 25.
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B. Understanding Warrants
A warrant is a security that permits the holder to buy a
specified number of common shares (the ``underlying'' shares)
at a specified price (the ``strike price'') on or before a
specified date (the ``expiration''). With a couple of technical
caveats,\6\ warrants can be considered a form of call option
and are often issued as ``sweeteners'' with fixed-income
securities, such as preferred shares or debt (much like
employee stock options are used to enhance compensation
packages). When warrants are issued, their strike price is
usually set above the current share price; they generally have
no value if exercised immediately because the holder could
immediately buy shares on an exchange at a lower price.
However, warrants may be traded on public or private markets,
and they can be highly valued by investors who believe the
share price of the issuing company is likely to rise above the
strike price. Typically, prospective warrant investors will use
mathematical models to calculate the value of warrants based on
the probability of the share price rising above the warrant's
strike price.
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\6\ Including a warrant's potential dilutive effect and its balance
sheet treatment, discussed infra.
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When a holder exercises its rights under a warrants
agreement, the company must issue new common shares. This
necessarily has the effect of reducing the percentage of the
company owned by existing shareholders (known as ``dilution'').
The prospect of potential dilution means that the issuance of
warrants tends to depress the trading price of the common
shares to some extent.\7\
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\7\ Such price declines reflect the potential for each share of
common stock to represent less ownership control. Stock exchange rules
temper the impact of this dilution by requiring shareholder votes in
the event that the proposed issuance would increase the outstanding
number of shares by more than 20 percent. See New York Stock Exchange,
Listed Company Manual Sec. 312.03(c)(1); NASDAQ Stock Market, Equity
Rules Sec. 5635(a)(1)(A).
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When warrants are issued in conjunction with other
securities, as in the CPP, and valued and traded separately
from the preferred shares (i.e., they are ``detachable''),\8\
the issuer allocates a corresponding value as paid-in capital
on its balance sheet.\9\ This value is based on the fair value
of the securities relative to the fair value of the warrants at
the time of issuance and does not change in subsequent
financial statements.\10\
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\8\ Financial Accounting Standards Board, Accounting for Derivative
Instruments and Hedging Activities, 12, 16 (FAS No. 133) (June 1998)
(as amended by FAS No. 155).
\9\ Letter from James Kroeker, Securities and Exchange Commission,
and Russell Golden, Financial Accounting Standards Board, to Assistant
Secretary David G. Nason, U.S. Department of the Treasury (Oct. 24,
2008) (online at financialstability.gov/docs/CPP/secfasbletter.pdf).
\10\ When the warrants are exercised, the value allocated to the
warrants is removed from the ``stock warrants outstanding'' account
and, together with the cash received on exercise, credited to the stock
account for par or stated value, with any excess over the par value
being credited to the ``additional paid-in capital'' account. When
warrants are reacquired, the amount paid in excess of the amount
assigned to warrants at issuance is charged to retained earnings. If
warrants are reacquired at a price less than the amount originally
assigned to them, the difference is credited to additional paid-in
capital.
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When a company offers or sells securities, the transaction
must be registered with the SEC under the Securities Act of
1933,\11\ unless the transaction is exempt from registration.
Private sales, such as the CPP transactions with Treasury, are
exempt from registration. However, if the original holder
wishes to have the ability to sell the warrants into the public
markets (which is permitted in the case of the CPP warrants)
the issuer must have agreed to register the public resale of
the warrants.\12\
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\11\ Securities Act of 1933, Pub. L. No. 73-22, Sec. 5 (codified at
15 U.S.C. Sec. 77(a) et seq.).
\12\ Securities Purchase Agreement, infra note 15 at Sec. 4.5(p).
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C. Statutory and Contractual Provisions Governing Repurchase and
Warrants Under TARP
The Emergency Economic Stabilization Act of 2008 (EESA)
authorizes Treasury to purchase financial instruments.\13\
Through the CPP and Targeted Investment Program (TIP), Treasury
bought $203.2 billion and $40 billion, respectively, of
preferred shares from financial institutions. Preferred shares
entitle the holder to a fixed rate of dividend, and in that
respect function somewhat like a loan to the institution. EESA
also requires that any such purchase of financial instruments
from financial institutions must be accompanied by the issuance
to Treasury of warrants to purchase common shares of the
institution, so that taxpayers can benefit from a rise in the
price of the institution's shares, presumably reflecting the
value of the assistance Treasury has provided.\14\
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\13\ Emergency Economic Stabilization Act of 2008, Pub. L. No. 110-
343 (online at frwebgate.access.gpo.gov/cgi-bin/
getdoc.cgi?dbname=110_cong_bills&docid=f:h1424enr.txt.pdf) (codified at
12 U.S.C. Sec. 5201 et seq.) (hereinafter ``EESA''), as amended by Pub.
L. No. 111-5, Sec. 7001 and Pub. L. No. 111-22, Sec. 403.
\14\ EESA, supra note 13 Sec. 113(d)(2)(a) (codified at 12 U.S.C.
Sec. 5223(d)(2)(A)) (``[The] terms and conditions of any warrant . . .
shall . . . at a minimum, be designed . . . to provide for reasonable
participation by the Secretary, for the benefit of taxpayers, in equity
appreciation in the case of a warrant or other equity security . . .
and to provide additional protection for the taxpayer against losses
from sale of assets by the Secretary under [EESA] and the
administration expenses of the TARP.''); EESA, supra note 13,
Sec. 113(d)(1) (codified at 12 U.S.C. Sec. 5223(d)(1)) (providing that
the warrants may be to purchase either nonvoting common stock, common
stock with respect to which Treasury agrees not to exercise voting
power, or preferred shares of any institution from which Treasury
purchases financial instruments. If the institution involved is
privately-held, the warrant may be ``for common or preferred stock or a
senior debt institution from such institution.'').
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The terms of the preferred shares and the warrants are
governed both by statute and by individual contracts with each
institution receiving assistance. Each bank's agreement with
Treasury includes a Securities Purchase Agreement (SPA) and a
Form of Warrant to Purchase Common Stock (Form of Warrant),
which are attached to a Letter Agreement.\15\ These documents
set out the detailed terms of each security.
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\15\ The terms of these documents vary somewhat by institution
type--public, private, S-corporation, mutual holding company, or mutual
bank--but are substantially similar. See, e.g., U.S. Department of the
Treasury, Securities Purchase Agreement: Standard Terms (online at
www.financialstability.gov/docs/CPP/spa.pdf) (hereinafter ``Securities
Purchase Agreement''); U.S. Department of the Treasury, Form of Warrant
to Purchase Common Stock (online at www.financialstability.gov/docs/
CPP/warrant.pdf) (hereinafter ``Form of Warrant'').
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The statute, the contracts, and Treasury policy interact to
shape the terms of the preferred shares and warrants, including
terms relating to their redemption or repurchase. The statutory
provision regarding repurchases has been amended twice since
EESA was enacted. As discussed in more detail below, initially
the repayment of preferred shares and warrants was made
somewhat difficult for banks. EESA was then amended to allow a
bank to repay with the approval of its supervisor, and to
mandate that Treasury liquidate the warrants on redemption of
the preferred shares.\16\ In May 2009, EESA was further amended
to provide Treasury with discretion as to whether to hold or
liquidate the warrants upon a bank's redemption of the
preferred shares. Because the contracts were entered into under
the original statutory regime, Treasury has needed to adapt to
the amendments. It has done so through both its policy and
changes to the contracts. The end result, as described in this
section, is a process created by a combination of the statute,
contract, and policy. Under this process, a bank may redeem its
preferred shares only with the approval of its supervisor, as
required by EESA, after which it may repurchase its warrants at
a price determined by a specific valuation procedure, as
required by the contracts.
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\16\ See infra notes 23 and text accompanying note 44; Section One
Part C(2) of this report.
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1. PREFERRED SHARES
a. Terms of Preferred Shares
The CPP preferred shares pay cumulative \17\ dividends of
five percent per year for the first five years of the
program.\18\ They are senior to the institution's common
shares, have an equal preference to existing preferred shares,
and are non-voting.\19\
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\17\ A bank that is not a subsidiary of a holding company pays non-
cumulative dividends at the same rates. U.S. Department of the
Treasury, TARP Capital Purchase Program Senior Preferred Stock and
Warrants Summary of Senior Preferred Terms (online at www.treas.gov/
press/ releases/reports/document5hp1207.pdf) (hereinafter ``CPP Term
Sheet'').
\18\ In the sixth year, the dividends are raised to 9 percent. U.S.
Department of the Treasury, Factsheet on Capital Purchase Program (Mar.
17, 2009) (online at www.financialstability.gov/roadtostability/
CPPfactsheet.htm) (hereinafter ``CPP Factsheet'').
\19\ The preferred stock do have ``class voting rights on (i) any
authorization or issuance of shares ranking senior to the Senior
Preferred, (ii) any amendment to the rights of Senior Preferred, or
(iii) any merger, exchange or similar transaction.'' CPP Term Sheet,
supra note 17. In addition, ``[i]f dividends on the Senior Preferred
are not paid in full for six dividend periods, whether or not
consecutive, the Senior Preferred will have the right to elect 2
directors. The right to elect directors will end when full dividends
have been paid for four consecutive dividend periods.'' CPP Term Sheet,
supra note 17.
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b. Redemption of Preferred Shares
In the same way that loans are repaid, preferred shares are
``redeemed'' by the institution paying back the ``liquidation''
amount of the shares, equivalent to the principal amount of a
loan.\20\ There are both statutory and contractual provisions
that govern when and how this happens.
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\20\ In transactions of preferred shares generally, the amount paid
for preferred shares is not always equal to their liquidation amount.
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i. Timing. EESA, as amended, sets requirements for the
timing of redemption of these investments. Originally, under
the SPAs, BHCs were not permitted to repay TARP funds within
the first three years unless they had completed a qualified
equity offering (QEO) of at least 25 percent of the issue
price.\21\ A QEO is a sale before 2010 of shares that qualify
as tier 1 capital that raises an amount of cash equal to the
value of the preferred shares issued to Treasury.\22\ The
American Recovery and Reinvestment Act of 2009 (ARRA) amended
EESA, adding section 111(g), which now provides that, ``subject
to consultation with the appropriate federal banking agency
[Treasury] shall permit a TARP recipient to repay [CPP
preferred] without regard to whether the financial institution
has replaced such funds from any other source or to any waiting
period. . . .'' \23\
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\21\ If the bank did such a qualified equity offering, it could
redeem up to the amount of the proceeds that it had received in the
qualified equity offering. CPP Term Sheet, supra note 17.
\22\ Securities Purchase Agreement, supra note 15, 4.4.
\23\ American Recovery and Reinvestment Act of 2009 (ARRA), Pub. L.
111-5, Sec. 7001 (online
at frwebgate.access.gpo.gov/cgi-bin/
getdoc.cgi?dbname=111_cong_bills&docid=f:h1enr.txt.pdf) (hereinafter
``ARRA'').
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Repayment applications must be approved by the bank's
supervisor before they are sent to Treasury.\24\ The Federal
Reserve Board has indicated that supervisors will weigh an
institution's desire to repay its TARP assistance against the
contribution of that assistance to the institution's overall
soundness, capital adequacy and ability to lend.\25\ BHCs must
also have a comprehensive internal capital assessment
process.\26\ In addition, prior to repayment, the eighteen
stress-tested BHCs that received TARP funds must have a post-
repayment capital base consistent with the stress test capital
buffer, and must demonstrate their financial strength by
issuing senior unsecured debt for terms greater than five
years, not backed by FDIC guarantees, and in amounts sufficient
to demonstrate a capacity to meet funding needs
independently.\27\
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\24\ Id.
\25\ Board of Governors of the Federal Reserve System, Joint
Statement by Secretary of the Treasury Timothy F. Geithner, Chairman of
the Board of Governors of the Federal Reserve System Ben S. Bernanke,
Chairman of the Federal Deposit Insurance Corporation Sheila Bair, and
Comptroller of the Currency John C. Dugan on the Treasury Capital
Assistance Program and the Supervisory Capital Assessment Program (May
6, 2009) (online at www.federalreserve.gov/newsevents/press/bcreg/
20090506a.htm).
\26\ Id.
\27\ Id.
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The Federal Reserve summarizes the criteria that it will
use in determining whether to allow repayment as requiring that
stress-tested banks wishing to repay ``have a robust longer-
term capital assessment and management process geared toward
achieving and maintaining a prudent level and composition of
capital commensurate with the BHC's business activities and
firm-wide risk profile.'' \28\ Representative Hensarling, one
of the five members of the Panel, has introduced legislation
that would codify the Federal Reserve's criteria as part of
EESA.\29\ The Panel takes no position on the bill.
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\28\ Id.
\29\ H.R. 2745, TARP Repayment and Termination Act of 2009, 111th
Cong. (hereinafter ``H.R. 2745'').
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In testimony before the Panel on April 21, 2009, Secretary
of the Treasury Timothy Geithner said the ``ultimate test'' for
repayment would be whether an individual bank's repayment would
result in a reduction in the overall credit available to the
economy.\30\ While any repayment would reduce capital and thus
funds available for lending, some banks are raising capital
from the private markets, thereby replenishing that capital.
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\30\ Congressional Oversight Panel, Testimony of Treasury Secretary
Timothy Geithner (Apr. 21, 2009).
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The original contractual terms of the SPAs concerning
approval and timing of redemption of the preferred shares have
been superseded by the statutory amendments, as described
above.\31\ Treasury has announced that banks can redeem CPP
preferred under terms other than those specified in the
SPA.\32\
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\31\ See supra notes 22, 23, and accompanying text.
\32\ U.S. Department of the Treasury, FAQs addressing Capital
Purchase Program (CPP) changes under the American Recovery and
Reinvestment Act of 2009 (Feb. 26, 2009) (online at
www.financialstability.gov/docs/CPP/CPP-FAQs.pdf).
---------------------------------------------------------------------------
ii. Pricing. The statute sets no terms for the price
Treasury must obtain for the preferred shares it holds, other
than the general statutory injunction that it should administer
the Act in a manner that will ``minimize any potential long-
term negative impact on the taxpayer.'' \33\ The contractual
provisions governing the preferred shares provide that they are
to be redeemed at ``liquidation preference,'' essentially the
principal amount of the debt. In addition, the institution must
repay any dividends that are owed but unpaid on the shares.\34\
---------------------------------------------------------------------------
\33\ EESA, supra note 13, Sec. 113(a)(1) (codified at 12 U.S.C.
Sec. 5223).
\34\ Securities Purchase Agreement, supra note 15, Sec. 4.4.
---------------------------------------------------------------------------
2. WARRANTS
a. Terms of warrants
The warrants have a ten year life. Treasury can exercise or
transfer half of the warrants it holds at any time; the other
half can be exercised after 2009 if the bank has not engaged in
a QEO.\35\
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\35\ Form of Warrant, supra note 15, Sec. 13(H). As a contractual
condition to a bank's redemption of its preferred stock, Treasury
requires that the bank sign a ``cross-receipt.'' This cross-receipt has
the effect of exchanging the original warrants issued to Treasury for
``substitute warrants'' that are identical to the original warrants
except for the removal of the qualified equity offering 50 percent
warrant decrease provision. The cross-receipt also eliminates the
warrant transfer restrictions contained in the Securities Purchase
Agreement. A bank is not, however, required to provide a substitute
warrant if it informs Treasury of its plans to repurchase the warrants
immediately.
---------------------------------------------------------------------------
For BHCs that are public companies,\36\ the warrants must
be exercisable for an amount of common shares of the bank with
a value, at the time of the investment, equal to 15 percent of
the amount of the preferred shares purchased by Treasury from
the issuer. Because the maximum amount of preferred shares
eligible for the CPP is generally the lesser of $25 billion and
three percent of the bank's risk-weighted assets, warrants for
$3.75 billion in value of the bank's common shares are the
maximum amount that may be issued by a single institution. The
bank's shareholders must approve the issuance of the warrant
shares, the increase in the number of underlying shares to
cover the warrants, or both.
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\36\ Private banks issue warrants to purchase preferred shares
``having an aggregate liquidation preference equal to 5 percent of the
Preferred amount on the date of investment.'' The underlying shares of
a private bank warrant have the same rights as the preferred shares,
except that they pay dividends of 9 percent per year. U. S. Department
of the Treasury, TARP Capital Purchase Program (Non-Public QFIs,
excluding S Corps and Mutual Organizations) Preferred Securities
Summary of Preferred Terms (Nov. 19, 2008) (online at
www.financialstability.gov/docs/CPP/Term%20Sheet%20-
%20Private%20C%20Corporations.pdf) (hereinafter ``CPP Term Sheet for
Private Banks'').
---------------------------------------------------------------------------
The actual number of shares subject to the warrants is set
by reference to the market price for the common shares of the
issuer on the date of the preferred share investment,
calculated on a 20-trading day trailing average. Thus, if
warrants for common shares equal to $1 billion in value were to
be issued and the 20-trading day average stock price was $10,
then the bank must issue warrants for 100 million shares of the
common shares.
The number of underlying shares covered by the warrants is
subject to two possible adjustments. First, the shares subject
to warrant could be changed by standard anti-dilution
adjustments. Thus, if the issuer splits its stock on a two for
one basis (issuing two shares in place of every existing
share), the number of shares subject to the CPP warrants in the
previous example would be increased from 100 to 200 million. On
the other hand, the number of shares subject to the warrants is
decreased by 50 percent if the issuer engages, before December
31, 2009, in a QEO in which it receives gross proceeds of at
least 100 percent of the liquidation price of the preferred
shares.\37\
---------------------------------------------------------------------------
\37\ Form of Warrant, supra note 15, Sec. 13(H). See text
accompanying supra note 35 for a definition of ``Qualified Equity
Offering.''
---------------------------------------------------------------------------
The strike price of the warrants is determined in the same
way as the number of shares subject to warrant, that is, the
price is set at the 20-trading day trailing average price of
the common shares on the date Treasury's investment is made.
Thus, if the 20-day average stock price is $10, the holder of
the warrant must pay $10 for each share of stock when it
exercises the warrant.\38\ Private bank warrants carry an
exercise price of $0.01 per share. Treasury has announced that
it will immediately exercise private bank warrants.\39\
---------------------------------------------------------------------------
\38\ The exercise price, however, is subject to reduction if
necessary shareholder consents are not obtained; the maximum reduction
is 45 percent.
\39\ CPP Term Sheet for Private Banks, supra note 36.
---------------------------------------------------------------------------
Treasury agrees to waive its voting rights with respect to
any voting stock it receives when it exercises its
warrants.\40\ This restriction does not apply to any person to
whom Treasury transfers the shares or warrants.
---------------------------------------------------------------------------
\40\ Securities Purchase Agreement, supra note 15, Sec. 4.6. This
provision reflects the requirements of EESA. See 12 U.S.C.
Sec. 5223(d)(1)(A).
---------------------------------------------------------------------------
b. Repurchase of warrants
i. Timing of Repurchase. Timing of repurchase is governed
by both statutory and contractual provisions. Treasury is of
the opinion that the contractual provisions are the more
constraining.
The statute originally permitted Treasury to convert a
warrant to cash or exercise it when Treasury decided that doing
so would allow the public reasonable gain from an increase in
the price of the stock involved, and that ``the market [was]
optimal for such assets, in order to maximize the value for
taxpayers.'' \41\ The amendment that eliminated conditions on
redemption of preferred shares also required Treasury to
``liquidate'' the warrants it held when the assistance was
repaid (i.e., when the preferred shares Treasury held were
redeemed).\42\ A further amendment to the same provision
resulted in language that attempts to restore Treasury's
discretion regarding the timing of warrant repurchases.\43\
EESA now provides that Treasury ``may liquidate warrants
associated with such assistance.'' \44\
---------------------------------------------------------------------------
\41\ EESA, supra note 13, Sec. 113(a)(2)(A) (codified at 12 U.S.C.
Sec. 5223(a)(2)(A)).
\42\ ARRA, supra note 23, Sec. 7001.
\43\ Helping Families Save Their Homes Act of 2009, Pub.L. 111-22,
Sec. 403 (May 20, 2009) (online at frwebgate.access.gpo.gov/cgi-bin/
getdoc.cgi?dbname=111_cong_ bills&docid=f:s896enr.txt.pdf) (amending 12
U.S.C. Sec. 5221). Floor statements made by the provision's sponsor and
the committee chairman support a plain meaning analysis and explain
that the sponsors' intentions were to grant Treasury authority to time
warrant repurchases in order to maximize financial returns on the
warrants to taxpayers. See Statement of Senator Jack Reed,
Congressional Record S5114 (May 5, 2009); Statement of Senator
Christopher Dodd, Congressional Record, S5115 (May 5, 2009).
\44\ ARRA, supra note 23, Sec. 7001.
---------------------------------------------------------------------------
The SPAs governing Treasury's purchase of preferred shares
and warrants were executed before the EESA amendment concerning
the timing of warrant repurchases became law. The SPAs grant
the redeeming financial institution the right to repurchase the
warrants upon notice to Treasury (after it has redeemed its
preferred shares).\45\ Treasury staff has informed the Panel
that Treasury is contractually bound by the timing provisions
of the SPAs. In addition, Treasury staff has stated that it is
Treasury's policy to dispose of the government's investments as
soon as practicable.\46\ Therefore, a bank may repurchase its
warrants as soon as it has redeemed its preferred shares.
---------------------------------------------------------------------------
\45\ Securities Purchase Agreement, supra note 15, Sec. 4.9(a).
Though the amended section 111(g) of EESA expressly provides Treasury
discretion as to when to allow repurchase of the warrants, it does not
explicitly override the contracts.
\46\ See U.S. Department of the Treasury, Treasury Announces
Warrant Repurchase and Disposition Process for the Capital Purchase
Program (June 26, 2009) (online at www.financialstability.gov/latest/
tg_06262009.html) (hereinafter ``Treasury Warrant Repurchase
Announcement'') (``The President has clearly stated that his objective
is to dispose of the government's investments in individual companies
as quickly as is practicable.'').
---------------------------------------------------------------------------
Although Treasury is bound by the statute and the
contracts, it does have flexibility both in the negotiation
process and in the inputs used in modeling value. As noted
above, EESA provides that the terms and conditions of the
warrants be designed ``at a minimum . . . to provide for
reasonable participation by the Secretary, for the benefit of
taxpayers, in equity appreciation'' and ``that the Secretary
may sell, exercise, or surrender a warrant . . . based on
[these] conditions.'' \47\ The negotiation step of the
contractual valuation procedure (discussed in detail in the
next section), requires that Treasury and the bank ``promptly
meet to resolve the objection and agree on the Fair Market
Value.'' \48\ In order to provide for ``reasonable
participation in equity appreciation,'' Treasury could take a
tougher negotiating position, possibly resulting in a higher
fair market value. Treasury is not bound as to the basis on
which it will agree or disagree with the bank's proposed fair
market value. Of course, there are many considerations that
Treasury must balance in its decision making, and this is only
one of them.
---------------------------------------------------------------------------
\47\ EESA, supra note 13, Sec. 113(d)(2) (codified at 12 U.S.C.
Sec. 5223(d)(2)).
\48\ Securities Purchase Agreement, supra note 15, Sec. 4.9(c)(ii).
---------------------------------------------------------------------------
If the bank informs Treasury that it will repurchase the
warrants, then it must go through the valuation procedure in
the SPA, described below.
ii. Repurchase Price. From a statutory point of view,
Treasury is required to repurchase warrants ``at market
price.'' \49\ As discussed below, the SPAs executed for each
TARP transaction provide for repurchase of the warrants at
``fair market value,'' reflecting the statutory requirement
that TARP assets are to be sold ``at a price that the Secretary
determines, based on available financial analysis, will
maximize return on investment for the Federal Government.''
\50\
---------------------------------------------------------------------------
\49\ ARRA, supra note 23, Sec. 7001. Initially the statute required
repurchase at a price set by the Secretary, subject to the overriding
condition specified above, namely that the price constitutes ``a
reasonable participation . . . in equity appreciation,'' and
``additional protection against losses from the sale of [TARP] assets .
. .'' ARRA overrode that language to require that warrants be
liquidated at ``current market price,'' and the subsequent amendment
produced the language in the text, calling for liquidation at ``market
price.''
\50\ EESA, supra note 13, Sec. 113(a)(2)(B) (codified at 12 U.S.C.
Sec. 5223(a)(2)(B)).
---------------------------------------------------------------------------
The SPAs set out a procedure for valuing the warrants of a
public bank when the bank invokes its right to repurchase its
warrants.\51\ After a bank has redeemed 100 percent of its
preferred shares (or Treasury has transferred the preferred
shares to an unaffiliated third party), the bank may repurchase
the warrants issued in conjunction with those preferred
shares.\52\
---------------------------------------------------------------------------
\51\ Securities Purchase Agreement, supra note 15, Sec. 4.9.
\52\ Securities Purchase Agreement, supra note 15, Sec. 4.9(a).
---------------------------------------------------------------------------
The first step in this procedure is that the bank's board
of directors must propose the fair market value of the
warrants, using the opinion of an independent, nationally-
recognized investment banking firm. (The Panel assumes that
none of the firms used have, or is an affiliate of a BHC or
bank that has, received TARP assistance and issued TARP
warrants. Were this assumption to prove incorrect, serious
conflict of interest questions would arise.)
The bank's board presents the valuation to Treasury, which
has ten days to object to the valuation. Though it is not
specified in the SPA, Treasury will have determined its own
fair market value, working with outside investment banks and
consultants. Treasury uses several methods to determine fair
market value. These include obtaining quotes from a group of
investment banks and investment companies that have volunteered
their time,\53\ creating their own model using a binomial
American-style options model, performing a fundamental analysis
of the bank, and using outside, paid consultants, who use a
slightly different binomial American style options model.\54\
---------------------------------------------------------------------------
\53\ These investment banks' and investment consultants' names are
not disclosed to the public. They include both domestic and global
entities. Some of the domestic entities' parent companies received CPP
funds. Treasury staff has informed Panel staff that when Treasury
solicits quotes for the warrants, it uses a mix of banks whose parents
have received CPP and those that have not. Treasury has put into place
careful conflict of interest rules governing firms that assist Treasury
with the warrant valuation process.
\54\ The Panel's methodology for determining the fair market value
of the CPP and TIP warrants, and its comparison to Treasury's
methodology, is discussed in detail in Annex A of this report.
---------------------------------------------------------------------------
If Treasury objects to the bank's proposed fair market
value, then representatives of Treasury and the bank have ten
days to meet to resolve the objection and agree on a fair
market value. If Treasury and the bank cannot agree on a fair
market value during that period, either party may invoke the
Appraisal Procedure.
By invoking the appraisal process a bank can require
Treasury to allow it to repurchase the warrants, so long as the
repurchase is made ``as soon as practicable'' after the fair
market value has been determined. The Appraisal Procedure
provides that each party chooses an independent appraiser.\55\
If within 30 days after their appointment, the independent
appraisers cannot agree on a fair market value, a third
appraiser is chosen by mutual consent of the two appraisers.
This third appraiser will provide its fair market value within
30 days of its appointment. The average of all three appraisals
is binding on both Treasury and the bank.\56\ If the bank
wishes to repurchase the warrants, the bank and Treasury are
bound by the appraised value. Treasury staff has told Panel
staff that the bank, however, is not bound to repurchase the
warrants and may revoke its notice exercising its right to
repurchase the warrants; the bank may restart the repurchase
process at any time--unless Treasury has disposed of the shares
in the interim--by initiating a new round of valuations and
subject to the same terms.
---------------------------------------------------------------------------
\55\ The costs of the appraisal process are borne by the bank.
Securities Purchase Agreement, supra note 15, Sec. 4.9(c)(i).
\56\ Securities Purchase Agreement, supra note 15, Sec. 4.9(c)(ii).
If one of the three appraisals is disparate from the middle appraisal
by more than twice the amount that the other appraisal is disparate
from the middle appraisal, such appraisal is disregarded in the
determination of the average.
---------------------------------------------------------------------------
Like a public bank, a private bank may repurchase its
warrants once it has redeemed its preferred shares. Private
bank warrants' values are established in the SPAs at a
specified dollar amount, so they do not go through the same
valuation procedure. As mentioned earlier, Treasury exercises
private bank warrants immediately upon issuance. Private bank
warrants have a liquidation amount of the full value of the
preferred shares that Treasury received on exercise. Therefore,
to repurchase the underlying shares of the warrant, a private
bank must pay five percent of Treasury's non-warrant equity
investment.\57\ H.R. 2745 would, for the period through the end
of September 2009, allow private banks to repurchase the
underlying shares associated with the warrants issued at the
time of the CPP investment at the price that Treasury paid for
the warrants, i.e., one cent per share.\58\
---------------------------------------------------------------------------
\57\ CPP Term Sheet for Private Banks, supra note 36, at 2; See
also Schedule A to Warrant to Purchase Preferred Stock, First Southwest
Bancorporation (Mar. 6, 2009) (online at www.financialstability.gov/
docs/agreements/03202009/First%20Southwest%20Bancorpation.pdf).
\58\ H.R. 2745, supra note 29.
---------------------------------------------------------------------------
If the bank chooses not to repurchase its warrants,
Treasury may sell them to third party investors.\59\ Treasury
has told the Panel that the Secretary had discretion to
determine the time period for liquidating the warrants, and
that in accordance with Treasury policy to dispose of ownership
interests as soon as possible, it will auction the warrants
within several months of a bank's delivery of a substitute
warrant.\60\
---------------------------------------------------------------------------
\59\ At this point, Treasury may sell all the warrants. This is
because when the bank determines that it will repurchase the preferred
shares, it must deliver to Treasury a substitute warrant instrument
that eliminates the 50 percent qualified equity offering adjustment.
See U.S. Department of the Treasury, Acknowledgment of Repurchase
(Public Issuers) (online at www.financialstability.gov/docs/CPP/
UST%20Acknowledgement%20of%20Repurchase%20 (Public%20Issuers).pdf).
\60\ Letter from Secretary Timothy Geithner, U.S. Department of the
Treasury, to Chair Elizabeth Warren, Congressional Oversight Panel
(July 1, 2009) (attached as Appendix II of this report, infra).
---------------------------------------------------------------------------
Alternately, Treasury may choose to exercise the warrant at
any time.\61\ If Treasury has exercised the warrants and still
holds the shares received on exercise, the bank may repurchase
the shares on the open market, or Treasury may sell the shares
to a third party.\62\
---------------------------------------------------------------------------
\61\ If Treasury exercises the warrants before December 31, 2009
and before the preferred shares are repurchased, it may only exercise
half of the warrants, as the other half are subject to cancellation if
the bank makes a qualified equity offering before that date. Securities
Purchase Agreement, supra note 15, Sec. 4.4.
\62\ Securities Purchase Agreement, supra note 15, Sec. 4.9(a).
---------------------------------------------------------------------------
D. Repayments of CPP and TIP Capital Investments
On June 17, nine of the stress-tested BHCs and one other
BHC redeemed their CPP preferred shares from Treasury, in
aggregate returning almost $68.2 billion of taxpayer funds
provided under the TARP. The annualized return on Treasury's
investments in these banks is at least five percent, due to the
required five percent annual dividends paid to CPP preferred
shares.\63\ It will not be possible to calculate an internal
rate of return (IRR) with any precision until Treasury has sold
the warrants it holds for these banks' shares (or sells its
shares after exercising the warrants). However, even after
Treasury sells the warrants for these banks, the IRR realized
on these particular investments--likely the safest of the whole
program--would not be representative of the potential return on
the entire TARP portfolio. (IRRs for the few small banks that
have repurchased their warrants are presented in Section E
below.)
---------------------------------------------------------------------------
\63\ Accrued dividends are paid upon the repurchase of the CPP
preferred shares.
---------------------------------------------------------------------------
Following the results of the stress tests, and the
subsequent capital-raising by BHCs which required a
strengthened capital buffer, the appropriate bank supervisor or
supervisors authorized repayments based on their determination
that these banks possessed adequate capital safety buffers to
absorb losses through 2010 if economic conditions continue to
deteriorate.\64\ Additionally, the banks were required to
satisfy a number of conditions set by the Federal Reserve,
notably the demonstrated ability to access public equity
markets and raise five-year debt without an FDIC guarantee.\65\
The Federal Reserve also evaluated whether repayment would have
an adverse effect on the future operations of the bank or
financial markets.\66\
---------------------------------------------------------------------------
\64\ Only the results of the stress tests under the adverse
scenario were published, which assumed for 2009: a 3.3 percent decline
in GDP, 8.9 percent unemployment, and a 22 point decline in the Case-
Shiller 10-city composite index of housing prices.
\65\ Board of Governors of the Federal Reserve System, Federal
Reserve Outlines Criteria It Will Use to Evaluate Applications to
Redeem U.S. Treasury Capital from Participants in Supervisory Capital
Assessment Program (June 1, 2009) (online at www.federalreserve.gov/
newsevents/press/bcreg/20090601b.htm).
\66\ Id.
---------------------------------------------------------------------------
It should be noted, however, that although these banks are
no longer being supported directly by the TARP, they remain
eligible to use the FDIC's Temporary Liquidity Guarantee
Program,\67\ as well as other indirect support through the
Federal Reserve's various liquidity programs. Except for the
Term Asset-Backed Securities Loan Facility (TALF), which is
currently set to expire at the end of 2009, these programs were
recently extended through February 2010.\68\ All told, the
Federal Reserve's balance sheet has expanded by almost $1.2
trillion since August 2007.\69\
---------------------------------------------------------------------------
\67\ The FDIC's Temporary Liquidity Guarantee Program (TLGP)
essentially guarantees the senior unsecured debt issued by financial
institutions, allowing them in effect to obtain financing at reduced
rates; without the threat of default, the risk premium included in the
interest charged for the debt is reduced substantially. Currently, the
TLGP guarantees some $285 billion of debt of 34 BHCs, thrift holding
companies, and other non-FDIC-insured financial institutions.
\68\ Board of Governors of the Federal Reserve System, Federal
Reserve Announces Extensions of and Modifications to a Number of its
Liquidity Programs (June 25, 2009) (online at www.federalreserve.gov/
newsevents/press/monetary/20090625a.htm).
\69\ See Board of Governors of the Federal Reserve System, Federal
Reserve Statistical Release H.4.1: Factors Affecting Reserve Balances
(July 2, 2009) (online at www.federalreserve.gov/releases/h41/Current/)
(accessed July 2, 2009) (hereinafter ``Fed Balance Sheet July 2'').
FIGURE 1: CPP REPAYMENTS AS OF JULY 2, 2009
----------------------------------------------------------------------------------------------------------------
Date Institution Repurchase amount Bank or BHC type
----------------------------------------------------------------------------------------------------------------
3/31/2009............................... Signature Bank............ $120,000,000 Public
3/31/2009............................... Old National Bancorp...... 100,000,000 Public
3/31/2009............................... Iberiabank................ 90,000,000 Public
3/31/2009............................... Bank of Marin Bancorp..... 28,000,000 Public
3/31/2009............................... Centra Financial 15,000,000 Private
Holdings, Inc./Centra
Bank, Inc..
4/8/2009................................ Sun Bancorp, Inc......... 89,310,000 Public
4/15/2009............................... Shore Bancshares......... 25,000,000 Public
4/22/2009............................... TCF Financial Corporation 361,172,000 Public
4/22/2009............................... Firstmerit Bank, National 125,000,000 Public
Association.
4/22/2009............................... Independent Bank Corp.... 78,158,000 Public
4/22/2009............................... First ULB Corp........... 4,900,000 Private
5/5/2009................................ Sterling Bancshares, Inc. 125,198,000 Public
5/13/2009............................... Texas Capital Bancshares, 75,000,000 Public
Inc..
5/13/2009............................... Alliance Financial 26,918,000 Public
Corporation.
5/20/2009............................... SCBT Financial 64,779,000 Public
Corporation.
5/20/2009............................... Somerset Hills Bancorp... 7,414,000 Public
5/27/2009............................... Washington Federal Inc... 200,000,000 Public
5/27/2009............................... First Niagara Financial 184,011,000 Public
Group.
5/27/2009............................... Berkshire Hills Bancorp, 40,000,000 Public
Inc..
5/27/2009............................... First Manitowoc Bancorp 12,000,000 Private
Inc..
6/3/2009................................ Valley National Bancorp.. 75,000,000 Public
6/3/2009................................ HF Financial Corp........ 25,000,000 Public
6/17/2009............................... JPMorgan Chase & Co...... 25,000,000,000 Public
6/17/2009............................... Morgan Stanley........... 10,000,000,000 Public
6/17/2009............................... The Goldman Sachs Group.. 10,000,000,000 Public
6/17/2009............................... US Bancorp............... 6,599,000,000 Public
6/17/2009............................... Capital One Financial 3,555,199,000 Public
Corporation.
6/17/2009............................... American Express Company. 3,388,890,000 Public
6/17/2009............................... BB&T Corp................ 3,133,640,000 Public
6/17/2009............................... Bank of New York Mellon.. 3,000,000,000 Public
6/17/2009............................... State Street Corporation. 2,000,000,000 Public
6/17/2009............................... Northern Trust 1,576,000,000 Public
Corporation.
--------------------
Total............................. 32 Banks.................. 70,124,589,000
----------------------------------------------------------------------------------------------------------------
E. Valuing TARP Warrants
Before presenting the Panel's estimates of the value of
Treasury's CPP, TIP and Asset Guarantee Program (AGP) warrants,
it is useful to briefly note the major conceptual approaches to
making such estimates and to explain the methodology used by
the Panel. A more detailed discussion of the most widely-used
warrant valuation methodologies and the choices and assumptions
made by the Panel in the approach it used is provided in Annex
A.
1. CONCEPTUAL APPROACHES
An important consideration in valuing a warrant is its
intrinsic value, given by the difference between the current
share price and the warrant's strike price. Intrinsic value
represents the value of the warrant if it were exercised at the
current moment, and is a useful measure of a warrant's worth if
it is close to expiration or if it will be exercised early.
However, intrinsic value reveals only a snapshot value at the
current moment, not what the value of the warrant may be when
it expires or at any other time. It does not take into account
the likelihood that the stock price will increase prior to the
warrant's expiration, a particularly important consideration
given the ten-year term of the TARP warrants. Because intrinsic
value ignores the value of future stock movement, it is not
used by market participants to value the TARP warrants. More
likely, potential investors will value warrants using either
the binomial options pricing model or the Black-Scholes model.
The binomial options pricing model \70\ values a warrant
based on how the price of its underlying shares may change over
the warrant's term.\71\ The binomial model has a number of
advantages that stem from breaking down a warrant's term into a
number of discrete time increments. An analyst using a binomial
model may change his input assumptions at different periods of
the evaluation--for example, the assumed volatility of the
underlying shares' price movements can be varied over time.
Similarly, a binomial model can account for the possibility
that a warrant will be exercised early if the share price
exceeds a certain threshold.
---------------------------------------------------------------------------
\70\ John Cox, Stephen Ross & Mark Rubinstein, Option Pricing: A
Simplified Approach, Journal of Financial Economics (Mar. 1979)
(hereinafter ``CRR Binomial Paper'').
\71\ The binomial model produces a tree of stock prices at
specified time increments, calculates the intrinsic value of the
warrant at expiration (based on the estimated stock price
distribution), and then works backwards through earlier branches to
calculate the current value of the warrant.
---------------------------------------------------------------------------
The Black-Scholes model \72\ has been the industry standard
for option valuation since it was first published in 1973.\73\
The popularity of Black-Scholes is largely based on its ease of
use; it can be calculated on a hand-held calculator with only a
few inputs.\74\ A Black-Scholes valuation is a specific version
of the binomial model in which it is assumed that all inputs
are constant over time. Both derive an expected value for a
warrant based on the probability of the warrant's underlying
share price exceeding its strike price.
---------------------------------------------------------------------------
\72\ Fischer Black & Myron Scholes, The Pricing of Options and
Corporate Liabilities, Journal of Political Economy (1973) (online at
www.math.uwaterloo.ca/mboudalh/BS1973.pdf) (hereinafter ``Black-Scholes
Paper'').
\73\ Mark Rubinstein, Implied Binomial Trees, Journal of Finance
(July 1994) (online at www.haas.berkeley.edu/groups/finance/WP/
rpf232.pdf) (hereinafter ``Implied Binomial Trees'') (``This [the
Black-Scholes] model is widely viewed as one of the most successful in
the social sciences and has [sic] perhaps (including its binomial
extension) the most widely used formula, with embedded probabilities,
in human history.'').
\74\ The inputs of the Black-Scholes model are the strike price of
the option, the underlying stock price, the time to expiration of the
option, the risk-free interest rate, the volatility of the underlying
stock price, and the dividend yield of the underlying stock.
---------------------------------------------------------------------------
As is true of all models, the validity of either a Black-
Scholes or a binomial analysis depends on the input assumptions
used. If one uses equivalent assumptions, these models tend to
produce very similar results.\75\ The most significant cause of
divergence between different warrant valuations comes from the
assumptions made about the future volatility and dividend yield
of the underlying shares. Future volatility is particularly
difficult to predict. Nonetheless, nearly all market
participants, government agencies, specialist firms and
corporations value warrants through models that use future
volatility as an input.\76\ Future volatility can be estimated
in a number of ways, resulting in a range of possible
volatility assumptions and a range of possible warrant
values.\77\
---------------------------------------------------------------------------
\75\ Mathematically, Black-Scholes is essentially the limit of the
binomial model as the number of steps taken approaches infinity. A
binomial valuation, given the same assumptions, thus converges on the
Black-Scholes valuation.
\76\ See, e.g., Congressional Oversight Panel, Duff & Phelps
Final Valuation Report to the Congressional Oversight Panel
(Feb. 4, 2009) (online at cop.senate.gov / documents / cop-020609-
report-dpvaluation.pdf); Financial Accounting Standards Board,
Statement of Financial Accounting Standards No. 123 (Oct. 1995) (FSP
FAS 157-4) (online at www.fasb.org / cs / BlobServer? blobcol =
urldata&blobtable = MungoBlobs&blobkey = id&blobwhere =
1175818755677&blobheader=application%2Fpdf); Congressional Budget
Office, The Troubled Asset Relief Program: Report on Transactions
Through June 17, 2009 (June 2009) (online at www.cbo.gov/ftpdocs/100xx/
doc10056/06-25-TARP.pdf).
\77\ Consider the example of a warrant to buy one share of Company
X at $150 that expires in one year. X's common stock is currently
trading at $100 and the risk free rate (i.e., the Treasury rate) is one
percent. Under Black-Scholes, if X's stock price volatility is modeled
at 30 percent, the warrant would be valued at $1.59; with volatility at
60 percent, the warrant would be valued at $10.91. If the volatility is
below 15 percent, the warrant is estimated to be worth less than three
cents.
---------------------------------------------------------------------------
There are two commonly used methods for estimating the
future volatility of a stock. The first is to calculate
volatility from historical prices changes. Many different
volatility assumptions for the binomial or Black-Scholes Models
can be justified from historical figures. An analyst's choice
of the time period over which he or she will measure historical
volatility as an estimate of future volatility can have a large
effect on a valuation. As the past two years have been
particularly turbulent, the volatility figures derived from
this period are high and may not be representative of the
volatility of bank stock prices over the next ten years, and
will likely overvalue the warrants. On the other hand, using
volatilities calculated from the past ten years may undervalue
warrants if one believes that bank shares will be more volatile
over the next decade than they have been in the previous one.
The second approach to estimating future stock price
volatility is to use implied volatility from the market. While
implied volatility has certain drawbacks, particularly the fact
that the market's implied volatility may be over a different
future time period than the term of the warrant being
valued,\78\ using implied volatility to value a warrant
provides a better picture of ``fair market value'' because it
uses actual market information to estimate this important input
assumption.
---------------------------------------------------------------------------
\78\ For example, across most banks for which there are data, the
market is expecting volatility to decrease over time. Thus, using short
term implied volatility to value long term warrants would overvalue the
warrants.
---------------------------------------------------------------------------
2. METHODOLOGY USED IN THIS REPORT \79\
---------------------------------------------------------------------------
\79\ A full discussion of the Panel's methodology is included in
Annex A.
---------------------------------------------------------------------------
The Panel adopted a modified Black-Scholes analysis to
value the warrants held by Treasury.\80\ As discussed in Annex
A, the modifications were necessary to account for two aspects
of the TARP warrants that distinguish them from the type of
options Black-Scholes was designed to analyze: dilution \81\
and dividend yield.\82\ The Panel did not apply a liquidity
discount in its valuation. If Treasury can hold the warrants to
expiration, then the value of the warrants to Treasury should
not include a liquidity discount because Treasury does not need
to sell them. Further, any liquidity discount for the larger
institutions, whose warrants constitute the bulk of Treasury's
portfolio by value, would likely be small since their shares
are heavily traded.
---------------------------------------------------------------------------
\80\ In applying the Black-Scholes model rather than a binomial
model, the Panel assumed that the risk free rate, the dividend yield,
and the stock price volatility of each bank would be constant through
time. Market participants and finance professors with whom Panel staff
consulted thought these were reasonable assumptions given the purposes
of the analysis.
\81\ Unlike options, which grant a claim to already-issued stock,
the exercise of a warrant requires the company to issue new common
shares, which has the effect of reducing the percentage of the company
owned by existing shareholders (known as ``dilution'').
\82\ Dividend yield represents an investor's return on investment
if the stock is not sold, calculated by the ratio of annual dividends
per share to share price.
---------------------------------------------------------------------------
The Panel developed high, low and best estimates for the
value of the warrants that Treasury held on July 6, 2009, based
on varying estimates of stock price volatility. In the high
estimate, the volatility input for each bank was the maximum of
several historical and implied volatility measures of its stock
price.\83\ In the low estimate, the volatility input for each
bank was the minimum of the same set of volatility measures. In
the best estimate, the volatility input for 18 of the banks was
derived from the implied volatility of publicly-traded, long
dated options on those banks' shares. The warrants for these 18
banks' shares represent 89 percent of the total value of
Treasury's warrant portfolio. For the remaining banks, the best
estimate volatility input for each bank was the longest of the
available one, two, five and ten year historical volatility
measures of the bank's share price.\84\ For all estimates, each
bank's dividend yield input was set equal to its five-year
average dividend yield. The only difference in assumptions for
the three estimates was the volatility input.\85\
---------------------------------------------------------------------------
\83\ These Panel's measures were: the (i) two, (ii) five and (iii)
ten year historical volatilities ending on July 2, 2009; the ten year
historical volatilities ending on (iv) July 2, 2008, (v) July 2, 2007,
(vi) July 3, 2006, (vii) July 4, 2005, (viii) July 2, 2004, (ix) July
2, 2003, (x) July 2, 2002, (xi) July 2, 2001, (xii) July 3, 2000,
(xiii) July 2, 1999; and (xiv) the midpoint of implied volatilities of
call and put options on the underlying stock expiring after Dec 31,
2010 as calculated on July 2, 2009. When any of these measures was
unavailable, it was removed from the set of possible volatility inputs.
All historical volatilities were calculated from daily returns,
adjusted for dividends and capital changes.
\84\ The implied volatility input for each bank was set equal to
the midpoint of implied volatilities of call and put options on the
bank's shares expiring after Dec. 31, 2010 as calculated on July 2,
2009.
\85\ All three estimates used each bank's closing price on July 2,
2009 as the model's share price input. The risk free rate input was
calculated as the yield on ten year Treasury bonds on July 2, 2009,
adjusted to be made continuous.
---------------------------------------------------------------------------
As noted above in Section C, the CPP warrants have a
reduction provision such that if a recipient bank has a QEO of
100 percent of the CPP investment by the date of the preferred
redemption or December 31, 2009, whichever comes sooner, then
half of Treasury's warrants are eliminated.\86\ To simplify the
analysis, the Panel assumed that unless a BHC had already
redeemed its preferred and held a QEO by July 2, 2009, then it
would not do so by the end of this year. This seems a
reasonable assumption considering that of the 32 banks which
had redeemed their preferred shares by July 2, 2009, only three
had a QEO prior to repayment.\87\ To the extent that there is a
possibility that CPP-recipient banks will have QEOs prior to
redeeming their TARP preferred shares or the end of the year,
the Panel's valuation of the warrants should be discounted
accordingly.
---------------------------------------------------------------------------
\86\ See supra notes 34, 35, and accompanying text.
\87\ These three banks were State Street, First Niagara and
Iberiabank. U.S. Department of the Treasury, Troubled Asset Relief
Program: Transactions Report For Period Ending June 30, 2009 (July 2,
2009) (online at www.financialstability.gov/docs/transaction-reports/
transactions-report_070209.pdf).
---------------------------------------------------------------------------
Using Black-Scholes, the Panel also estimated the value of
the warrants that Treasury has already sold.\88\ These
valuations were performed as of the date of the sale to enable
a comparison between the fair market value of the repurchased
warrants, as calculated by Black-Scholes, and the compensation
Treasury actually received for them.\89\ Other than adjusting
for the transaction dates, the Panel used the same methodology
for valuing the past sales as that applied to outstanding TARP
warrants.
---------------------------------------------------------------------------
\88\ As of July 2, 2009, 11 banks have repurchased their warrants:
Treasury sold its warrants in Old National Bank, Iberiabank,
FirstMerit, Sun Bancorp, Alliance Financial, Independent Bank Co.,
First Niagara Financial Group, Berkshire Hills Bancorp, Somerset Hills
Bancorp, HF Financial and SCBT Financial. No third party buyers were
involved in these transactions--Treasury sold the warrants back to the
banks which originally issued them--and only Iberiabank and First
Niagara had conducted a QEO by the time the warrants were sold. Id.
\89\ The valuations of Treasury's remaining portfolio of warrants
on July 6, 2009 cannot be compared against future transactions that
involve these warrants as the values of the warrants can change over
time. Transactions can only be evaluated against fair market value on
the date of the transaction.
---------------------------------------------------------------------------
The Panel was aided in its valuation efforts by three
finance experts, Professor Robert Merton, Professor Daniel
Bergstresser and Professor Victoria Ivashina, all of the
Harvard Business School. These three professors independently
reviewed both the technical valuation model and the assumptions
that were built into the models; they concluded that the
approaches reported here were reasonable and that they produced
reliable estimates.
3. RESULTS
The Panel's high, low and best estimates for the aggregate
value of Treasury's warrants as of July 6, 2009 are $12.3
billion, $4.7 billion and $8.1 billion, respectively. The range
between the Panel's high and low estimates is driven by
different volatility assumptions in the Black-Scholes model.
The future volatility and dividend yield of the banks'
underlying shares are difficult to predict.\90\ The Panel
accounted for this uncertainty by casting a wide net across
what it considers reasonable boundaries in developing high and
low volatility estimates.
---------------------------------------------------------------------------
\90\ Conversely, strike price, expiration date, underlying share
price and the risk free rate are all known or easy to estimate.
---------------------------------------------------------------------------
As shown in figure 2, the Panel's valuation of the warrants
falls within the same broad ranges as the estimates of Credit
Suisse, University of Louisiana at Lafayette Assistant
Professor Linus Wilson, and Bloomberg.\91\ It is important to
remember that these studies were performed on different dates,
so some variation would be expected. Among other reasons for
these studies being incompatible, the value of Treasury's
warrants is highly correlated to the fluctuating share prices
of CPP-recipient banks. To the extent that these shares have
changed in value between the dates of the different valuation
analyses, the warrants have altered in value accordingly.
---------------------------------------------------------------------------
\91\ See Linus Wilson, Valuing the First Negotiated Repurchase of
the TARP Warrants (May 23, 2009) (online at http://papers.ssrn.com/
sol3/papers.cfm?abstract_id=1404069) (Professor Wilson examines Old
National Bancorp, the first of the CPP recipient banks to repurchase
its CPP warrants. He concludes that the warrants were sold back to Old
National Bancorp at a discounted price.); Linus Wilson, A Model for
Estimating the Cancellation Probabilities of TARP Warrants, University
of Louisiana at Lafayette (June 16, 2009) (online at http://
papers.ssrn.com/sol3/papers.cfm?abstract_id=1413442) (hereinafter
``Wilson Cancelation Probabilities'') (Professor Wilson creates a model
for estimating the value, and likelihood of cancelation, of TARP
warrants. The established formula can be used in evaluating Treasury's
negotiation performance.); Edward Tom and Sveinn Palsson, The Valuation
of TARP Warrant (Part I and II)s, Credit Suisse Research Report (May
26, 2009, June 2, 2009) (hereinafter ``Credit Suisse Warrant Report'')
(Credit Suisse used 10 year mean realized volatility to calculate a
Black-Scholes value for the CPP investments in the 19 stress-tested
banks, coming up with a median estimate of $5.7 billion, and a range of
$5.2 to $7.8 billion); Mark Pittman, TARP Warrants Show Banks May Reap
``Ruthless Bargain'', Bloomberg (May 22, 2009) (online at
www.bloomberg.com/apps/news?pid=20601206&sid=ae2fQFMrDer4) (hereinafter
``Bloomberg Warrant Article'').
FIGURE 2: COMPARISON OF PANEL'S VALUATION WITH OTHER VALUATIONS
[All values are presented in millions]
----------------------------------------------------------------------------------------------------------------
COP Valuation of Comparable (as
of 7/6/09)
Valuation by Valuation of Result --------------------------------
Low Best High
----------------------------------------------------------------------------------------------------------------
Credit Suisse 92 (6/2/09)............... Stress Test Banks ex. $5,680 $3,470 $5,590 $8,410
Keycorp (CPP Warrants
only).
Linus Wilson 93 (6/10/09)............... Stress Test Banks (CPP, 9,900 3,930 6,960 10,630
TIP, and AGP).
Bloomberg 94 (5/22/09).................. JPMorgan, Morgan Stanley, 4,000 2,400 2,830 4,120
and Goldman Sachs.
CBO 95 (6/17/09)........................ CPP Warrants Only......... 6,000 4,310 6,940 10,520
----------------------------------------------------------------------------------------------------------------
\92\ Credit Suisse Warrant Report, supra note 91. Credit Suisse used standard volatilities to calculate a Black-
Scholes value for the CPP investments in the 18 of the 19 stress tested BHCs (it did not value warrants in
Keycorp), producing a median estimate of $5.7 billion, and a range of $5.2 to $7.8 billion.
\93\ Wilson Cancelation Probabilities, supra note 91. Wilson estimates the value of the warrants held by the
government for the 19 stress test banks using the same model as the Panel (Black-Scholes-Merton modified with
Galai-Schneller). The higher estimates he obtained are likely the result of differing volatility assumptions.
Wilson calculates implied volatilities derived from short term options, which represent the market's
prediction of variations in stock price over the next few months. For most securities, such short-term
predictions tend to be much higher than what the market's prediction of volatility would be for longer periods
such as those for which the warrants are available to be exercised (10 years). Wilson's methodology also
adjust for the predicted likelihood of qualified equity offerings by BHCs, a step considered unnecessary by
the Panel.
\94\ Bloomberg Warrant Article, supra note 91. Information on methodology is unavailable. Bloomberg does not
break down its valuations by individual BHC.
\95\ The CBO analysis did not consider the effect of Treasury's requirement that banks which repay their
preferred before Dec. 31, 2009 must sell their warrants immediately or replace Treasury's warrants with
substantially similar ones that are stripped of the QEO provision.
Most of the value of Treasury's portfolio of warrants comes
from only a few banks. By value, the warrants in JP Morgan
Chase, Bank of America, Morgan Stanley, Goldman Sachs,
Citigroup and Wells Fargo account for 70 percent of the total
value. Figure 3 below shows high, low and best estimates for
Treasury's ten most valuable holdings of warrants.
FIGURE 3: PANEL ESTIMATE OF VALUE OF WARRANTS
[All values are presented in millions]
----------------------------------------------------------------------------------------------------------------
Low High Best
Institution Investment date estimate estimate estimate
----------------------------------------------------------------------------------------------------------------
Bank Of America........................... 10/28/08, 1/9/09 & 1/16/09... $430 $1,850 $1,130
JP Morgan Chase........................... 10/28/08..................... 660 1,560 1,020
Wells Fargo & Co.......................... 10/28/08..................... 340 1,480 1,020
Goldman Sachs Group....................... 10/28/08..................... 940 1,250 940
Morgan Stanley............................ 10/28/08..................... 800 1,310 870
Citigroup................................. 10/28/08, 12/31/08 & 1/16/09. 70 1,030 560
American Express.......................... 1/9/09....................... 220 370 300
PNC Financial Services Group.............. 12/31/08..................... 70 330 190
Bank Of New York Mellon................... 10/28/08..................... 120 240 160
Capital One Financial..................... 11/14/08..................... 110 210 140
All Other Banks........................... ............................. 950 2,640 1,720
--------------------------------
----------------------------------------------------------------------------------------------------------------
In its analysis of warrants already repurchased, the Panel
finds that, in general, Treasury has been selling its warrants
back to banks at below market value. In the aggregate, Treasury
sold its warrants in these banks for $18.7 million. Figure 4
below compares the repurchase price paid by these 11 banks and
the Panel's valuation of the warrants on the date of
repurchase. It also shows Treasury's total internal rate of
return (IRR) on its investments in each of these banks,
including its return on preferred shares and warrants. A more
complete discussion of the sources of the difference between
Treasury's results and the Panel's estimates of the value of
the warrants sold to date in the context of one particular such
warrant sale, Old National Bancorp, can be found in Annex B.
FIGURE 4: WARRANT REPURCHASES AS OF JULY 2, 2009
[All values presented in thousands]
--------------------------------------------------------------------------------------------------------------------------------------------------------
Panel
Institution Inv. date QEO 96 Repurchase Repurchase valuation Price/est. IRR 97
date amount (best est.) (percent) (percent)
--------------------------------------------------------------------------------------------------------------------------------------------------------
Old National......................... 12/12/08............... No..................... 5/8/09 $1,200 $2,150 56 9.3
Iberiabank........................... 12/5/08................ Yes.................... 5/20/09 1,200 2,010 60 9.4
FirstMerit........................... 1/9/09................. No..................... 5/27/09 5,052 4,260 118 20.3
Sun Bancorp.......................... 1/9/09................. No..................... 5/27/09 2,100 5,580 38 15.3
Independent Bank..................... 1/9/09................. No..................... 5/27/09 2,200 3,870 57 15.6
Alliance Financial................... 12/19/08............... No..................... 6/17/09 900 1,580 57 13.8
First Niagara Financial.............. 11/21/08............... Yes.................... 6/24/09 2,700 3,050 89 8.0
Berkshire Hills...................... 12/19/08............... No..................... 6/24/09 1,040 1,620 64 11.3
Somerset Hills....................... 1/16/09................ No..................... 6/24/09 275 580 48 16.6
SCBT Financial....................... 1/16/09................ No..................... 6/24/09 1,400 2,290 61 11.7
HF Financial......................... 1/21/09................ No..................... 6/30/09 650 1,240 52 10.1
--------------------------
--------------------------------------------------------------------------------------------------------------------------------------------------------
\96\The issue is discussed infra Part C Section one of this report. Upon a qualified equity offering, the number of shares underlying Treasury's
warrants is halved.
\97\This is the total return Treasury has received on its investment in each bank. The calculation includes returns from dividends, preferred shares
repayments and warrant repurchases. The IRRs in this figure very slightly underestimate the actual rate of return because the Panel assumed that all
dividends were paid on the date of repurchase of the preferred, when in fact they were paid quarterly.
The results show that in its sales of warrants Treasury has
received about 66 percent of the Panel's best estimate of fair
market value. These results may suggest that Treasury has not
been successful in receiving fair market value for its warrants
and in maximizing taxpayer returns. On the other hand, factors
not included in the Panel's model, such as the illiquidity of
the warrants--especially for smaller institutions--may explain
the difference between the amount that Treasury has received
for its sold warrants and the Panel's valuation of those
warrants.
In interpreting these results, it is important to bear in
mind the scale of the warrant repurchases as compared to the
total warrant portfolio. The sold warrants represent less than
one quarter of one percent of the Panel's best estimate of the
value of Treasury's warrant portfolio on July 6, 2009. Thus,
these sold warrants represent a very small slice of the
outstanding warrants, and Treasury's relative performance in
selling them may not accurately predict its success in selling
the balance of the warrants it holds.
The results also show that Treasury received a 12 percent
rate of return on the 11 CPP investments in public banks that
have fully exited the TARP. However, this rate of return is not
predictive of the rate of return Treasury will receive across
its entire TARP portfolio because it only reflects the return
on these 11 early repaying banks. These banks are among the
healthiest of the TARP-recipient banks and thus Treasury's
return on these banks is likely to be higher than its return on
its aggregate TARP investment.\98\ Further, this rate of return
does not factor in the likelihood that some banks, including
systemically significant institutions, may be unable to repay
their TARP investments.
---------------------------------------------------------------------------
\98\ Each bank's TARP repayment is conditioned on that bank's
supervisors finding that the bank is sufficiently capitalized to no
longer need a government investment. Thus, only healthy banks have been
able to repay. Supra note 23.
---------------------------------------------------------------------------
F. Alternatives for Disposing of TARP Warrants
Although, thus far, Treasury has sold warrants back only to
the banks which issued them, as discussed in Section C it may
sell the warrants to any party subject to the following two
restrictions: first, before December 31, 2009, or, if earlier,
the date when a bank redeems its preferred, Treasury may sell
only half of its warrants in that bank; second, after a bank
redeems its preferred it may negotiate to repurchase its
warrants, and, if this fails, the bank may invoke an appraisal
procedure which leads to a binding price at which Treasury must
sell.\99\
---------------------------------------------------------------------------
\99\ The issue is discussed supra in Part C of Section One of this
report.
---------------------------------------------------------------------------
Thus, Treasury's options are dictated by whether a bank has
redeemed its preferred shares. Before a bank redeems its
preferred, Treasury can sell half of its warrants in that bank
to any party. After a bank redeems its preferred, Treasury must
allow that bank a chance to negotiate the repurchase of its
warrants if the bank wishes to do so. If the negotiations reach
an impasse and the appraisal procedure is not invoked, or if
the procedure is invoked but the bank is not willing to
purchase at the resulting binding price, then Treasury can sell
all of its warrants in that bank on the open market. In other
words, if the parties cannot agree on a price and if the bank
is unwilling to purchase at the price determined by the
appraisers, then Treasury may sell its warrants through a
public auction or other public sale.
1979 CHRYSLER LOAN GUARANTEE
The federal government has received warrants before in
exchange for providing credit support to ensure a company's
viability. The federally-guaranteed loan made to a teetering
Chrysler Corporation in 1980 is one example. In that case, the
federal government seemed to make a profit on its loan to
Chrysler when the warrants were sold.
The Chrysler Corporation Loan Guarantee Act of 1979 was
officially signed into law on January 7, 1980. It created the
Chrysler Corporation Loan Guarantee Board, which was
responsible for determining the conditions for making a
commitment to guarantee third party loans to Chrysler. Any
loans made under the Act had to be repaid by December 30, 1990,
and the amount outstanding at any time was not to exceed $1.5
billion.\100\
---------------------------------------------------------------------------
\100\ Chrysler Corporation Loan Guarantee Act of 1979, Pub. L. No.
96-185.
---------------------------------------------------------------------------
Chrysler used $1.2 billion of the $1.5 billion in loan
guarantees. In return for the loan guarantees, the federal
government received warrants to purchase 14.4 million shares of
Chrysler stock at $13 per share until 1990.\101\ At the time
they were granted in 1980, Chrysler stock was selling for about
$5 a share.
---------------------------------------------------------------------------
\101\ Id.
---------------------------------------------------------------------------
After receiving the loans, Chrysler's fortunes changed for
the better. Between 1980 and 1982, the corporation downsized a
significant amount of its operations, cutting roughly half of
its work force,\102\ and quickly returned to
profitability.\103\ By the first half of 1982, the company made
a profit of $482.2 million. It repaid its government guaranteed
notes in June and August of 1982.\104\
---------------------------------------------------------------------------
\102\ Thomas J. Lueck, Chrysler Tops Bids to Buy Back Stock Rights,
New York Times (Sep. 13, 1983).
\103\ Id.
\104\ Id.
---------------------------------------------------------------------------
The U.S. government auctioned the Chrysler warrants on
September 12, 1983. At the auction, Chrysler purchased the
warrants for $311 million.\105\ Chrysler officials said that
they sought to avoid having the warrants converted into common
shares because conversion would dilute the value of the current
shares. The stocks that the warrants purchased represented 12
percent of Chrysler's shares outstanding. Chrysler also had the
option of retiring the warrants at no cost. It chose not do so,
though, because it did not want to forgo $187 million in income
it could earn from the exercise of the warrants.\106\
---------------------------------------------------------------------------
\105\ Id.
\106\ Id.
---------------------------------------------------------------------------
Whether or not Treasury actually made a profit on the sale
of its Chrysler warrants is subject to debate. Prior to 1992,
federal loan guarantees were treated as a contingent liability
of the U.S. government for budgetary purposes. As a result, a
loan guarantee resulted in no cost to the budget unless and
until the guarantee was called and resulted in an actual loss.
Under this budgeting convention, the federal government could
show a $311 million profit on its loan guarantees and warrant
for Chrysler Corporation in the early 1980s. Today, however,
the cost of a similar loan guarantee would require an upfront
appropriation to cover the possibility of default. No such
estimate was made at the time, however, so it cannot be
determined whether such an estimate would have been greater or
less than the $311 million the government received upon sale of
the warrants.
1. SELLING TARP WARRANTS THROUGH NEGOTIATION WITH THE BANKS
Treasury sold its warrants in Old National Bank,
Iberiabank, FirstMerit, Sun Bancorp, Alliance Financial,
Independent Bank Co., First Niagara Financial Group, Berkshire
Hills Bancorp, Somerset Hills Bancorp, HF Financial and SCBT
Financial through exclusive negotiations with the issuing
banks. These banks initiated the negotiations by first
redeeming Treasury's preferred shares and then invoking their
right to repurchase the warrants they had issued to Treasury.
None of these banks invoked the appraisal procedure; they all
reached a negotiated agreement with Treasury on the price to be
paid for the warrants.
When negotiating with a bank on the repurchase price of
that bank's warrants, Treasury makes an assessment of the
warrant's fair market value. Treasury's valuation process has
four inputs: comparable market data, warrant pricing models,
fundamental company analysis and an outside consultant's
appraisal.\107\ First, Treasury finds comparable securities
that are publicly traded and solicits quotes from market
participants on the warrants being valued to develop a market
perspective of their fair value. Second, Treasury utilizes an
American-style binomial option pricing model and a Black-
Scholes option pricing model to develop a theoretical value for
the warrants. Treasury calculates the volatility input for this
model from both implied and historical volatility measures--
Treasury uses the average 60-day trailing volatility for the
last ten years to determine a stock's historical volatility.
For each bank, Treasury develops a dynamic volatility curve,
which generally shows volatility decreasing over time from
current levels to historic norms.\108\ Third, Treasury performs
a fundamental analysis of the repurchasing bank's performance,
looking at growth projections, price-to-book ratios, and other
indicators of financial health. Fourth, Treasury obtains an
outside consultant's appraisal of the warrants. In addition to
the four inputs, Treasury may also include a liquidity discount
in its valuation of the warrants. This discount ranges from
zero to 50 percent and is determined by analyzing factors such
as (1) a potential buyer's ability to hedge its warrant
position by shorting the company's stock, and (2) the volume of
shares traded. An additional discount may be applied for
insolvency risk over the ten-year period. Using these inputs,
Treasury develops a range of acceptable values at which it will
sell the warrants. It should also be noted that Treasury has
devoted a team to valuing the warrants and that each warrant
sale must meet the approval of a four-person committee and the
Assistant Secretary for Financial Stability.\109\
---------------------------------------------------------------------------
\107\ On June 26, 2009 Treasury released information on its
valuation procedure. In conversations with Panel staff, Treasury
provided further insight into its method. Treasury Warrant Repurchase
Announcement, supra note 46.
\108\ Generally, the blended volatility of this curve is slightly
above the historical ten-year volatility of repurchasing bank's shares.
\109\ U.S. Department of the Treasury, Treasury Announces
Repurchase and Disposition Process for the Capital Purchase Program
(June 26, 2009) (online at www.financialstability.gov/docs/CPP/Warrant-
Statement.pdf).
---------------------------------------------------------------------------
This is a sophisticated valuation procedure and likely
results in a reasonable valuation for the warrants.
Nonetheless, it may not produce a maximization of taxpayers'
return on the warrants. As discussed above, for the warrants it
had sold by July 2, 2009, Treasury only received 66 percent of
the Panel's best estimate valuation. There are several reasons
why this may be the case.
Treasury may be generous to banks in its valuation of the
warrants. Treasury is restricted by the terms of its warrant
contracts, which require it to give banks the right to
repurchase their warrants at ``fair market value.'' This is a
nebulous term in the absence of market exchanges, so Treasury
has considerable leeway in determining the fair market value
for which it will sell the warrants. Treasury's model may lead
to a lower valuation than is necessary in at least two ways.
First, Treasury's use of average 60-day trailing volatility
over ten years as its measure of historical volatility leads to
a lower volatility model input and a lower warrant valuation
than would the use of other historical volatility
measures.\110\ Other measures, such as historical daily
volatility, as used by the Panel, result in higher volatility
inputs and higher valuations. These other, higher volatility
measures are in common use and are legitimate inputs for option
pricing models. Second, Treasury includes significant liquidity
discounts in valuing the warrants. If Treasury can hold the
warrants to expiration, it is not clear that their valuation
should include a liquidity discount at all.\111\ Even if a
liquidity discount is merited, the discount Treasury applies is
significantly larger than that used by other accredited
valuation firms.\112\
---------------------------------------------------------------------------
\110\ Treasury's measure of historic volatility, average 60-day
trailing volatility for ten years, is distinct from ten year historic
volatility. When calculated for the same time period, the two measures
will vary significantly because they are different mathematical
computations. Inputting Treasury's measure of historic volatility, the
average 60-day trailing volatility for ten years, into the Panel's
model results in a valuation of $5.5b for Treasury's outstanding
warrants. By comparison, the Panel derived its volatility assumptions
from implied volatilities for some banks and ten year historical
volatilities for the rest of the banks, valuing the warrants at $8.1b.
Using only the ten year historic volatilities for all of the banks
results in a valuation of $7.5b.
\111\ The issue is discussed infra in Part C of Section One and
Annex B of this report.
\112\ In its February report to the Panel on the value of
Treasury's TARP assets, the valuation firm Duff and Phelps' used a zero
to 20 percent liquidity discount range. Duff and Phelps, Valuation
Report to the Congressional Oversight Panel (Feb. 4, 2009) (online at
cop.senate.gov/documents/cop-020609-report-dpvaluation.pdf).
---------------------------------------------------------------------------
Further, banks may not be willing to pay as much as other
market participants for warrants in their own equity. The only
way Treasury can maximize taxpayers' return on their investment
is to sell its warrants to the buyers who are willing to pay
the best price. To the extent that a bank is unwilling to pay
as much as other market participants, a two-party exclusive
negotiation process necessarily fails to maximize returns
because it excludes other buyers who may be willing to pay
higher prices. On the other hand, it is possible that a bank
will actually pay a premium over other market participants to
keep its warrants from trading into unknown hands in the
market.
Finally, in conversations with Panel staff, Treasury staff
has explained that its valuation model is designed to arrive at
a ``correct and reasonable'' valuation, not a valuation that
maximizes taxpayer returns. Treasury then uses this valuation
as its first bid in negotiations with each repurchasing bank.
To the extent that Treasury's initial valuation is then lowered
as part of the negotiation process, Treasury's good faith
effort to reach agreement is resulting in valuations that are
below its own model's valuation of fair market value. On the
other hand, Treasury is contractually obligated to negotiate.
The warrant contracts stipulate that if Treasury rejects a
bank's valuation of its warrants, then it must work to
``resolve the objection[s] and to agree upon a Fair Market
Value.'' \113\
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\113\ Securities Purchase Agreement, supra note 15, at Sec. 4.9.
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2. SELLING WARRANTS TO THE MARKET
Treasury would be more likely to maximize taxpayer returns
if it sold the warrants through auctions. The reason is
straightforward: an auction would cause the warrants to be
allocated to the buyers willing to pay the highest price, and
competitive pressures in the bidding process may push bids up.
By setting proper reserve values, Treasury can protect itself
against a failed auction and ensure that it will at least
receive fair market value. Equally important, auctions can put
upward pressure on negotiated transactions by setting new,
higher transaction precedents and by showing that a secondary
market for these warrants exists, leading to a smaller
liquidity discount in the negotiated transactions.
Selling the warrants through auctions would have auxiliary
policy benefits to Treasury. Auctions would enable Treasury to
sell at least half of its warrants immediately. By returning
these warrants to the private market, auctions would further
Treasury's aim of exiting its equity positions in TARP-
recipient banks as soon as possible. Auctions would also
require significantly less time commitment from Office of
Financial Stability (OFS) staff and could easily be outsourced
if Treasury preferred. Finally, auctions would have the
additional benefit of promoting transparency in Treasury's
disposition of the warrants.
To be sure, there are obstacles to using an auction
process. Banks have the contractual right to an exclusive
negotiation for their warrants following the redemption of
their preferred shares. Thus, there is a period following a
bank's redemption of its preferred shares when Treasury cannot
auction its warrants in that bank. However, Treasury may
auction half a bank's warrants even before the bank redeems its
preferred. Treasury could initiate this process immediately.
More importantly, Treasury could use the threat of an auction
as a bargaining chip in discussions with banks to ensure that
negotiated transactions are consummated at fair market value.
Selling some warrants through auctions would make it clear to
all banks that Treasury has well-developed and viable options
if the bank does not offer an adequate price for the warrants.
Other obstacles are related to whether there are sufficient
bidders for auctions to be successful. It is possible that the
illiquidity of these securities--especially for smaller
institutions--will cause investors to stay away, and many
potential bidders are banks that may be restricted from bidding
because of regulations on inter-bank ownership. Interest may be
further depressed by investor concerns regarding the risk of
bank insolvency over the warrants' ten year horizon, the
limited ability of investors to hedge the warrants, and
pessimism about the bank sector in general. Further, rather
than buy Treasury's warrants in any given bank, an investor may
find it much simpler to invest in the bank directly or to buy
call options. On the other hand, it is hard to believe that an
auction with a proper reserve value would ever achieve a lower
valuation than a negotiation.
Ultimately, open market transactions are the only way to
determine true ``fair market value.'' In his testimony before
the Panel on June 24, 2009, Assistant Secretary Allison
explained this in relation to the toxic assets on bank balance
sheets: ``We can have our theories, [but] in the last analysis
that's why you have financial markets. You have to have liquid
interchanges and then the truth will come out as to what the
assets are actually worth.''\114\ The same should be said about
pricing Treasury's warrants.
---------------------------------------------------------------------------
\114\ Congressional Oversight Panel, Testimony of Assistant
Treasury Secretary for Financial Stability Herbert Allison, Jr.,
Hearing with Assistant Treasury Secretary Herbert Allison (June 24,
2009) (online at cop.senate.gov/hearings/library/hearing-062409-
allison.cfm).
---------------------------------------------------------------------------
G. Issues
In reaching a judgment with the bank supervisors to allow a
particular bank to repay its TARP assistance and in determining
the price, time and manner at which it will sell the warrants
it holds in that bank, Treasury must take into account two
overriding statutory considerations:
(1) protecting the interests of taxpayers by
maximizing overall returns and minimizing the impact on
the national debt; [and] (2) providing stability and
preventing disruption to financial markets in order to
limit the impact on the economy and protect American
jobs, savings, and retirement security.\115\
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\115\ EESA, supra note 13, Sec. 103 (1) and (2) (codified at 12
U.S.C. Sec. 5213(1) and (2)). Sec. 5213 lists seven additional facts
that Treasury must take into consideration in administering EESA.
EESA also recognizes that the two objectives complement one
---------------------------------------------------------------------------
another:
The Secretary shall use the authority under this Act
in a manner that will minimize any potential long-term
negative impact on the taxpayer, taking into account
the direct outlays, potential long-term returns on
assets purchased, and the overall economic benefits of
the program, including economic benefits due to
improvements in economic activity and the availability
of credit, the impact on the savings and pensions of
individuals and reductions in losses to the Federal
Government.\116\
---------------------------------------------------------------------------
\116\ 12 U.S.C. 5223 Sec. 113(a)(1).
---------------------------------------------------------------------------
The public has a strong interest in recovering the money
spent to provide assistance to the financial system. But it
also has an important stake in restoration of stability to the
financial markets as part of a general economic recovery.
Treasury must balance the public interests in financial
stabilization and economic growth.
In this section, the Panel examines issues Treasury faces
in trying to reach such a balance. It looks in turn at the
problem from the perspective of the financial stabilization
program and of the BHCs and banks subject to the program.
1. FINANCIAL STABILIZATION PROGRAM
Treasury has consistently stated that the decision by the
government to take ownership positions in financial
institutions was a result of emergency conditions, and,
consequently, it intends to limit its involvement in management
of those institutions and to divest itself of its preferred
shares ownership positions in financial institutions \117\ as
soon as financial conditions normalize.\118\ As referenced
above, the Federal Reserve Board has indicated that its
approval for repayment (and hence to a substantial degree its
determination that emergency conditions no longer affect the
BHC or bank whose repayment is permitted) is based on (i)
capital to lend, (ii) ability to maintain the capital levels
that supervisors expect, and (iii) ability to satisfy
counterparty risk while reducing reliance on government
capital. Three important additional considerations not
mentioned prominently in Treasury statements are (i) various
regulatory and related considerations involving Treasury's
maintenance of bank ownership interests (ii) the status of
funds repaid to Treasury, and (iii) the remaining period of
Treasury's TARP authority.
---------------------------------------------------------------------------
\117\ Treasury owns common stock in Chrysler LLC and is in the
process of converting preferred stock into common stock for Citicorp.
Treasury contains convertible preferred shares in AIG and GMAC and is
in the process of receiving common stock in GM (NewCo). The origin and
terms of disposition for those equity interests are outside the scope
of this report.
\118\ See, e.g., Treasury Warrant Repurchase Announcement, supra
note 46 (``The President has clearly stated that his objective is to
dispose of the government's investments in individual companies as
quickly as is practicable.''); U.S. Department of the Treasury.
Secretary Geithner Introduces Financial Stability Plan (Feb. 10, 2009)
(online at www.treasury.gov/press/releases/tg18.htm) (``We believe our
policies must be designed to mobilize and leverage private capital, not
to supplant or discourage private capital. When government investment
is necessary, it should be replaced with private capital as soon as
possible.''); U.S. Department of Treasury, Treasury White Paper: The
Capital Assistance Program and Its Role in the Financial Stability Plan
(February 9, 2009) (online at http://www.ustreas.gov/press/releases/
reports/tg40_ capwhitepaper.pdf) (``[T]o the extent that significant
government stake in a financial institution is an outcome of the
program [Capital Assistance Program], our goal will be to keep the
period of government ownership as temporary as possible and encourage
the return of private capital to replace government investment.'').
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a. Financial Stability and the Stress Tests
The ``restor[ation] of liquidity and stability to the
financial system of the United States'' is a primary purpose
for Congressional authorization of the TARP.\119\ The critical
judgment in approving repayment, as the Federal Reserve Board
criteria for approval for stress-tested BHCs recognize, is the
ability of those BHCs to ``maintain core capital levels
consistent with supervisory expectations.'' \120\ The Board has
also linked adequate capital to ability to lend.\121\
---------------------------------------------------------------------------
\119\ EESA, supra note 13, 2 (1).
\120\ Board of Governors of the Federal Reserve System, Federal
Reserve outlines criteria it will use to evaluate applications to
redeem U.S. Treasury capital from participants in Supervisory Capital
Assessment Program, supra note 65.
\121\ Board of Governors of the Federal Reserve System, The
Supervisory Capital Assessment Program: Overview of Results (May 7,
2009) (online at www.federalreserve.gov/newsevents/press/bcreg/
bcreg20090424a1.pdf)() (``Given the heightened uncertainty about the
economy and potential losses in the banking system, and the potential
in the current environment for adverse economic outcomes to be
magnified through the banking system, supervisors believe it prudent
for large BHCs to hold substantial capital to absorb losses should the
economic downturn be longer and deeper than now anticipated.'').
---------------------------------------------------------------------------
In its evaluation of the stress tests,\122\ the Panel cited
the finding of its academic experts that the economic modeling
used to conduct the tests was generally soundly conceived and
conservative (based on the information available). It stated
that ``the addition of capital to ten of the tested BHCs is
certainly a good step forward,'' although it also concluded
that the tests ``should not be taken for more than they are''
because ``they do not project the capital necessary to prevent
banks from being stressed to near the breaking point.'' \123\
---------------------------------------------------------------------------
\122\ Panel June Report, supra note 2, at 30-35.
\123\ The Panel gave the supervisors themselves credit for not
over-emphasizing the scope of the tests, which they made clear were
conducted within ``the present supervisory framework.'' Panel June
Report, supra note 2, at 49-50 (``[I]t would be as much a mistake to
dismiss the stress tests as it would be to assign them greater value
than they merit or in fact that the supervisors claim for them.'').
---------------------------------------------------------------------------
When one turns to repayment of TARP assistance, two of the
Panel's observations about the stress tests are particularly
relevant. The first is that ``the stress-testing regimen can be
valuable if it is firmly instituted by the supervisors
themselves for future periods and is repeated by the
supervisors if bank or economic conditions worsen to a greater
degree than assumed in the stress test modeling.'' \124\
Second, it emphasized that ``[t]he fact that the holding
companies have added certain amounts of capital on certain
assumptions does not mean that the financial crisis is over or
that the holding companies are now free from the risk of the
sort of crisis-laden conditions many found themselves
experiencing during 2008 and early 2009.'' \125\
---------------------------------------------------------------------------
\124\ Panel June Report, supra note 2, at 50.
\125\ Panel June Report, supra note 2, at 50.
---------------------------------------------------------------------------
Because the Federal Reserve Board's repayment standards
require the institution involved to be able to maintain the
capital ratios set by the stress tests, it is important that no
repayments compromise that ability. Some commentators believe
that U.S. banks are unlikely to experience a ``lost decade''
that beset banks in Japan in the 1990s because, unlike Japan,
U.S. banks will have well performing loans and will be able to
``earn'' their way out of future solvency problems.\126\ In
this respect, the various loan facilities and guarantees on
bank debt that have been instituted by the FDIC can be viewed
not simply as an effort to restore confidence and liquidity in
the banking system, but also as a mechanism to aid banks'
efforts to earn their way to solvency. Other commentators are
less sanguine and have argued that the possibility of further
or renewed economic decline, insufficient private investment,
and immense commercial real estate and other debts to be
refinanced will limit the ability of the banking system to earn
its way to health.\127\
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\126\ Mark Trumbull, Ten US Banks To Repay TARP Money, The
Christian Science Monitor (June 9, 2009) (online at
features.csmonitor.com/economyrebuild/2009/06/09/ten-us-banks-to-repay-
tarp-money/) (citing Goldman Sachs economist Jan Hatzius that U.S.
banks should have sufficient profit streams on good loans ``to offset
even a rising tide of losses through 2010.'').
\127\ See, e.g., The Economist, Less Wobbly Now: The Process of
Returning Banks to Private Ownership Begins (June 9, 2009) (online at
www.economist.com/businessfinance/displayStory.cfm?story--id=13811147);
Martin Neil Baily and Douglas J. Elliott, Brookings Institution, The US
Financial and Economic Crisis: Where Does It Stand and Where Do We Go
from Here?, at 11-13 (June 2009) (online at www.brookings.edu//media/
Files/rc/papers/2009/0615_economic_crisis_baily_elliott/
0615_economic_crisis_baily_elliott.pdf) (concluding that there is
``wide band of uncertainty'' regarding future bank capital requirements
given future credit losses in categories such as commercial real
estate, commercial and industrial loans, and credit cards).
---------------------------------------------------------------------------
b. Macroeconomic conditions
The goal of the stress tests was the ability of the tested
institutions to maintain current levels of activity based on an
``adverse scenario'' for deterioration of economic conditions
through the end of 2010.\128\ Thus, the state of the economy is
a crucial element for any decision to approve repayment of TARP
assistance.
---------------------------------------------------------------------------
\128\ Board of Governors of the Federal Reserve System, The
Supervisory Capital Assessment Program: Overview of Results, at 2 (May
7, 2009) (online at www.federalreserve.gov/newsevents/press/bcreg/
bcreg20090507a1.pdf). ; Panel June report, supra note 2.
---------------------------------------------------------------------------
As shown in the table below, two key economic measures used
in the stress test continue to show troublesome trends and
pessimistic IMF forecasts.
----------------------------------------------------------------------------------------------------------------
Baseline More adverse IMF projections Current
------------------------------------------------------------------ data \129\
Metric -----------
2009 2010 2009 2010 2009 2010 (Most
recent)
----------------------------------------------------------------------------------------------------------------
GDP Growth........................ -2.0 2.1 -3.3 0.5 -2.6 \130 0.0 -5.5 \131\
\
Unemployment Rate................. 8.4 8.8 8.9 10.3 8.9 \132\ 10.1 9.5 \133\
----------------------------------------------------------------------------------------------------------------
\129\ Because the baseline and adverse scenarios are projected as annual averages, they are not directly
comparable to monthly or quarterly data.
\130\ International Monetary Fund, World Economic Outlook: Update, at 2 (July 8, 2009) (online at www.imf.org/
external/pubs/ft/weo/2009/ update/02/pdf/0709.pdf).
\131\ First quarter 2009, percent change from preceding quarter in chained 2000 dollars (final figure, revised
from the preliminary estimate of -5.7 percent). U.S. Department of Commerce, Bureau of Economic Analysis,
Gross Domestic Product, 1st quarter 2009 (final) (June 25, 2009) (online at www.bea.gov/newsreleases/national/
gdp/gdpnewsrelease.htm) (accessed July 9, 2009). This figure is up from the 6.3 percent decline in the fourth
quarter of 2008. Id.
\132\ International Monetary Fund, World Economic Outlook: Crisis and Recovery, at 65 (Apr. 2009) (online at
www.imf.org/external/pubs/ft/weo/2009/01/pdf/text.pdf).
\133\ U.S. Department of Labor, Bureau of Labor Statistics, The Employment Situation: June 2009 (July 2, 2009)
(USDL 09-0742) (online at www.bls.gov/news.release/pdf/empsit.pdf) (accessed July 6, 2009) (hereinafter
``Employment Situation''). This figure is the unemployment rate through June 2009. The year-to-date average
unemployment rate stands at 8.67 percent. See Id. at 11.
Thus, the supervisors must consider the possibility of
unrealized losses in commercial real estate, credit card, and
other sectors that have not yet shown up on bank balance
sheets. This issue is particularly important in the case of
small commercial and regional banks, some of which have
extensive commercial real estate loans on their portfolios that
are not now mature, but may face defaults upon maturity.\134\
---------------------------------------------------------------------------
\134\ Panel June Report, supra note 2 at 41-42; Richard Parkus and
Jing An, The Future Refinancing Crisis in Commercial Real Estate, at 3-
4 (Apr. 23, 2009) (online at cop.senate.gov/documents/report-042309-
parkus.pdf); Maurice Tamman and David Enrich, Local Banks Face Big
Losses, Wall Street Journal (May 19, 2009) (online at online.wsj.com/
article/SB124269114847832587.html).
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c. Government's dual role
A benefit from repayment of TARP assistance is the end of
the government's conflicting roles as regulator of the very
institutions in which it owns shares and on whose profitability
repayment of public funds depends. Specific regulatory
policies, for example those affecting capital levels, the
application of accounting conventions to financial reporting by
BHCs or banks, and conflicts among regulators of various parts
of BHCs, are complicated by the government's dual interests.
d. Future of the TARP
The most difficult problem raised by repayment of TARP
assistance may prove to be its impact on Treasury's ability to
respond to a second wave of financial distress. Treasury
believes that it can maintain TARP assistance up to a ceiling
of $700 billion until expiration of its authority to make new
TARP purchases.\135\ But its authority to expend funds to
reinfuse capital into the nation's financial institutions
through the purchase of bank securities or of assets on an
institution's books terminates at the end of 2009, unless the
Secretary of the Treasury extends that authority until October
3, 2010.\136\ But at that point any additional expenditure
depends on Congressional action further extending EESA.\137\
---------------------------------------------------------------------------
\135\ Treasury's position, as most recently been expressed in a
letter from Secretary Geithner to Senator David Vitter, is that the
interaction of various sections of EESA produces the following result:
(i) Treasury's authority to purchase ``troubled assets'' is ``limited
to $700 billion outstanding at any one time,'' (ii) amounts repaid to
Treasury must be returned to the government's general accounts, and
(iii) repaid funds free up an additional amount of space under the
ceiling, and Treasury can use the proceeds of the sale of government
securities to restore that amount to the fund from which TARP
expenditures can be made, so long as the fund does not somehow exceed
$700 billion. See EESA, supra note 13, Sec. 106 (d), 115(a), 118
(codified at 12 U.S.C. Sec. Sec. 5216(d), 5225(a), 5228). Treasury's
reading is disputed. An attempt to amend EESA to make it clear that all
repayments simply reduce remaining expenditure authority failed in the
Senate 48-47. S. Amend. 1030, (May 5, 2009) (online at http://
thomas.loc.gov/cgi-bin/bdquery/z?d111:SP1030:). H.R. 2745 would amend
EESA to reach the same result. H.R. 2745, supra note 29, adding
Sec. 137(d)(2) to EESA.
\136\ H.R. 2745, supra note 29, would amend EESA to eliminate the
ability of the Secretary to extend Treasury's TARP authority.
\137\ EESA, supra note 13, Sec. 120. Expiration of the authority to
make new expenditures does not affect Treasury's ability to hold or
repurchase preferred stock. EESA, supra note 13, 106(e) (codified at 12
U.S.C. Sec. 5216(e)). 12 USC 5216(e).
---------------------------------------------------------------------------
Treasury has evidently made the decision that repayment of
TARP assistance will not affect the government's ability to
respond to future crises, and Secretary Geithner has stated
that the decision whether or not to extend the TARP or seek
Congressional approval for a further extension of the TARP has
not been made.\138\ However, the lack of a publicly-expressed
position about the future is worrisome. The Panel noted in its
June report that both its own independent experts and other
commentators have expressed a concern that the results of the
tests understate the risks that existing loans will result in
substantial losses in 2011, following the two-year period for
which the stress testing occurred.
---------------------------------------------------------------------------
\138\ U.S. Treasury Secretary Timothy Geithner, Testimony to the
Senate Committee on Banking, Housing, and Urban Affairs (June 18,
2009).
---------------------------------------------------------------------------
2. WARRANT REPURCHASE
The issues surrounding warrant repurchase are relatively
simple. Although they may constitute only a limited portion of
the value of Treasury's total investment in the institutions
involved, the warrants are the only vehicle through which the
public can realize a return on its investment in addition to
the dividends paid on the preferred shares for the relatively
short period for which the stock will prove to have been held.
The warrants cover a ten-year period, however, and as noted in
the valuation discussion above, their value likely more
accurately reflects the market's long-term assessment of the
prospects of institutions whose operations Treasury stabilized.
As indicated above, Treasury's choices in continuing to
hold the warrants it now holds are limited by the SPAs. But
even if it continues to hold warrants in institutions that
repay their assistance but do not opt to repurchase their
warrants, Treasury should consider carefully its alternative
courses of action. There is, of course, a chance for equity
appreciation greater than that predicted by present valuation;
but there is likewise a chance that by continuing to hold
warrants their potential value will drop, wiping out any upside
that can be captured by taxpayers. However, the scenario in
which bank stock prices fall is also likely to be a scenario in
which banks' capital positions are weaker than they are today.
The disposition of the warrants is of direct financial
interest to the public. For that reason, it is especially
important that Treasury be absolutely transparent about the
nature and substance of the decisions it is making and the
reasons for those decisions. The Panel has emphasized the need
for transparency in administration of the TARP since its first
report, and it is disheartening to have received the following
response from Secretary Geithner about warrant valuation data:
It is not Treasury's policy to publish estimates of
the fair market value of its investments made under the
Troubled Asset Relief Program (``TARP''). In the
present case, Treasury believes it would not be in the
taxpayer's interest for Treasury to disclose any
valuations it has performed in connection with warrants
whose repurchase is currently pending or that may be
repurchased in the near term.\139\
---------------------------------------------------------------------------
\139\ Letter from Secretary Timothy Geithner to Congressional
Oversight Panel Chair Elizabeth Warren (July 1, 2009) (attached as
Appendix II to this report).
However, warrants are still only 15 percent of the original
CPP investment. Since it is the healthy banks that are
currently repaying, the value of their respective warrants has
no doubt gone up. In this respect, early sales of these
warrants may leave Treasury holding the warrants of weaker
institutions with lower stock prices and less likelihood of
appreciation in the value of their warrants, at least in the
immediate future.
The Panel recognizes that Treasury must protect proprietary
information and use care to avoid giving other institutions
information that would prejudice the interests of the taxpayer,
but it must make any decision to restrict disclosure for these
reasons only in the most thoughtful and judicious manner.
Transparency throughout the negotiation process is essential
for accountability and acceptance of the valuations.
3. THE FINANCIAL INSTITUTIONS' PERSPECTIVE
Financial institutions, especially large ones, appear to
want to repay their TARP assistance as soon as they can obtain
approval to do so. In some cases, of course, they may feel that
they simply do not need the money any longer. However, there
are likely several additional reasons for pursuing prompt
repayment of the TARP investments.
Despite the Administration's consistent statements that its
policy is not to be involved in bank management and to cease to
hold ownership positions in banks as soon as practicable,\140\
Treasury retains influence over the business decisions and
internal governance of institutions in which it holds
substantial preferred shares and warrant interests. Although
ownership of preferred shares or warrants convertible into
nonvoting common shares does not provide the sort of leverage
that common shares ownership does, holding a substantial block
of preferred shares with the terms of the Treasury preferred
(discussed below) significantly constrains aspects of the
issuing institution. Such constraints, for example, hinder the
ability to pay dividends or engage in certain capital
transactions, in exchange for bolstering the institution's
capital. Replacing the Treasury investment with independently
raised equity frees the institution from those constraints. At
the same time, however, repayment of TARP assistance will not
free an institution from the scope of the enhanced supervisory
regime that has evolved during the worst months of the crisis
as that regime would apply to the institution in any event.
---------------------------------------------------------------------------
\140\ See supra note 46 Congrerssional Oversight Panel Hearing,
Testimony of Herbert Allison, Assistant Secretary of the Treasury for
Financial Stability (June 24, 2009) (``We are very reluctant
shareholders in corporations. We don't want to be in that position.'').
---------------------------------------------------------------------------
The second motivation for prompt repayment of TARP
investments has to do with the specific rules or conditions to
which TARP recipients are subject. The prime examples involve
executive compensation and corporate governance restrictions
applicable to TARP recipients. While banks were aware that they
were subject to restrictions upon entrance into the CPP,\141\
they point to new provisions established in ARRA and by
subsequent Treasury regulatory action\142\ that are
retroactively applicable to past recipients of TARP financial
assistance who have not yet repaid Treasury. As the American
Bankers Association explained in a letter sent to the House of
Representatives opposing additional restrictions on executive
compensation for CPP recipients because of the impact of
uncertainty on business operations, ``the risk of unilateral
changing of the rules at any time . . . is extremely disruptive
to sound business planning.'' \143\
---------------------------------------------------------------------------
\141\ CPP contracts contained a covenant obligating recipients to
implement the executive compensation provisions required under section
111(b) of the EESA and any Treasury regulations implementing the
section promulgated by the closing date of the investments. Section
111(b) provisions included: (1) a prohibition on TARP recipients from
receiving tax deductions for bonuses above $500,000 for top five senior
executives; (2) a clawback provision for any top five executives who
knowingly engage in providing inaccurate information that is used to
calculate their bonuses; and (3) a golden parachute restriction that
prevents top five top executives from receiving severance bonuses in
excess of three years' compensation.
By contract, Treasury imposed more stringent requirements on SSFI
program and TIP investments beyond those required by the section 111(b)
regulations. Most notably, the size of the 2008 and 2009 bonus pools
for AIG, Citigroup, and BofA were capped. In February 2009, Treasury
imposed new compensation requirements for future CAP recipients that
were slightly more restrictive than those applicable to their CPP
counterparts and retroactively applicable requirements for recipients
of ``exceptional assistance,'' including restricting non-restricted
stock compensation to $500,000 for senior executives, imposition of
non-binding say-on-pay shareholder votes, expanding the number of
executives subject to clawback and golden parachute payments, and
mandating exposure on company policy on luxury expenditures. U.S.
Department of the Treasury, Press Release: Treasury Announces New
Restrictions on Executive Compensation (Feb. 4, 2009) (available at
www.treasury.gov/press/releases/tg15.htm).
\142\ Robin Sidel, U.S. Gets TARP Payback from 10 Banks, Wall
Street Journal (June 18, 2009) (http://online.wsj.com/article/
SB124524619467123215.html) (``some bankers complained it had outlived
its purpose and imposed needless complications on compensation and
other decisions.'').
\143\ See Memorandum from Floyd Stoner, American Bankers
Associations to Members of the House of Representatives (March 30,
2009) (online at www.aba.com/NR/rdonlyres76DCD307-2D7E-48A6-A10F-
623175F0AEAD/59034/ExecComp_ABAHouseLetter_033009.pdf).
---------------------------------------------------------------------------
With respect to employee compensation, ARRA's amendment of
EESA's executive compensation and corporate governance
restrictions and Treasury's subsequent regulatory action has
subjected CPP recipients to restrictions that are, in many
respects, stronger and more far reaching than those that they
faced under the CPP contracts and pre-ARRA regulations.\144\ In
one respect, however, ARRA's amendment to section 111 of EESA
has benefitted banks seeking to be free from executive
compensation regulations: if a bank redeems all of its CPP
preferred shares, it is immediately free from these conditions
regardless of whether Treasury still holds warrants for the
purchase of its common shares.\145\
---------------------------------------------------------------------------
\144\ As compared to EESA's original provisions, the new
requirements cover more employees (in some cases expanding their scope
from five senior executives to twenty and, in cases of exceptional
assistance recipients, an additional 100 most highly compensated
employees). They also contain stricter restrictions on bonus and
severance payments, encompass additional corporate governance
standards, and are in part enforced by the new Treasury office of
Special Master for TARP Executive Compensation. In addition, by
regulation, Treasury has created a Special Master for TARP Executive
Compensation who has authority to review any compensation (payments)
for senior executive officers and next 20 most highly compensated
employees at firms receiving exceptional assistance; to approve the
compensation structure for the next 100 highly compensated employees of
such firms; and to issue advisory opinions on the compensation and
compensation structure at non-exceptional assistance TARP recipients.
See ARRA, supra note 23, Sec. 7001; U.S. Department of the Treasury,
Interim Final Rule on TARP Standards for Compensation and Corporate
Governance (accessed June 12, 2009) (online at www.treas.gov/press/
releases/reports/ec%20ifr%20fr%20web%206.9.09tg164.pdf); U.S.
Department of the Treasury, Press Release: U.S. Department of the
Treasury, Interim Final Rule on TARP Standards for Compensation and
Corporate Governance (June 10, 2009) (online at www.treas.gov/press/
releases/tg165.htm).
\145\ ARRA, supra note 23, Sec. 7001.
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Banks have argued that TARP-related executive compensation
restrictions are making it difficult for them to attract or
retain talented executives and employees because these
employees can be better compensated by financial services firms
free of the restrictions. These include private equity and
hedge funds,\146\ large international financial institutions
such as HSBC or Barclays that are ineligible to receive TARP
funds, and firms that have freed themselves of the restraints
by redeeming their CPP preferred shares.
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\146\ Edmund Andrews and Eric Dash, Stimulus Plan Places New Limits
on Wall St. Bonuses, New York Times (Feb. 13, 2009) (online at
www.nytimes.com/2009/02/14/business/economy/14pay.html) (``Top economic
advisers to President Obama adamantly opposed the pay restrictions,
according to Congressional officials, warning lawmakers behind closed
doors that they went too far and would cause a brain drain in the
financial industry during an acute crisis. . . . Others warned that
because of the rules, firms might lose their best traders and managers
to hedge funds and foreign banks.'').
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In addition to executive compensation and corporate
governance restrictions, TARP-recipient banks are subject to
restrictions on hiring foreign workers. The Employ American
Workers Act (EAWA), section 1611 of ARRA, prohibits any
recipient of funding under Title I of EESA or section 13 of the
Federal Reserve Act from hiring new H-1B workers unless they
had offered positions to equally- or better-qualified U.S.
workers, and it prevents recipients from hiring H-1B workers in
occupations in which they have laid off U.S. workers.\147\
Hence, while EAWA applies to CPP recipients, repayments will
not necessarily free banks from its restrictions such as
restraints on hiring foreign workers.
---------------------------------------------------------------------------
\147\ ARRA, supra note 23, Sec. 1611(b).
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Banks also explain that they are motivated to repay TARP
funds as soon as possible so they can be free of conditions
currently imposed by contract, statute, or regulation on
recipients and the uncertainty related to the possibility of
new conditions in the future.\148\
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\148\ Eric Dash, 10 Large Banks Allowed to Exit U.S. Aid Program,
New York Times (June 10, 2009) (online at www.nytimes.com/2009/06/10/
business/economy/10tarp.html) (``The banks are eager to escape TARP and
the restrictions that come with it, particularly the limits on how much
they can pay their 25 most highly compensated workers.''); Deborah
Solomon, Nine Banks to Repay TARP Money, Wall Street Journal (June 9,
2009) (online at online.wsj.com/article/SB124450458046896047.html)
(``many [TARP recipients] are uncomfortable with the restrictions that
come with the government's investment, including on pay, dividends and
stock buybacks''); Robin Sidel, U.S. Gets TARP Payback from 10 Banks,
Wall Street Journal (June 18, 2009) (online at online.wsj.com/article/
SB124524619467123215.html ) (``some bankers complained it had outlived
its purpose and imposed needless complications on compensation and
other decisions''); Stephen Labaton, Some Banks, Feeling Chained, Want
to Return Bailout Money, New York Times (Mar. 10, 2009) (online at
www.nytimes.com/2009/03/11/business/economy/11bailout.html) (``One of
the biggest concerns of the banks is that the program lets Congress and
the administration pile on new conditions at any time.'').
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The SPA places restrictions on a bank's dividend and
repurchase abilities. These restrictions apply until the
earlier of the date the bank redeems its shares, when the
shares are transferred to a third party, or three years after
the CPP preferred shares' issuance.\149\ There are two dividend
restrictions. The first is a common restriction for preferred
shares that gives dividend payments to preferred shareholders
priority over dividend payments to common or junior preferred
shares. The second dividend restriction is much less common,
and quite favorable to Treasury. It caps for a period of time
the amount of dividends that the bank can pay on its common
shares The cap is set at the amount of the last regular
quarterly cash dividend prior to October 14, 2008.\150\ The
stock repurchase restrictions are parallel to the dividend
restrictions.\151\ The bank may not redeem common or junior
preferred shares if dividends on the preferred have not yet
been paid. Redemption of common and junior preferred shares is
prohibited during the times in which dividends are capped.
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\149\ Securities Purchase Agreement, supra note 15, Sec. 4.8(a).
\150\ Securities Purchase Agreement, supra note 15, Sec. 4.8(a)(i).
The dividend amount is subject to certain adjustments, for stock
splits, etc.
\151\ The repurchase of common stock is economically equivalent to
a dividend.
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These restrictions improve the value of the warrants by
preventing banks from paying excessive dividends, which, in
turn, could impair the bank's capital structure and ultimately
negatively impact the value of its shares. Moreover, these
restrictions protect the value of the preferred shares by
prioritizing dividend payments to preferred shareholders over
those of junior preferred and common shareholders.
Finally, a number of institutions argue that they were
forced directly or indirectly by Treasury and their supervisors
to participate in the CPP in the interests of stability of the
financial system as a whole. They may be worried that,
especially after the stress tests, their failure to repay the
assistance they receive will have unfair consequences in the
way the markets assess their strength. Some, especially small,
banks may worry about general public anger at ``bailout
banks.'' \152\
---------------------------------------------------------------------------
\152\ Eric Dash, Four Small Banks Are the First to Pay Back TARP
Funds, New York Times (Mar. 10, 2009) (online at www.nytimes.com/2009/
04/01/business/01bank.html) (``About 500 small banks have received
$73.7 billion. But the purpose of the TARP money and the public
perception of the fund have changed since then. What was billed as a
program intended to help healthy banks increase lending and swallow up
troubled rivals widened to include a number of struggling banks. . .
`We don't want to be touched by the stigma attached to firms that had
taken money,' said Scott A. Shay, the chairman of Signature Bank.'');
David Segal, We're Dull, Small Banks Say, but Have Profits, New York
Times (May 11, 2009) (online at http://www.nytimes.com/2009/05/12/
business/12small.html) (``[C]ommunity bankers have felt compelled in
recent months to mount public relations campaigns to emphasize their
fiscal health and in some cases to announce they rejected Troubled
Asset Relief Program, or TARP, funds. Some have held cookouts, others
have held `reassurance' meetings in their lobbies, hoping to educate
customers and prevent panics. All are dealing with banker jokes and the
occasional wisecrack.''); Bob Davis and Jon Hilsenrath, Federal
Intervention Pits `Gets' vs. `Get-Nots,' Wall Street Journal (June 15,
2009) (online at http://online.wsj.com/article/
SB124501974568613573.html) (``Some businesses are trying to tap this
antibailout sentiment. Worthington National Bank has erected billboards
around Fort Worth, Texas, boasting that it hasn't been bailed out--a
shot at a crosstown rival that took federal cash.'').
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The reasons why many banks may be seeking to repay their
CPP investments promptly may also help to explain why some
institutions have declined to participate in the TARP. Since
the introduction of the CPP, a total of 372 banks have
withdrawn their applications after receiving preliminary
approval by Treasury. On occasion, this situation has arisen
when Treasury or the regulator had reason to believe that a
bank would not receive final approval, and therefore encouraged
it to withdraw voluntarily (so as not to create a disclosable
event). In the vast majority of cases, however, it was entirely
the bank's decision not to take the funds.\153\
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\153\ Weekly data reported to the Panel by Treasury do not
distinguish between banks that withdrew after receiving approval and
those that withdrew at any time, but it would appear that voluntary
withdrawals, rare occurrences in the last months of 2008, increased in
frequency starting around the second week of January.
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H. Conclusion--Policy Choices and Trade-Offs
The repayment of more than one-third of the financial
assistance provided under the CPP portion of the TARP, by
financial institutions comprising approximately one-third of
bank and bank holding company assets, marks a turning point in
the TARP and requires careful examination of Treasury's exit
strategy for the program. If the program has contributed to the
restoration of stability in the nation's financial system,
forming an important piece of the broader economic recovery
effort, then the timing and manner in which the TARP is wound
down is as important as the way it was begun.
The judgments involved in the timing of the decision to
permit repayment of financial assistance are not simple.
Government ownership of substantial interests in the financial
institutions that it is supposed to regulate presents
substantial challenges, in part because it runs the risk of
appearing to prefer some institutions in which it has made
investments over others. However, that difficulty has been
inherent in the TARP from the beginning. The question now is
whether there have been sufficient changes in the last eight
months in the condition of the nation's largest financial
institutions and the state of the nation's economic recovery to
justify repayment of TARP assistance.
The banks that have been permitted to repay have for the
most part been able to raise funds in the equity markets. But
there is little firm evidence that their lending figures have
improved or that their capital condition will remain firm. The
stress tests, as the Panel's June report made clear, are a step
forward, but do not resolve the issue. Moreover, there are
questions about whether the economy has improved to a
sufficient degree to eliminate the capital buffer the
assistance created, or whether weak loans and similar assets
have been sufficiently eliminated from the institutions'
balance sheets. In addition, the desire of banks to free
themselves of various regulatory restrictions imposed on TARP
recipients cannot in any way influence the policy of Treasury
and the Federal Reserve Board in determining whether and when
to allow TARP assistance to be repaid.
The Panel's valuations offer reasonable estimates of the
fair market value of the warrants. They may help Treasury as it
balances the return to the taxpayer indicated by its own
estimates of value and the host of other relevant market,
regulatory and economic factors applicable to the disposition
of sophisticated financial instruments. In addition, Treasury
should promptly provide written reports to the American
taxpayers analyzing in sufficient detail the fair market value
determinations for any warrants either repurchased by a TARP
recipient from Treasury or sold by Treasury through an auction,
and it should disclose the rationale for its choice of an
auction or private sale. Most important, Treasury should
undertake to negotiate the disposition of the warrants in a
manner that is as transparent and fully accountable as
possible.
As the Panel has made clear since its beginning,
transparency is essential--perhaps now more than ever. Treasury
and the Federal Reserve Board must explain fully and clearly to
the public the reasons for approval for repayment of financial
assistance. Treasury must be equally transparent about the way
warrants are valued, the exit strategy for, or future use of
the TARP. Without such transparency, the credibility of the
decisions of Treasury and the Federal Reserve Board and of
Treasury's stewardship of the TARP can only fall into serious
question.
ANNEX A: Technical Explanation of Warrant Valuation Methods
This annex provides background on the most commonly used
methods of valuing warrants and an explanation of the
assumptions the Panel made in applying one such method to
calculate the value of the TARP warrants.
The most prominent warrant valuation model is Black-
Scholes, which has been the method of choice since it was first
published in 1973.\154\ Since that time, it has seen many
extensions and modifications, but the main theoretical and
mathematical basis for the method has remained the same.
Another method, the binomial options pricing model, introduced
by Cox, Ross and Rubinstein in 1979,\155\ relies on many of the
ideas set forth in Black-Scholes while approaching the
mathematical calculations in a very different manner. Finally,
the simplest valuation of an option is its intrinsic value,
which values the option solely on its moneyness.\156\ These
three methods are representative of the majority of valuation
techniques used today, and most traders use models based on one
of these three models.
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\154\ Fischer Black & Myron Scholes, The Pricing of Options and
Corporate Liabilities, Journal of Political Economy, Vol. 81 No. 3
(May/June 1973) 637-654.
\155\ John Cox, Stephen Ross & Mark Rubinstein, Option Pricing: A
Simplified Approach, Journal of Financial Economics (July 1979) Vol. 7
229-263.
\156\ Moneyness is the property of an option that describes the
relationship between its strike price and the current share price of
the underlying stock. An option is ``In The Money'' when its strike
price is less than the underlying's current share price, ``At The
Money'' when its strike is equal to it the underlying's share price,
and ``Out of The Money'' when its strike is above the current share
price.
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The intrinsic value of a warrant is calculated by the
simple equation:
Warrant Price = Current Share Price - Strike Price (1)
The resultant value is the net gain a trader would realize
upon exercising the warrant and selling the underlying stock at
any given moment. This value is very useful in determining the
prices of warrants very near the end of their terms, and for
modeling hypothetical early executions of non-European
options.\157\ However, in valuing warrants that are not near
their expiration date, and especially in valuing Long-Term
Equity Anticipation Securities (LEAPs) \158\ such as the
warrants issued under the TARP, using intrinsic value to model
fair market value presents significant problems. These problems
stem from its one major flaw--the assumption that no matter the
term, a warrant's value is the difference between the
underlying share price and the warrant's strike price. While
intrinsic value can provide useful information about the value
of a warrant if exercised immediately, it says very little
about the future value of that warrant or its value on the open
market, as there is always a positive probability that the
underlying stock price will increase. Since intrinsic value
ignores the value of future stock movement and the time option
captured in a warrant, the TARP warrants must be worth more
than their intrinsic value.
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\157\ European options are options which can only be exercised on
the day they expire. The most prevalent type of non-European option is
the American option, which can be exercised on any day until it
expires.
\158\ Long-Term Equity AnticiPation securities are options that
have an expiry date more than one year away.
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The binomial options pricing model and the Black-Scholes
model rely on many of the same assumptions: efficient markets,
no transaction costs, Brownian motion,\159\ and lognormal
growth.\160\ For the binomial model, these assumptions allow a
binomial tree to be constructed that follows a random walk of
the underlying share prices, where the term of the option is
split into different periods. The first period consists of one
point that represents the current share price. From this, using
the model inputs,\161\ a possible increase in the share price
and a possible decrease are calculated. These newly calculated
points represent the two possible prices which could be
attained by the stock in the next period. This process is
continued through all of the periods in the model until the
warrant's term is complete. This process creates a lattice of
interconnecting possible future paths of the underlying share
price. From this result, option prices are calculated backward
from the final period to determine the appropriate price, given
the statistical probabilities of the outcomes, of the option in
the original period.
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\159\ A theory developed by Robert Brown to describe the random
movements of particles in suspensions, which was later quantified by
Einstein and Smoluchowski and used to prove the existence of atoms. The
mathematical model describes random movement and is often used in many
fields to mathematically describe random events. In this context, it is
used to describe the random motion of stock prices.
\160\ At this limit, or after a large number of periods, the result
of the Binomial Options Pricing Model becomes equivalent to the pricing
of the Black-Scholes model with respect to the valuation of European
Options. Lognormal growth, an underlying tenant of Black-Scholes, is
found to be a property at the limit as well.
\161\ The assumption of no arbitrage allows the model to assume
that all of the stocks information is appropriately incorporated into
the share price.
---------------------------------------------------------------------------
While a Black-Scholes valuation relies on a continuous
model of share prices, the binomial model operates in discrete
periods of time. Because of this, the binomial model has a
number of beneficial features, all of which stem from its
ability to incorporate different assumptions at different
periods in a warrants term. Further, it allows for the modeling
of American options which can be exercised early.\162\ However,
the ability to add these features results in a more
sophisticated set of inputs, creating a more complicated and
less reproducible model as a result.
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\162\ An American option can be exercised at any time until the
expiration date. By contrast, a European option can only be exercised
on the expiration date.
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The lack of reproducibility caused by the use of
sophisticated and complex inputs is one of the major problems
of the binomial model. Since the Panel attempted a transparent
valuation of the TARP warrants, it used a Black-Scholes model,
which uses only a few simple inputs.
The most popular option pricing model is Black-Scholes,
which has been an industry standard since it was first
introduced and is routinely used by options traders. To value
an option, the Black-Scholes model sets up a fully hedged
portfolio, which is long the underlying stock and short the
option. Since in an efficient market a portfolio cannot exist
with a guaranteed return greater than the risk free rate, this
perfectly hedged portfolio must earn the risk free rate. This
parity can be expanded out through stochastic calculus to a
partial differential equation which has the closed-form
solution:\163\
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\163\ This expansion is made possible by a number of assumptions
including: the assumption that stock prices ``follow a random walk, in
continuous time with a variance rate proportional to the square of the
stock price. Thus the distribution of possible stock prices at the end
of any finite interval is lognormal.'' Black-Scholes Paper, supra 72,
at 640. In equations (2) (3) and (4), N(d) refers to cumulative normal
density function, w(x,t) refers to the price of the warrant with
respect to the share price of the underlying(x) and time(t). (r) refers
to the risk free interest rate, and (c) refers to the strike price. (v)
refers to the volatility of the underlying.
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
The popularity of the Black-Scholes model is driven by its
ease of use, which is the product of its closed form solution.
Anyone can plug in the standard inputs required for valuing any
option and then solve the equation for the value of the option.
The model is also preferred by options traders because it has a
high degree of accuracy. Although some believe that the
binomial model is more accurate, the Black-Scholes model's ease
of use has made it the industry standard for valuing warrants,
as acknowledged by many respected options experts, including
Mark Rubinstein, the co-creator of the binomial method.\164\
---------------------------------------------------------------------------
\164\ Rubinstein Implied Binomial Trees Paper, supra note 73 (``The
[Black-Scholes] formula can be implemented in a fraction of a second on
widely available low-cost computers and calculators. In many situations
of practical relevance, the inputs can be easily measured and the
related securities are traded in highly efficient markets. This model
is widely viewed as one of the most successful in the social sciences
and has perhaps (including its binomial extension) the most widely used
formula, with embedded probabilities, in human history.'').
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It is important to note that the Black-Scholes model, as
well as every other popular options pricing model, was created
to reflect the prices of options with short terms, ranging from
days to months. As no options are traded on the Chicago Board
Options Exchange (CBOE) with terms longer than three
years,\165\ it is very difficult to come up with a ``fair
market value'' of the TARP warrants which have terms of ten
years. The lack of publicly traded comparable derivatives makes
any valuation of ten-year warrants difficult.
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\165\ Chicago Board Options Exchange, Product Specification: Equity
LEAPS (online at www.cboe.com/Products/EquityLEAPS.aspx) (accessed July
8, 2009) (``Expirations Months: May be up to 39 months from the date of
initial listing, January expiration only.'' However, there may be some
FLEX options with terms as long as 15 years, however these are custom
instruments, and not traded, listed, or priced like regular options,
and therefore unusable for the purposes of this analysis.).
---------------------------------------------------------------------------
More generally, there is the problem of lack of knowledge
about most of the inputs to the model. For example, while ten-
year Treasury bills factor in what the market expects the
interest rate risk for the next ten years to be, it is
impossible to know the validity of the market's expectations.
Thus, once again, it is important to note that the value that
we are searching for here is not based on our expectations of
the future, but rather our estimate of the market's
expectations. Because the goal of the Panel's valuations was to
estimate the value the financial markets would place on these
warrants, we tried to use the inputs most likely to be used by
prospective buyers.
The input that is the least defined in the Black-Scholes
model and has the largest effect on the price of the warrant is
the volatility of the underlying stock price. Volatility is
defined as the standard deviation of the continuously
compounding returns of a stock. It is clear from this
definition that there are an almost infinite number of
variations of the calculation of this number. The volatility is
important in the Black-Scholes model because it features
prominently in both of the probability calculations in the
closed-form solution, meaning that differing values of
volatility can create substantial differences in the final
valuations of the warrants. The following example illustrates
this point with respect to the Black-Scholes model. Assume that
a warrant to buy one share of company XYZ at $150 expires in
one year, that XYZ is currently trading at $100 and that the
risk free rate is one percent. If XYZ's volatility is 30
percent, the warrant is worth $1.59, but if the volatility is
60 percent, the warrant is worth $10.91. In fact, if the
volatility is below 15 percent, the warrant is virtually
worthless.
There are two main ways to estimate the future volatility
of a stock. The first is to calculate it from historical
prices. Any time period can be used to measure volatility,
although standard practice dictates that the time period chosen
be at least three months and at most ten years backward from
the valuation day. An analyst's choice of the time period over
which he or she will measure historical volatility as an
estimate of future volatility can have a large effect on a
valuation. For example, since the past two years have been
particularly turbulent, the volatility figures derived from
this period are high and may not be representative of the
volatility of stocks over the next ten years. Using these
volatility figures to value the TARP warrants would likely lead
to an overvaluation. On the other hand, using volatilities
calculated from the past ten years may undervalue the warrants
if one believes that shares will be more volatile over the next
decade than they have been in the previous one. Modulating the
time period over which historical volatility is calculated can
affect the valuation of the warrants in some banks by more than
an order of magnitude. Apart from the time period over which
volatility is measured, historical volatility measures also
differ based on the time increments from which they calculate
variance in returns: days, weeks, months, or other lengths of
time.
The second method of determining volatility of a stock is
to derive its ``implied volatility.'' Implied volatility of a
stock is calculated by solving the Black-Scholes equation for
volatility after plugging in the market price of a publicly
traded option on that stock. This process yields the market's
estimate of the stock's volatility, following from the Black-
Scholes assumption that all of a security's information is
incorporated into its price. While this number has its
drawbacks, particularly because publicly traded options do not
have terms nearly as long as the TARP warrants, it is the best
estimate of the market's current perception of volatility.
While these two methods of calculating volatility are the
most widely used, and thus the most useful in estimating the
fair market value of the TARP warrants, there are a number of
other methods that can be used to calculate volatility. One
example is the calculation of volatility from credit default
swaps (CDS). Using Merton's model, which defines an option on a
stock as an option on the underlying firm's assets, it is
possible to translate CDS spreads into implied volatilities,
which is useful, since the market for ten-year CDSs is more
liquid than the market for ten-year options. However,
calculations based on CDSs rely on the Merton model's
characterization of equity, which may be incorrect due to the
different tiers debt and equity represent in a firm's capital
structure. This method for calculating volatility is most
appropriately used ``when the long-term prospects of a company
are driven by downside credit concerns rather than upside
growth potential.'' \166\ In today's market of relatively low
stock prices and extensive government support for the financial
sector, it appears that share prices for banks are more likely
to be determined by the potential for rebound, as opposed to
potential failures due to credit problems. This means that CDS
spreads are not likely to be as useful in calculating the value
of TARP warrants.
---------------------------------------------------------------------------
\166\ Credit Suisse Valuation Report, supra note 91.
---------------------------------------------------------------------------
While the lack of a specific method for calculating
volatility creates uncertainty in the determination of Black-
Scholes values, the model may also fail to account for a number
of other factors which affect the value of options. One
overlooked factor is the dividend yield. Dividend yield is
calculated as the ratio of annual dividends per share to share
price. The dividend yield represents an investor's return on
investment if the stock is not sold. While the Black-Scholes
model assumes that companies do not issue dividends, most do,
and dividends create a premium for holding the underlying stock
compared to the warrant. As a result, all other things being
equal, the higher the dividend yield of the underlying stock,
the lower the value of the warrant. Since many of the companies
for which Treasury holds warrants issue dividends, it is
necessary to adjust for this factor in any valuation of its
holdings.
While the Black-Scholes model provides insight into the
pricing of short term European call options on stocks that do
not pay dividends, it does not provide a proper valuation for
American LEAPs on companies that pay dividends, like the TARP
warrants. In order to price these securities, it is necessary
to use some of the many extensions that have been developed for
Black-Scholes since its inception. The first extension was
created by Robert C. Merton in 1973 before the Black-Scholes
paper was published. This extension allows for the integration
of dividends into the Black-Scholes model by making the
assumption that ``since the warrant owner is not entitled to
any part of the dividend return, he only considers that part of
the expected dollar return to the common stock due to price
appreciation.'' \167\ This extension is used as the standard
for pricing options that have a dividend-issuing underlying
stock, and has been adopted in the methodology used by the
Panel in this report.
---------------------------------------------------------------------------
\167\ Robert C. Merton, Theory of Rational Option Pricing, The Bell
Journal of Economics and Management Science, at 170 (Spring 1973).
---------------------------------------------------------------------------
The other extension that the Panel used is that of Galai
and Schneller.\168\ This extension accounts for the fact that
warrants are fundamentally different from call options, since
exercising a warrant causes an increase in the number of
outstanding shares, diluting common equity holders. This means
that--all other things being equal--a stock is worth less after
the exercise of a warrant than it was before exercise. In order
to account for this, the Black-Scholes value of the option is
calculated, multiplied by the ratio of the number of warrants
to the number of fully diluted shares, and then this value is
added to the share price to create a new share price input. The
Black-Scholes value is calculated again, using this new share
price input. This process is carried out repeatedly until the
Black-Scholes values converge, at which point dilution has been
sufficiently factored out of the warrant's price. This final
value is then multiplied by the ratio of the number of shares
outstanding to the number of shares outstanding plus the number
of warrants to arrive at a warrant valuation that considers the
effect of dilution.
---------------------------------------------------------------------------
\168\ Dan Galai and Meir I. Schneller, Pricing of Warrants and the
Value of the Firm, The Journal of Finance, at 1333-1342 (Dec. 1978).
---------------------------------------------------------------------------
A FINAL NOTE ON THE CONVERGENCE OF THE BINOMIAL AND BLACK-SCHOLES
METHODS
The binomial method and the Black-Scholes model are both
used extensively to model the values of warrants. In fact, FAS
123(R) states that, ``A lattice model (for example, a binomial
model) and a closed-form model (for example, the Black-Scholes-
Merton formula) are among the valuation techniques that meet
the criteria required by this Statement for estimating the fair
values of employee share options and similar instruments,''
acknowledging both Black-Scholes-Merton and the binomial method
as valid in pricing stock options issued as compensation.\169\
The Panel has chosen to use the Black-Scholes method for the
reasons described above. In fact, however, the choice does not
matter, because, given the same inputs, the binomial method
converges on Black-Scholes as the number of nodes in the
binomial tree grows (see Figure 5). In fact, the Black-Scholes
equations are merely the closed form solution of the binomial
model in the special case that inputs are constant and that the
number of nodes is taken to the limit. From this, it is clear
that any difference in the valuations of warrants is due not to
the choice of the binomial or Black-Scholes model, but rather
the input assumptions that are made.
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
\169\ While executive compensation options are not the same as TARP
warrants, they share certain characteristics, such as their long terms.
Thus, methods acceptable for valuing executive compensation options are
also probably appropriate for valuing TARP warrants. Financial
Accounting Standards Board, Statement of Financial Accounting Standards
No. 123(R): Share-Based Payment (October 1995).
ANNEX B: Analysis of the Old National Bancorp Warrants
This annex compares Treasury's valuation and sale of its
Old National Bancorp warrants with the Panel's valuation of
those warrants and illustrates the general valuation processes
carried out by Panel staff and Treasury. As noted in the text,
11 BHCs have already repurchased their warrants for $18.69
million. Old National Bancorp was the first BHC to do so.
Headquartered in Evansville, Indiana, Old National Bancorp
is a BHC with $8.3 billion in assets.\170\ Its stock is traded
on the New York Stock Exchange under the ticker ONB. ONB
received a $100 million CPP investment on December 12, 2008.
The bank then repaid its CPP investment on March 31, 2009 at
par value. In the interim, it paid over $1.5 million in
dividends to Treasury. Upon repayment of its CPP investment,
ONB entered into negotiations with Treasury to buy back
warrants for 813,008 shares of its stock, which it had issued
to Treasury in conjunction with the initial CPP investment in
December. On May 8, ONB completed the repurchase of these
warrants for $1.2 million. Using a Black-Scholes-Merton model
extended by Galai-Schneller, as described in Annex A of this
report, the Panel staff valued these warrants at $2.15 million.
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\170\ Board of Governors of the Federal Reserve System, Bank
Holding Company Peer Group Reports: Peer Group 2, at 28 (Mar. 31, 2009)
(online at www.ffiec.gov/nicpubweb/content/BHCPRRPT/REPORTS/BHCPR_PEER/
March2009/PeerGroup_2_March2009.pdf).
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The standard inputs to any warrant valuation model are the
strike price of the warrant, the expiration date, the
underlying share price, the future dividend yield, the future
volatility of the underlying shares, and the risk free rate
over the term of the warrant. The Panel staff and Treasury used
the same strike price and expiration date, $18.45 and December
12, 2018 respectively, as inputs to their models for the ONB
warrants. The Panel staff used the closing share price on May
7, 2009, the day before the ONB transaction closed, for the
underlying share price input. The share price on this day was
$13.78. Treasury used the 20-day trailing average share price
on April 22, $13.15. It is unclear to the Panel staff why
Treasury used this unconventional input, particularly when it
yields a lower valuation than the most recent closing share
price would.
Dividend yield, which is the ratio of dividends paid to
share price, must be forecast for the term of the warrant being
valued. Obviously, in the case of the TARP warrants, predicting
the dividend issuances of TARP recipients for the next ten
years is difficult. Market participants informed Panel staff
that they would typically seek the input of securities analysts
who follow the company in question in order to obtain
predictions for dividend yield. To preserve the clarity and
reproducibility of the Panel's methodology, Panel staff elected
to forgo this process.
Instead, the Panel staff used an alternative standard
practice, predicting future dividends from average historical
dividend yields. This number is calculated by averaging the
dividends paid over a particular period of time and then
dividing them by the average market price per share during that
period.\171\ The Panel used ONB's five-year average dividend
yield, 4.19 percent. Treasury used ONB's ten-year average
dividend yield, 3.69 percent. Treasury's assumption may seem
more logical as the historical period it analyzes mirrors the
duration of the TARP warrants. However, the Panel staff
believes that the more recent past is more indicative of future
bank dividend policy.\172\ Thus, the Panel staff, in
consultation with academics and market participants, used a
five-year average dividend yield to predict the future dividend
performance of ONB and the other TARP recipients. In the case
of ONB, the difference between the five and ten-year average
dividend yields was only 50 basis points.
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\171\ Average Dividend Yield = Average Dividends Over Period
Average Share Price Over Period 100
\172\ It is also important to note that TARP recipients' dividend
payments are capped at the amount of the last regular quarterly cash
dividend prior to October 14, 2008 while the government continues to
hold preferred shares in them. Therefore, dividend yields for banks
which have not repaid their TARP investments are likely to be lower
than they have been in the past.
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The choice of volatility input has a large effect on any
warrant valuation. There are two main ways to predict future
volatility, implied volatility and historical volatility.
Implied volatility is derived from publicly traded comparable
options, through solving an extended Black-Scholes model for
volatility. Implied volatility is what the market predicts
volatility will be over the term of the comparable option.
Historical volatility is calculated from the historical
returns of a stock. It assumes a log normal distribution of
returns. The historical volatility of a stock over a period of
time is calculated as the standard deviation of the natural log
of the interim returns in that period. Different interim
returns can be used: daily, weekly, or monthly returns, for
example, would all be acceptable.\173\
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\173\ Theoretically the choice of interim period should not have an
effect on the volatility measurement.
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Both methods of calculating volatility are valid. However,
as many TARP recipients have only thinly traded options with
short durations, Panel staff believes that the implied
volatilities calculated from these options are unreflective of
the market's long term volatility expectations. For example,
the implied volatility calculated from ONBLW call options on
ONB, which had a strike price of $17.50 and a maturity date of
December 12, 2009, was estimated by the Panel to be 57.2%.\174\
The Panel staff believes that this figure is more indicative of
the market's expectations for ONB short term volatility than
its volatility over the next ten years.
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\174\ Option price was calculated from the average of the closing
bid and ask prices.
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The drawbacks in using implied volatility to value the ONB
warrants led Panel staff to use historical volatility instead.
The most important assumption in calculating historical
volatility is the period over which it will be measured. In
this case, the most standard choice is to calculate the
historical volatility from the date of the valuation backward
for the term of the option. For example, the TARP warrants all
have terms of ten years, so the ten-year historical volatility
would be the most appropriate estimate of volatility over the
next ten years. Following standard practice, the Panel staff
calculated ONB's ten-year historical volatility from daily
returns for the period ending May 7, 2009 at 34.12%. This value
was used in the Panel's model to arrive at a best estimate of
the value of the ONB warrants.
Treasury also calculated volatility over a ten-year period
for the TARP recipients, but used a very different and
unorthodox method. Treasury used ``the average 60-day trailing
volatility for the last ten years'' to determine each BHC's
historical volatility.'' \175\ Specifically, Treasury's ten-
year volatility measure is calculated by taking the arithmetic
average of the 60-day trailing historical volatilities for each
day over the past ten years.\176\ According to calculations
performed by Panel staff, Treasury's procedure results in a
ten-year volatility measure for ONB of 27.5%, more than 650
basis points lower than the Panel's ten-year volatility
measure. In consultation with academics and market
participants, Panel staff has determined that over any time
period Treasury's estimation of historical volatility will, in
almost all cases, yield volatilities that are lower than those
calculated by more standard methods. As a result of this
difference, ceteris paribus, Treasury's valuation of the TARP
warrants will be significantly lower than valuations using more
standard volatility inputs.
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\175\ U.S. Department of Treasury, Treasury Announces Warrant
Repurchase and Disposition Process for the Capital Purchase Program,
supra note 46.
\176\ Treasury further adjusts this number downward to compensate
for unusual volatility during the financial crisis beginning in late
2007. Treasury also considers implied volatility numbers, but has not
given the Panel any guidance on how.
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Some portion of the difference between the Panel's estimate
of the value of the ONB warrants, $2.15 million, and the price
actually received by Treasury, $1.2 million, can be explained
by the differing share price, dividend yield and volatility
assumptions as discussed above. However, in its final
determination of the ONB warrants' fair market value, Treasury
also applied a liquidity discount. For thinly traded stocks,
such as ONB, Treasury believes that its warrant positions are
too large to be sold for their model value on the open market.
Therefore, Treasury applies a liquidity discount to better
approximate what they believe the warrants' fair market value
would be. Treasury staff has told Panel staff that these
liquidity discounts range from zero to 50 percent depending on
the recipient institution. Treasury staff has also indicated
that they have applied discounts from 15 to 35 percent in
transactions to date. As discussed above,\177\ it is unclear
whether liquidity discounts of this magnitude should be applied
in valuing TARP warrants or even if they should be applied at
all.
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\177\ See Section One Part F of this report.
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One final observation, based upon market data, calls into
question the adequacy of the price Treasury received for its
ONB warrants. On May 7, 2009, the day before ONB repurchased
its warrants, the last bid on the ONBLW option--an option on
ONB stock with a strike price of $17.50 and a duration of 7
months--was $0.75, while the last asking price was $1.35.
Backing out Treasury's sale price for the ONB warrants yields a
value of $1.48 per warrant. This means that Treasury sold the
ten-year warrants it held in ONB for 13 cents per share more
than the asking price of a comparable option with a term of
only seven months.
SECTION TWO: ADDITIONAL VIEWS
A. Richard H. Neiman
I agree with the main thrust of this month's report that
the warrants need to be valued carefully and at fair market
value by Treasury and that the process should be conducted with
as much transparency as possible. While I voted for the report,
I am providing these Additional Views to clarify my positions
and to add some perspective, particularly on issues where the
Panel did not reach consensus.
1. BENEFITS TO THE U.S. TAXPAYER
The total benefit to the American taxpayer has to take into
account the non-financial as well as the financial returns. The
financial returns include repayment of the principal of the
preferred stock loans, the dividends received, and the value of
the warrants. The non-financial benefits include the important
policy objectives that have been achieved on behalf of the
American people of stabilizing and reviving the financial
system during a very difficult period of time. The CPP program
has achieved and continues to achieve objectives and we should
not lose sight of this. I think that this report focuses at
times too narrowly on the warrants to the exclusion of other
important components of return.
2. EXIT STRATEGY
I support the Administration's and Treasury's stated policy
objective to exit the warrant holdings as soon as practicable
after the banks have repaid their preferred stock under the
CPP. Government capital support for the banks was the product
of crisis conditions and the government should exit these
investments as soon as conditions stabilize. I would not
support selling the warrants while the preferred stock is
outstanding; nor do I think it would be wise to hold the
warrants for any protracted period after the preferred stock is
repaid in an effort to maximize value by trying to time the
markets.
I think it is sound policy that the banks have the
opportunity to elect to repurchase their warrants at market
prices, as they do under the Security Purchase Agreements,
before a market auction is held. The Chrysler sidebar in the
report demonstrates that the warrant issuer (in that case
Chrysler; in this case the banks) will often have the greatest
motivation to purchase its warrants in order to prevent share
dilution. Then, if the banks elect not to repurchase or if a
fair market value cannot be agreed upon, a fully transparent
auction should be held.
I also believe that the Federal Reserve and other banking
regulators have described a very reasonable and robust process
to screen banks for eligibility to repay the taxpayer's
investment, as outlined at pages 9-10 of the report. Therefore
I think that this process should be allowed to work and that
the return of the banks to private capital markets should be
encouraged wherever it is deemed appropriate.
3. IMPACT OF SMALL BANK REPURCHASES
The report draws certain conclusions based on an analysis
of the warrants of eleven small banks that have already been
repurchased. I believe that reasonable minds can disagree about
the appropriateness of liquidity discounts and complex
volatility measures. As the report points out these warrants
were a fraction of one percent of the value of all warrants
outstanding. We should be cautious before extrapolating too
many conclusions about the entire repurchase program based on
these early and small redemptions. Hopefully lessons can be
learned from these early efforts.
4. NEED FOR GREATER TRANSPARENCY
I believe it is vital from this point forward, especially
with the very large repaying banks' warrants coming up for
repurchase or auction in the near future, that there be greater
disclosure and transparency than there has been until now. In
this regard I am encouraged by Treasury's June 26 commitment to
greater transparency by:
[P]ublishing additional information on each warrant
that is repurchased, including a bank's initial and
subsequent determinations of fair market value, if
applicable. Following the completion of each
repurchase, Treasury will also publish the independent
valuation inputs used to assess the bank's
determination of fair market value.\178\
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\178\ See, Treasury Warrant Repurchase Announcement, supra note 46.
Disclosure as described above should substantially improve
the transparency of the warrant repurchase process going
forward.
B. Rep. Jeb Hensarling
I concur with the issuance of the July report subject to
the following observations.\179\ Treasury should accept the
panel's estimates of fair market value as good faith guidance
worthy of careful consideration along with its own estimates of
value and the host of other relevant market, regulatory and
economic factors applicable to the disposition of sophisticated
financial instruments. I object, however, to any inference that
(i) the panel's estimates reflect ``the'' fair market value of
the warrants, instead of an estimate of such value, (ii) the
panel's estimates should necessarily serve as the ``floor'' in
a negotiated private party transaction or the ``reserve price''
in an auction, (iii) an auction of the warrants will
necessarily yield a more favorable return to Treasury than a
privately negotiated sale, and (iv) holding the warrants for
the intermediate to long-term will necessarily yield a more
favorable return to Treasury.
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\179\ I commend the panel and its staff for their efforts in
producing the report.
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The determination of ``fair market value'' for financial
instruments as complex as the warrants issued by the TARP
recipients to Treasury requires a thoughtful and judicious
mixture of science--financial models such as Black-Scholes--and
art--an appreciation of the dynamics that influence the actions
of market participants. Treasury should resist the temptation
to rely upon science to the exclusion of art. It is worthwhile
to recall the lessons of the past year or so and the hubris of
financial modelers who asserted with profound conviction that,
for example, credit default swaps issued over mortgage backed
securities were virtually free of risk and that AAA-rated
tranches of collateralized debt obligations were investment
grade securities. Financial analysts may counter by claiming
that their models incorporate an appropriate mixture of inputs
and risk analysis and as such may be trusted to yield market
ready results. In many instances that is no doubt true but in
other cases it is critical for the decision makers to leave the
models and sit down at the table and engage in the art of
negotiation. I encourage Treasury to reflect upon the lessons
of this financial crisis in negotiating the disposition of its
warrants.
1. PANEL'S ATTEMPT TO ESTIMATE THE VALUE OF THE TARP WARRANTS
The warrant valuation process involves more than merely
plugging numbers into a financial model, Black-Scholes or
otherwise. Such determination requires the careful exercise of
judgment which comes from a seasoned understanding of the
business operations and prospects for each TARP recipient.
Experienced investment professionals may disagree on
fundamental concepts such as volatility and other subjective
inputs as well as whether Treasury should pursue a negotiated
private sale or an auction of the warrants. Given the various
permutations of potential inputs it is generally
counterproductive to argue that one professionally rendered
well-vetted assumption or approach is more reasonable than or
inherently preferable to another. What is clear, however, is
that Treasury should adopt a surgical approach that focuses on
each particular transaction and not on a one-size-fits-all
approach that misses the subtle distinctions that certainly
exist among the various TARP recipients.
At this time it appears that Treasury and the TARP
recipients are reasonably well positioned to appreciate the
multitude of factors that influence a negotiated determination
of fair market value pursuant to the terms of the Securities
Purchase Agreements (SPAs). Specifically, the SPAs, under
certain circumstances, provide each TARP recipient with the
right to repurchase its warrants granted to Treasury at a fair
market value price. If the parties fail to agree on the
valuation price an appraisal process is triggered. If the fair
market value price established by the appraisers is not
acceptable to a TARP recipient such recipient may reject the
price and not purchase its warrants from Treasury. In addition
and under certain circumstances, Treasury has the right to sell
the TARP warrants to third-parties through an auction process.
Under both procedures the fair market value of the warrants
will be determined pursuant to market oriented terms by well-
advised adverse parties who are negotiating at arm's length
without a compelling need to purchase or sell. I am concerned
that the TARP recipients and market participants may view the
panel's report as an attempt to prospectively second-guess
future determinations of fair market value undertaken in
accordance with the SPAs and the policies adopted by
Treasury.\180\ Any such perception may disrupt an otherwise
orderly valuation process.\181\
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\180\ Although I do not object to the undertaking, I nevertheless
question the necessity of the Panel's attempt to determine the fair
market value of the warrants since the procedures provided in the SPAs
for the disposition of the warrants as well as the internal procedures
adopted by Treasury for the valuation of the warrants appear market
oriented and reasonable in form and substance. Since the report does
not provide any indication that the process outlined in the SPAs is
inherently flawed (i.e., substantially off-market or subject to
manipulation or abuse) or that Treasury or any TARP recipient is not
acting in good faith, it is arguably premature for the Panel to attempt
to value the warrants.
In the February report I concurred with the Panel's attempt to
value the preferred stock and warrants acquired by Treasury from the
TARP recipients. As with the February report, I concur with the
issuance of this report. However, I believe the circumstances have
changed considerably since then. At the time the February report was
written, no TARP recipient was prepared or permitted to redeem its
warrants issued to Treasury and the valuation served an appropriate
purpose. Since February 6, 2009, when the Panel's report on ``Valuing
Treasury's Assets'' was released, events have materially changed. The
American Recovery and Reinvestment Act of 2009 was signed into law on
February 17, 2009, which requires Treasury to permit TARP recipients to
repay Capital Purchase Plan assistance without replacement of capital
from other sources. Since then, several TARP recipients have either
redeemed or are preparing to redeem their warrants. As such, I believe
that any attempt to value the warrants on a prospective basis is far
more nuanced than the approach taken in February and much more likely
to influence in an inappropriate and unintentional manner the actions
of Treasury, the TARP recipients and market participants as they
negotiate the redemption and sale of the warrants pursuant to the SPAs.
\181\ It is worth noting that although the TARP warrants have also
been valued by Credit Suisse, Bloomberg, Professor Linus Wilson and the
CBO, the Panel's report will most likely receive greater media
attention and become the de facto third-party appraisal.
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If the panel's determination of fair market value is too
low, the American taxpayers may not receive the benefit of
their bargain, and if the panel's determination is too high,
Treasury may fail in its efforts to sell the warrants back to
the TARP recipients or to third-parties pursuant to the market
oriented procedures provided in the SPAs. The latter result may
cause Treasury to hold the warrants for the intermediate to
long-term even though the President has clearly stated that his
objective is to dispose of the warrants ``as quickly as is
practicable.'' \182\ Although I disagree with the President on
many issues, I concur with this determination given (i) the
profound difficulty in valuing the warrants and advantageously
timing the market, (ii) the inherent risk associated with
holding investments of this nature, (iii) the clear desire of
the American taxpayers for the TARP recipients to repay all
TARP related investments sooner rather than later, (iv) the
troublesome corporate governance and regulatory conflict of
interest issues raised by Treasury's continued ownership of the
TARP warrants, and (v) the stigma associated with continued
participation in the TARP program by the recipients.\183\ If
the panel disagrees with the President on this issue the report
should clearly indicate such dissent, but the valuation process
itself should not directly or indirectly work to influence
Treasury's holding period of the TARP warrants. Such result
will occur if the panel accepts input metrics and assumptions
that overvalue the warrants and chill the resale market.\184\
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\182\ On June 26, 2009 Treasury released information on its
valuation procedure. The release contains the following statement:
``The President has clearly stated that his objective is to dispose of
the government's investments in individual companies as quickly as is
practicable. In reaching the judgment to dispose of the warrants in the
manner described, Treasury considered a range of options including
holding the warrants for a longer term or until their expiration. Under
those alternate scenarios, there was no certainty that we would realize
higher values, and it was not appropriate for the government to be
exercising discretionary judgment on timing market sales.'' U.S.
Department of Treasury, Treasury Announces Warrant Repurchase and
Disposition Process for the Capital Purchase Program, supra note 46.
\183\ More precisely, I believe that Treasury should promptly/
immediately dispose of its TARP warrants. If the somewhat vague notion
of ``as quickly as is practicable'' is interpreted by Treasury to
encompass an intermediate to long-term holding period for the TARP
warrants, then I disagree with such approach.
\184\ I do not intend to imply that the Panel has intentionally
attempted to overvalue the TARP warrants. Instead, I believe the Panel
may have taken the perspective of the ``seller'' of the warrants and as
such the Panel should appreciate that the ``buyer'' may have a
materially different perspective regarding fair market value.
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Evidence of my concern may be found in the panel's report.
In a passage destined to grab its share of media attention the
panel concludes that ``Treasury has received about 66% of the
Panel's best estimate of fair market value'' from the sale of
its warrants back to eleven TARP recipients (the ``Redeeming
Issuers'').\185\ The implication is clear--Treasury is
virtually giving the warrants back to the issuers. What should
the American taxpayers make of this claim? Should they conclude
that Treasury and its advisors are incompetent or that they
negotiated the repurchase of the warrants in bad faith and in
contravention of the letter and spirit of the SPAs? If the
panel believes that Treasury acted in an untoward manner or is
simply not up to the task then it should clearly state such
position and promptly investigate.
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\185\ See Section E.3. of the report.
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If we assume that Treasury discharged is duties and
responsibilities in good faith (and the report does not suggest
to the contrary) then we are left with a fairly pedestrian
disagreement between Treasury and the panel regarding the
valuation of the warrants; that is, a good faith difference of
opinion exists between Treasury's experts and the panel's
experts regarding the fair market value of the warrants issued
to Treasury by the Redeeming Issuers. As stated above,
reasonable minds may differ regarding these matters and
modestly different assumptions may materially affect the
valuation of warrants with a ten-year term. It is possible that
the panel selected inputs destined to yield the highest
possible ``reasonable'' set of valuations for the warrants of
the Redeeming Issuers. Such approach, however, is of little
benefit if it yields fair market value prices for the warrants
that neither the TARP recipient nor the market is willing to
pay. The panel should appreciate that the use of financial
models to value ten-year term warrants will at best only offer
a ``sticker price'' and, like careful consumers, sophisticated
market participants seldom pay ``sticker.'' \186\
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\186\ It is not at all surprising that the negotiated sales prices
fell short of the estimates generated by the financial models,
particularly those that do not incorporate liquidity discounts and
other appropriate adjustments. It appears reasonable to conclude that
in the context of the TARP warrants (and other sophisticated financial
instruments) any estimate of fair market value derived from financial
models will merely serve as the starting point for the negotiation of a
mutually agreeable valuation and under limited circumstances will such
price be accepted by an adverse party without challenge. It also
appears that Treasury terminated negotiations with two or so TARP
recipients and that the recipients did not invoke the appraisal
process. As such, Treasury will most likely seek to dispose of those
warrants in an auction in accordance with its current policy. Such
action indicates that Treasury will not accept a significantly off-
market price and will employ an auction where appropriate.
It is worth noting that the Panel states in Section E.3. of the
report that ``These results may suggest that Treasury has not been
successful in receiving fair market value for its warrants and in
maximizing taxpayer returns. On the other hand, factors not included in
the Panel's model, such as the illiquidity of the warrants especially
for smaller institutions may explain the difference between the amount
that Treasury has received for its sold warrants and the Panel's
valuation of those warrants.''
Since it appears that liquidity discounts and other adjustments may
be applicable to some or all of the Redeeming Issuers, it is
interesting that the Panel did not attempt to incorporate such
discounts into their fair market estimates. It seems that any statement
by the Panel regarding the price received by Treasury for the warrants
of the Redeeming Issues should note such qualification.
In the same section the Panel also states that the warrants
redeemed by the Redeeming Issuers represent ``less that one quarter of
one percent of the Panel's best estimate of the value of Treasury's
warrant portfolio as of July 6, 2009'' and that ``Treasury's relative
performance in selling them may not accurately predict its success in
selling the balance of the warrants it holds.''
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The report also suggests that Treasury may receive a
greater return on its investment if it disposes of its warrants
pursuant to an auction process rather than privately negotiated
transactions with the TARP recipients.\187\ While I generally
subscribe to the panel's reasoning it is important to note that
such approach should not be applied on a de facto basis. For
example, with respect to the disposition of the warrants issued
by the Redeeming Issuers it is entirely possible that a viable
auction market did not exist for the warrants of such
institutions and may not exist for the warrants of any other
TARP recipient the common stock of which is thinly traded. It
is also possible that similar liquidity, marketability,
minority interest and other appropriate discounts and
adjustments were demanded by the Redeeming Issuers as well as
the group of potential auction participants and that Treasury
after analyzing these inputs simply elected to proceed with the
least burdensome and costly approach.\188\
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\187\ See Section F.2. of the report.
\188\ In Section E.2. of the report the Panel states ``[i]f
Treasury can hold the warrants to expiration, then the value of the
warrants to Treasury does not include a liquidity discount because
Treasury does not need to sell them.'' It does not follow that
Treasury's ability (which it clearly has) to hold the warrants for
their full ten-year term should dictate such a holding period. As
noted, several compelling public policy issues favor an early
disposition of the warrants.
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Treasury will not be served by any ``failed auctions'' and
it should only go to market when its investment advisors are
all but assured of a successful disposition at an appropriate
price. Simply rolling out an auction with a Black-Scholes
generated ``reserve price'' without conducting a thoughtful
market-check is fraught with peril. I cannot help but wonder
how the markets would have responded if Treasury had set a
reserve price at or near the panel's ``Best Estimate'' price
for the warrants of the Redeeming Issuers. It is not
unreasonable to suspect that Treasury may have suffered one or
more failed auctions. This is a serious concern because
Treasury cannot afford to lose credibility with market
participants or TARP recipients. It will be interesting to note
how the fair market value determinations provided by the panel
will appear in a year or so and how many market dispositions
will occur at or near the panel's ``Best Estimate'' price.
It is also not unreasonable to expect that a TARP recipient
may be the highest bidder for its warrants. A repurchasing
institution may possess material inside information regarding
its business operations and prospects that permits it to pay a
premium over a pure market price. In addition, a TARP recipient
may pay a premium over market so as to cancel its warrants,
increase its earning per share and, perhaps, its market
capitalization.\189\ These complex matters must be considered
on a case-by-case basis. It is certainly no secret that the
public shares of many TARP recipients have traded at steep
discounts over the past year or so and, as such, it is not
unreasonable to think that the market will apply a similar
discount to the warrants of such institutions. Treasury and its
advisors should consider these factors in analyzing its exit
strategy and should select the approach that best fits the
particular facts and circumstances. I disagree with any
inference in the report to the effect that an auction of the
TARP warrants will necessarily yield a more favorable return to
Treasury than a privately negotiated sale.
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\189\ Warrants sold in an auction remain outstanding while warrants
repurchased by the issuer may be cancelled. Warrants sold in an
auction, however, do not deplete the resources of the issuer since the
acquisition price is funded by the third-party purchaser and not by the
issuer. In addition, financial accounting, regulatory and tax
considerations may favor one approach over the other.
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Although I am willing to grant Treasury and the TARP
recipients reasonable latitude in discharging their duties and
responsibilities under the SPAs, Treasury should promptly
provide written reports to the American taxpayers analyzing in
sufficient detail the fair market value determinations for any
warrants either repurchased by a TARP recipient from Treasury
or sold by Treasury through an auction. Since an auction may
yield the most favorable result for Treasury in some instances
and a privately negotiated sale in others, Treasury should
disclose its rationale for pursuing one method instead of the
other. Treasury should also undertake to negotiate the
disposition of the warrants in a transparent and fully
accountable manner with the stipulation that Treasury should
not be required to place itself (and the American taxpayers) in
an adverse negotiating position by disclosing proprietary
information that TARP recipients could use to their advantage
in subsequent negotiations. If Treasury finds it necessary to
omit from disclosure certain information that could be harmful
to negotiations were it made public, it must do so in only in
the most thoughtful and judicious manner.
2. TREASURY'S HOLDING PERIOD FOR THE TARP WARRANTS
The report may be interpreted to reflect the theme that
Treasury will somehow ``leave money on the table'' at the
expense of the American taxpayers unless it holds the TARP
warrants for the intermediate to long-term. Such impression is
misguided since (among other reasons) it is exceedingly
difficult to predict the value of financial securities and time
the markets over the short term much less the ten-year term of
the TARP warrants.\190\
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\190\ If we look back ten years to the summer of 1999 our economy
was in the middle of the dot com expansion and many (if not most)
investors viewed the financial markets as exceedingly robust. Just a
few months later the economy commenced a significant contraction--the
dot com collapse. September 11 followed with yet another material
disruption in the markets. The economy recovered and the value of
investment securities (such as the TARP warrants) steadily rose in
value only to fall dramatically beginning around the summer of 2007. To
say that the past ten years have yielded unpredictable results in the
financial markets is an understatement.
As such, any attempt by Treasury to time the disposition of its
ten-year term warrants with any degree of meaningful precision may be
met with disappointment. It is also possible that Treasury may sell the
warrants in a few years at a greater price than is available in the
near term but actually earn a lower return on a risk adjusted present
value basis.
---------------------------------------------------------------------------
I appreciate that modern corporate finance has developed
many fascinating econometric models whereby certain securities
may be valued with some degree of relative precision. The
report does a fine job of describing many of these techniques,
such as the binomial options pricing and Black-Scholes models.
While these models are remarkably sophisticated, they suffer
from the same problem endemic to all mathematical equations--
they are entirely dependent upon the input variables selected.
A thoughtful (and, perhaps, lucky) selection of variables may
yield meaningful results; otherwise the old adage of ``garbage
in, garbage out'' will prevail.\191\ Predicting inputs, such as
``volatility,'' and market adjustments, such as ``liquidity
discounts,'' over the next ten years for incorporation into the
TARP warrant valuation models is problematic at best.\192\ In
addition, valuations have a short shelf life. What may appear
reasonable today may look hopelessly out of date within a
relatively short period of time.\193\ As such, any attempt to
reflect or represent the panel's valuations as ``the'' fair
market value of the warrants is misguided.\194\ Decision makers
at Treasury should not subjugate their exercise of judgment
regarding the disposition or retention of any of the TARP
warrants solely to the results generated by financial models.
---------------------------------------------------------------------------
\191\ Many trading strategies adopted by hedge funds and other
alternative investment vehicles employ sophisticated econometric
models. They often perform as advertised and yield superior risk
adjusted returns, but occasionally they fail in a spectacular and
public manner as occurred with Long Term Capital Management in 1998 and
other investment funds over the past two years.
\192\ See Annex A to the report which includes: ``It is important
to note that the Black-Scholes model, as well as every other popular
options model, was created to reflect the prices of options with short
terms, ranging from days to months. As no options are traded on the
CBOE with terms longer than three years, it is very difficult to come
up with a ``fair market value'' of the TARP warrants which have terms
of ten years. The lack of publicly traded comparable derivatives makes
any valuation of ten year warrants difficult.
``More generally, there is the problem of lack of knowledge about
most of the inputs to the model. For example, while ten year Treasury
bills factor in what the market expects the interest rate risk for the
next ten years to be, it is impossible to know the validity of the
market's expectations. Thus, once again, it is important to note that
the value that we are searching for here is not based on our
expectations of the future, but rather our estimate of the market's
expectations. The goal of the Panel's valuations is to estimate the
value the financial markets would place on these warrants, and thus for
the inputs to our model, we try to use the inputs most likely to be
used by prospective buyers.
``The input that is the least defined in the Black-Scholes model
and has the largest effect on the price of the warrant is the
volatility of the underlying stock price. Volatility is defined as the
standard deviation of the continuously compounding returns of a stock.
It is clear from this definition that there are an almost infinite
number of variations of the calculation of this number. The volatility
is important in the Black-Scholes model because it features prominently
in both of the probability calculations in the closed-form solution,
meaning that differing values of volatility can create substantial
differences in the final valuations of the warrants. The following
example illustrates this point with respect to the Black-Scholes model.
Assume that a warrant to buy one share of company XYZ at $150 expires
in one year, that XYZ is currently trading at $100 and that the risk
free rate is one percent. If XYZ's volatility is 30 percent, the
warrant is worth $1.59, but if the volatility is 60 percent, the
warrant is worth $10.91. In fact, if the volatility is below 15
percent, the warrant is virtually worthless.''
The preceding example emphasizes the sensitivity of financial
models to changes in the various input variables. Since it is my
understanding that financial models may be ``manipulated'' or ``gamed''
but still yield ``perfectly defensible results,'' Treasury should
remain circumspect regarding fair market value determinations generated
by financial models without a real world market-check.
\193\ As an example, according to The New York Times, Citigroup
closed at $52.52 on July 9, 2007 and at $2.62 on July 8, 2009. Who
would have predicted such results?
\194\ The report reflects this concept in Section H as follows:
``The Panel's valuations offer reasonable estimates of the fair market
value of the warrants. They may help Treasury as it balances the return
to the taxpayer indicated by its own estimates of value and the host of
other relevant market, regulatory and economic factors applicable to
the disposition of sophisticated financial instruments.''
Although quite helpful, I remain concerned that others may construe
the Panel's estimates as somehow reflective of a single set of
``correct'' values.
---------------------------------------------------------------------------
The report also correctly notes that many recipients have
been stigmatized by their association with TARP and wish to
leave the program as soon as their regulators permit. Some of
the adverse consequences that have arisen for TARP recipients
include, without limitation, executive compensation
restrictions, corporate governance and conflict of interest
issues, employee retention difficulties and the distinct
possibility that TARP recipients (including those who have
repaid all CPP advances but have warrants outstanding to
Treasury) may be subjected to future adverse rules and
regulations.\195\
---------------------------------------------------------------------------
\195\ See Sections G(1)(c) and G(3) of the report.
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For these and other reasons, I recommend that Treasury not
operate under any inherent bias in favor of holding the TARP
warrants for the intermediate to long-term as opposed to
disposing of the warrants over the near term.\196\ Fortunately,
Treasury concurs with this perspective.\197\ In electing to
dispose of its warrants it appears that Treasury appreciates
that the warrants represent high risk, difficult to value
investment securities that are subject to the vagaries of the
markets and may materially diminish in value. The panel should
not discourage Treasury from promptly selling its warrants back
to the TARP recipients or from offering the warrants for sale
in the market pursuant to the SPAs. As noted, the exit strategy
undertaken by Treasury with respect to the warrants of each
TARP recipient must be carefully crafted to the facts and
circumstances of that recipient as well as the prevailing
market conditions in effect at the time of the proposed
disposition.\198\
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\196\ As noted above, I believe that Treasury should promptly
dispose of its warrants for the following reasons: (i) the profound
difficulty in valuing the warrants and advantageously timing the
market, (ii) the inherent risk associated with holding investments of
this nature, (iii) the clear desire of the American taxpayers for the
TARP recipients to repay all TARP related investments sooner rather
than later, (iv) the troublesome corporate governance and regulatory
conflict of interest issues raised by Treasury's continued ownership of
the TARP warrants, and (v) the stigma associated with continued
participation in the TARP program by the recipients.
\197\ See footnote 184.
\198\ I recently introduced legislation (H.R. 2745, supra note 29
that would require Treasury to divest its warrants in each TARP
recipient following the redemption of all outstanding TARP-related
preferred shares issued by such recipient and the payment of all
accrued dividends on such preferred shares.
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3. OTHER ISSUES
In Section G.1.c. of the report the Panel states:
A benefit from repayment of TARP assistance is the
end of the government's conflicting roles as regulator
of the very institutions in which it owns shares and on
whose profitability repayment of public funds depends.
Specific regulatory policies, for example those
affecting capital levels, the application of accounting
conventions to financial reporting by BHCs or banks,
and conflicts among regulators of various parts of
BHCs, are complicated by the government's dual
interests.
In Section G.3. of the report the Panel states:
Despite the Administration's consistent statements
that its policy is not to be involved in bank
management and to cease to hold ownership positions in
banks as soon as practicable, Treasury retains
influence over the business decisions and internal
governance of institutions in which it holds
substantial preferred stock and warrant interests.
Although ownership of preferred shares or warrants
convertible into nonvoting common shares does not
provide the sort of leverage that common stock
ownership does, holding a substantial block of
preferred stock with the terms of the Treasury
preferred (discussed below) significantly constrains
aspects of the issuing institution. Such constraints,
for example, hinder the inability to pay dividends or
engage in certain capital transactions, in exchange for
bolstering the institution's capital). Replacing the
Treasury investment with independently raised equity
frees the institution from those constraints.
The second motivation for prompt repayment of TARP
investments has to do with the specific rules or conditions to
which TARP recipients are subject. The prime examples involve
executive compensation and corporate governance restrictions
applicable to TARP recipients. While banks were aware that they
were subject to restrictions upon entrance into the CPP, banks
point to new provisions established in ARRA and by subsequent
Treasury regulatory action that are retroactively applicable to
past recipients of TARP financial assistance who have not yet
repaid Treasury.''
I concur with these remarks and recommend that Treasury
promptly proceed to dispose of its TARP warrants.
4. TERMINATION OF TARP
I reject any implication contained in the report to the
effect that the TARP program should be extended, or that well
capitalized TARP recipients should be prevented from redeeming
their preferred stock and warrants issued to Treasury.
5. TARP AS A REVOLVING FACILITY
From my review of the EESA statute I am not convinced that
Treasury may re-advance funds that have been repaid by the TARP
recipients. The panel should ask Treasury to provide a formal
written legal opinion regarding the matter.
6. PRIVATE BANK WARRANTS
The report briefly notes several of the unique issues that
have arisen with respect to the repurchase of private bank
warrants. I introduced legislation (H.R. 2745) to end the TARP
program on December 31, 2009. In addition, the legislation (i)
requires Treasury to accept TARP repayment requests from well
capitalized banks, (ii) requires Treasury to divest its
warrants in each TARP recipient following the redemption of all
outstanding TARP-related preferred shares issued by such
recipient and the payment of all accrued dividends on such
preferred shares, (iii) provides incentives for private banks
to repurchase their warrant preferred shares from Treasury, and
(iv) reduces spending authority under the TARP program for each
dollar repaid. The legislation enables private banks to
repurchase the exercised warrant preferred shares on or before
September 30, 2009 at their pre-exercise price. As such,
private banks that typically issued warrant preferred shares to
Treasury for $0.01 per share may repurchase the shares for
$0.01 per share. This legislation provides that each bank must
be current on all dividends to be eligible for repayment. The
policy objective for economically encouraging private banks to
repurchase their warrant preferred shares relates to the
structural differences between private and public bank
warrants. Pursuant to the SPAs, private banks are economically
encouraged to delay the repurchase of their warrant preferred
shares so as to decrease the overall cost to the private banks
of their participation in the TARP program.
C. John Sununu
This Report represents a good faith attempt to describe the
factors that must be weighed by Treasury, Regulators, Congress,
and Financial Institutions as the capital issued under the TARP
is returned to the Treasury. By offering a detailed examination
of these issues at the beginning of this process, the
Congressional Oversight Panel will help ensure that Treasury
and Congress place the maximum value on transparency and
consistency in the management of the CPP. These two qualities
are essential to sustaining public confidence in both
government and the financial marketplace.
In his Additional Views, Panel member Richard Neiman
highlights several key questions for policy makers: considering
the non-financial returns of the TARP, maintaining a clear
policy for exiting Treasury's warrant holdings in a timely
fashion, and exercising caution in drawing conclusions based
upon repayments by just a few small banks. These are very
important issues, and in each area I share the concerns he
describes in detail. I also wish to add several points of
emphasis and clarification:
Treasury and Congress should be particularly
mindful that retroactive changes in policy, process, or
contracts undermine confidence in TARP programs and discourages
participation. Both effects make any given program less likely
to fulfill its objectives. As Treasury works to protect
taxpayer interests during the CPP repayment process, it should
work to increase transparency while operating within the spirit
and letter of agreements that govern the CPP transactions.
Both the current and previous administrations have
made clear policy determinations to exit their warrant holdings
as soon as is practicable as banks redeem preferred shares
under the CPP. This policy is consistent with the original
intent of the legislation, reduces downside risk to taxpayers,
and conforms to the original share purchase agreements. Equally
important, this policy sends an important signal to the public
and to investors that the Federal Government does not wish to
exert undue control or influence over firms that are on solid
financial footing.
In most cases, the value of warrants held by
Treasury will prove difficult to calculate with precision due
to the broad assumptions that must be made with regard to both
the volatility and liquidity of the underlying securities. In
such an event, Treasury has taken important steps in defining a
clear process for repayments under CPP, utilizing independent
firms for valuation, and establishing an approach for resolving
differences in valuations that may arise.
As a final point, it should be noted that the
Executive Summary states that ``The Panel has not reached a
consensus on whether it is wise policy to release banks from
the TARP program at this time . . .'' This phrase suggests that
the Treasury has (or should have) the power to force healthy
banks that meet all regulatory requirements to hold CPP issued
securities. I do not believe that such powers were ever
contemplated by Congress in authorizing TARP. Nor do I believe
that it is the responsibility of the Congressional Oversight
Panel to determine which banks should be eligible (or required)
to participate in TARP.
As can be seen in the Panel Report, taxpayers will see a
positive rate of return for all repayments that have been
approved to date by Treasury under the CPP--even if the value
of warrants were excluded. While it is important that taxpayers
receive fair value for these securities, it is equally
important that the principal objectives of TARP, namely a
stable financial system, be realized and sustained. The best
way to ensure balance between these goals is to allow the
principles of transparency and consistency to guide the hand of
policy makers in the months ahead.
SECTION THREE: CORRESPONDENCE WITH TREASURY UPDATE
On behalf of the Panel, Chair Elizabeth Warren sent a
letter to Secretary Geithner on June 12, 2009, requesting
information about Treasury's announcement on June 9, 2009, to
allow ten of the largest U.S. financial institutions
participating in the CPP to repay their TARP funds.\199\ The
letter seeks answers to several key questions raised by the
TARP repayments and additional information relating to
Treasury's valuations of warrants outstanding, repurchased, and
of those ten institutions with which it is in warrant
repurchase negotiations. The letter specifically requests a
meeting between Panel staff and Treasury staff about the TARP
repayments and the treatment of warrants as part of those
repayments. On July 1, 2009, Secretary Geithner responded by
letter \200\ to this request. The letter, noting that Treasury
staff has recently held two meetings with Panel members Richard
H. Neiman and Damon Silvers and Panel staff concerning these
issues, represented Treasury's response to the Panel's
questions and information requests. Treasury provided copies of
the recently issued warrants policy press release and FAQ and a
written responses to each of the Panel's questions and
information requests, which Panel staff is currently reviewing.
---------------------------------------------------------------------------
\199\ See Appendix I of this report, infra.
\200\ See Appendix II of this report, infra.
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Chair Elizabeth Warren and Panel member Richard H. Neiman
sent a letter to Secretary Geithner on June 29, 2009,
requesting assistance with the Panel's oversight of federal
foreclosure mitigation efforts.\201\ In particular, the letter
references how the lack of adequate mortgage data has hampered
policymaking and notes Secretary Geithner's decision to include
data collection requirements for mortgage loans participating
in President Obama's Making Home Affordable (MHA) program,
announced on February 18, 2009. In order to evaluate the
effectiveness of foreclosure mitigation efforts, the letter
requests copies of the data collected under the MHA program, as
well as relevant reports, to be delivered on a monthly basis.
---------------------------------------------------------------------------
\201\ See Appendix III of this report, infra.
SECTION FOUR: TARP UPDATES SINCE LAST REPORT
A. INTERIM FINAL RULE ON TARP STANDARDS FOR COMPENSATION AND CORPORATE
GOVERNANCE
On June 10, 2009, Treasury released interim regulations
implementing the executive compensation and corporate
governance provisions governing TARP recipients set forth in
the American Recovery and Reinvestment Act of 2009 (ARRA),
announced a set of principles for future executive compensation
reform for all public corporations, and proposed two
legislative initiatives designed to advance these principles.
In announcing the interim rule, Secretary Geithner outlined
five principles for reform of executive compensation: (1)
compensation plans should properly measure and reward
performance; (2) compensation should be structured to account
for the time horizon of risks; (3) compensation practices
should be aligned with sound risk management; (4) retirement
packages should align with executive and shareholder interests;
(5) and compensation process should be transparent and
accountable. The Administration also indicated that it would
propose new legislation to provide compensation committees with
independence similar to the independence of audit committees
under Sarbanes-Oxley, and to provide the SEC authority to
require non-binding annual say-on-pay votes on compensation for
the top five executives and golden parachutes for executives at
all public companies.
B. REGULATION REFORM PROPOSAL
On June 17, 2009, Treasury released the Administration's
proposal entitled ``Financial Regulatory Reform: A New
Foundation,'' detailing its agenda and recommendations for
rebuilding financial supervision and regulation. The
Administration's plan touches almost every corner of financial
markets, from tougher consumer protection policies to stricter
rules over exotic financial products, such as credit
derivatives. The plan would bring many of the financial
products and companies that previously operated outside of the
banking system under federal scrutiny. In its proposal,
Treasury announced five principles for financial regulatory
reform: (1) promote robust supervision and regulation of
financial firms; (2) establish comprehensive regulation of
financial markets; (3) protect consumers and investors from
financial abuse; (4) provide the government with the tools it
needs to manage financial crises; and (5) raise international
regulatory standards and improve international cooperation.
On June 30, 2009, the Obama Administration sent a 150-page
proposal to Congress for a new agency to oversee consumer
lending and other financial activity, the Consumer Financial
Protection Agency. The proposed agency would consolidate
regulatory authority now spread over multiple agencies and
would have the authority to monitor and introduce regulation
aimed at ensuring transparency in consumer financial products.
C. CONFIRMATION OF HERBERT ALLISON AS ASSISTANT SECRETARY FOR FINANCIAL
STABILITY
On June 19, 2009, the Senate confirmed Herbert Allison as
Assistant Secretary for Financial Stability. In this role, Mr.
Allison will develop and coordinate Treasury programs related
to financial stability, including the TARP. Mr. Allison's prior
positions include President and Chief Executive Officer of
Fannie Mae, Chairman, President, and Chief Executive Officer of
TIAA-CREF, and President and Chief Operating Officer of Merrill
Lynch.
D. TREASURY ANNOUNCES PROCESS FOR REPAYMENT OF CPP
On June 9, 2009, Treasury announced that ten of the largest
Capital Purchase Program (CPP) participants had been approved
to repay the TARP funds they had received. The repayment is
expected to be approximately $68 billion.
On June 26, 2009, Treasury announced the process by which
TARP recipients would be able to repurchase the warrants issued
as part of the Capital Purchase Program in 2008. Under these
terms, once a bank has repaid the TARP money, it has 15 days to
submit a determination of fair market value to Treasury.
Treasury, within 10 days, may either accept the determination
or, if it is unable to reach agreement on the value with the
bank, may use the appraisal process outlined in the relevant
transaction documents. According to the appraisal process,
Treasury and the bank each select an independent appraiser.
Once the appraisers have conducted their own valuations, they
will attempt to agree on a fair market price. If they fail to
agree, a third appraiser is hired and a composite value from
the three appraisers is used as the fair market price.
E. TERM ASSET-BACKED SECURITIES LOAN FACILITY (TALF)
The Federal Reserve Bank of New York held a special
subscription on June 16, 2009, for TALF loans secured by new
commercial mortgage-backed securities (CMBS). There were no
requests made for loans on that date. The Bank intends to hold
a special subscription for legacy CMBS (those issued before
January 1, 2009) in late July.
During the regular TALF subscription on July 7, 2009, $5.4
billion in loans was requested. As a point of comparison, there
were $11.5 billion in loans requested at the June facility,
$10.6 billion requested at the May facility, $1.7 billion at
the April facility, and $4.7 billion at the March facility. The
July 7 subscription included requests for loans secured by
asset-backed securities in the auto, credit card, servicing
advances, small business, and student loan sectors. There were
no requests for loans in the equipment, floor plan, or premium
finance sectors. The July 7 subscription was not available for
loans secured by CMBS; a special CMBS subscription is planned
for later this month.
F. GENERAL MOTORS BANKRUPTCY PLAN APPROVED
On July 5, 2009, Judge Robert Gerber of the Bankruptcy
Court for the Southern District of New York approved a
bankruptcy plan for General Motors that would permit the auto
maker to emerge from bankruptcy as soon as mid-July. Under the
plan, NGMCO, Inc., an entity funded by the U.S. Treasury, would
purchase substantially all of GM's assets. NGMCO would then
change its name to General Motors Company and continue most of
former GM's business with a more streamlined product portfolio.
The new GM will remain headquartered in Detroit, Michigan, and
will be led by Fritz Henderson as president and CEO, and Edward
Whitacre as chairman of the board of directors. Of the common
stock for the new GM, 60.8 percent will be owned by the US
Treasury, 17.5 percent by the UAW Retiree Medical Benefits
Trust; 11.7 percent by the governments of Canada and Ontario,
and ten percent by old GM.
G. CPP MONTHLY LENDING REPORT
Treasury releases a monthly lending report showing loans
outstanding for CPP recipients. The most recent report includes
data up through the end of April 2009 and shows that CPP
recipients had $5.15 billion in loans outstanding as of April
30, 2009. This represents a 0.67 percent decline in loans
between the end of March and the end of April.
H. FUND MANAGERS FOR PPIP LEGACY SECURITIES FUNDS SELECTED
On July 8, 2009, Treasury, the Federal Reserve, and the
FDIC issued a joint release announcing the selection of nine
applicants for pre-qualification as PPIP fund managers. Ten
small, veteran-, minority-, and/or women-owned firms were also
selected to partner with the fund managers to provide asset
management, capital raising, broker-dealer, research, advisory,
investment sourcing, and fund administration services. The pre-
qualified firms will have twelve weeks to raise $500 million in
equity, $20 million of which must be provided by the firms
themselves. Once this money has been raised, the PPIP funds
will receive matching $500 million in Treasury equity, and will
be eligible for additional government-sponsored financing.
I. METRICS
In recent months, the Panel's oversight reports have
highlighted a number of metrics that the Panel and others,
including Treasury, the Government Accountability Office (GAO),
Special Inspector General for the Troubled Asset Relief Program
(SIGTARP), and the Financial Stability Oversight Board,
consider useful in assessing the effectiveness of the
Administration's efforts to restore financial stability and
accomplish the goals of the EESA. This section discusses
changes that have occurred in several indicators since the
release of the Panel's June report.
Interest Rate Spreads. Key interest rate spreads
have leveled off to some extent following precipitous drops
between the Panel's May and June oversight reports. While there
was no general pattern in interest rate spread movement in
recent weeks (some decreased modestly while others increased
modestly), spreads remain well below the crisis levels seen
late last year, and Treasury and Federal Reserve officials
continue to cite the moderation of these spreads as a key
indicator of a stabilizing economy.\202\
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\202\ See Congressional Oversight Panel, Testimony of Assistant
Treasury Secretary for Financial Security Herbert Allison, Jr., Hearing
with Assistant Treasury Secretary Herbert Allison (June 24,
2009)(online at cop.senate.gov/hearings/library-062409-
allison.cfm)(``There are tentative signs that the financial system is
beginning to stabilize and that our efforts have made an important
contribution. Key indicators of credit market risk, while still
elevated, have dropped substantially.'')
FIGURE 6: INTEREST RATE SPREADS
------------------------------------------------------------------------
Percent Change
Indicator Current Spread Since Last Report
(as of 7/9/09) (6/8/09)
------------------------------------------------------------------------
3 Month LIBOR-OIS Spread \203\.... 0.31 -24.39
1 Month LIBOR-OIS Spread \204\.... 0.11 10.00
TED Spread \205\ (in basis points) 32.94 -31.03
Conventional Mortgage Rate Spread 1.79 14.01
\206\............................
Corporate AAA Bond Spread \207\... 1.87 -6.50
Corporate BAA Bond Spread \208\... 3.65 -9.88
Overnight AA Asset-backed 0.18 0.00
Commercial Paper Interest Rate
Spread \209\.....................
Overnight A2/P2 Nonfinancial 0.27 -15.63
Commercial Paper Interest Rate
Spread \210\.....................
------------------------------------------------------------------------
\203\ 3 Mo LIBOR-OIS Spread, Bloomberg (online at www.bloomberg.com/apps/
quote?ticker=.LOIS3:IND1) (accessed July 9, 2009).
\204\ 1 Mo LIBOR-OIS Spread, Bloomberg (online at www.bloomberg.com/
apps;/quote?ticker=.LOIS1:IND1) (accessed July 9, 2009).
\205\ TED Spread, Bloomberg (online at www.bloomberg.com/apps/
quote?ticker=.TEDSP:IND) (accessed July 9, 2009).
\206\ Board of Governors of the Federal Reserve System, Federal Reserve
Statistical Release H.15: Selected Interest Rates: Historical Data
(Instrument: Conventional Mortgages, Frequency: Weekly) (online at
www.federalreserve.gov/releases/h15/data/Weekly_Thursday_/
H15_MORTG_NA.txt) (accessed July 9, 2009); Board of Governors of the
Federal Reserve System, Federal Reserve Statistical Release H.15:
Selected Interest Rates: Historical Data (Instrument: U.S. Government
Securities/Treasury Constant Maturities/Nominal 10-Year, Frequency:
Weekly) (online at www.federalreserve.gov/releases/h15/data/
Weekly_Friday_/H15_TCMNOM_Y10.txt) (accessed July 9, 2009)
(hereinafter ``Fed H.15 10-Year Treasuries'').
\207\ Board of Governors of the Federal Reserve System, Federal Reserve
Statistical Release H.15: Selected Interest Rates: Historical Data
(Instrument: Corporate Bonds/Moody's Seasoned AAA, Frequency: Weekly)
(online at www.federalreserve.gov/releases/h15/data/Weekly_Friday_/
H15_AAA_NA.txt) (accessed July 9, 2009); Fed H.15 10-Year Treasuries,
supra note 206.
\208\ Board of Governors of the Federal Reserve System, Federal Reserve
Statistical Release H.15: Selected Interest Rates: Historical Data
(Instrument: Corporate Bonds/Moody's Seasoned BAA, Frequency: Weekly)
(online at www.federalreserve.gov/releases/h15/data/Weekly_Friday_/
H15_BAA_NA.txt) (accessed July 9, 2009); Fed H.15 10-Year Treasuries,
supra note 206.
\209\ Board of Governors of the Federal Reserve System, Federal Reserve
Statistical Release: Commercial Paper Rates and Outstandings: Data
Download Program (Instrument: AA Asset-Backed Discount Rate,
Frequency: Daily) (online at www.federalreserve.gov/DataDownload/
Choose.aspx?rel=CP) (accessed July 9, 2009); Board of Governors of the
Federal Reserve System, Federal Reserve Statistical Release:
Commercial Paper Rates and Outstandings: Data Download Program
(Instrument: AA Nonfinancial Discount Rate, Frequency: Daily) (online
at www.federalreserve.gov/DataDownload/Choose.aspx?rel=CP) (accessed
July 9, 2009) (hereinafter ``Fed CP AA Nonfinancial Rate'').
\210\ Board of Governors of the Federal Reserve System, Federal Reserve
Statistical Release: Commercial Paper Rates and Outstandings: Data
Download Program (Instrument: A2/P2 Nonfinancial Discount Rate,
Frequency: Daily) (online at www.federalreserve.gov/DataDownload/
Choose.aspx?rel=CP) (accessed July 9, 2009).
Commercial Paper Outstanding. Commercial paper
outstanding, a rough measure of short-term business debt, is an
indicator of the availability of credit for enterprises. While
financial commercial paper outstanding saw an increase last
month, asset-backed and nonfinancial commercial paper levels
have continued to drop, with both falling by nearly 20 percent
since early June.
FIGURE 7: COMMERCIAL PAPER OUTSTANDING
------------------------------------------------------------------------
Current Level (as
of 7/9/09) Percent Change
Indicator (dollars Since Last Report
billions) (6/8/09)
------------------------------------------------------------------------
Asset-Backed Commercial Paper $456.75 -18.06
Outstanding (seasonally adjusted)
\211\............................
Financial Commercial Paper 554.15 4.46
Outstanding (seasonally adjusted)
\212\............................
Nonfinancial Commercial Paper 125.49 -19.89
Outstanding (seasonally adjusted)
\213\............................
------------------------------------------------------------------------
\211\ Board of Governors of the Federal Reserve System, Federal Reserve
Statistical Release: Commercial Paper Rates and Outstandings: Data
Download Program (Instrument: Asset-Backed Commercial Paper
Outstanding, Frequency: Weekly) (online at www.federalreserve.gov/
DataDownload/Choose.aspx?rel=CP) (accessed July 9, 2009).
\212\ Board of Governors of the Federal Reserve System, Federal Reserve
Statistical Release: Commercial Paper Rates and Outstandings: Data
Download Program (Instrument: Financial Commercial Paper Outstanding,
Frequency: Weekly) (online at www.federalreserve.gov/DataDownload/
Choose.aspx?rel=CP) (accessed July 9, 2009).
\213\ Board of Governors of the Federal Reserve System, Federal Reserve
Statistical Release: Commercial Paper Rates and Outstandings: Data
Download Program (Instrument: Nonfinancial Commercial Paper
Outstanding, Frequency: Weekly) (online at www.federalreserve.gov/
DataDownload/Choose.aspx?rel=CP) (accessed July 9, 2009).
Lending by the Largest TARP-recipient Banks.
Treasury's Monthly Lending and Intermediation Snapshot tracks
loan originations and average loan balances for the 21 largest
recipients of CPP funds across a variety of categories, ranging
from mortgage loans to commercial and industrial loans to
credit card lines. Originations decreased across nearly all
categories of bank lending in April when compared to
March.\214\ Lenders surveyed by Treasury attribute this decline
in originations to seasonality and a decrease in demand.\215\
The dramatic drop in commercial and industrial and commercial
real estate originations is particularly noteworthy, with
originations in both categories decreasing by over 30 percent.
Banks reported that demand for these commercial loans was well
below normal levels; further, banks predicted that this lower
demand would continue through the remainder of the second
quarter of 2009.\216\ Average loan balances fell across all
categories from March to April, with banks reporting that
borrowers are paying down existing debt.\217\ The data below
exclude lending by two large CPP-recipient banks, PNC Bank and
Wells Fargo, because significant acquisitions by those banks
since last October make comparisons difficult.
---------------------------------------------------------------------------
\214\ U.S. Department of the Treasury, Treasury Department Monthly
Lending and Intermediation Snapshot Data for October 2008-April 2009
(June 15, 2009) (online at www.financialstability.gov/docs/surveys/
Snapshot_Data_April%202009.xls)(hereinafter ``Treasury Snapshot April
Summary Data'').
\215\ U.S. Department of the Treasury, Treasury Department Monthly
Lending and Intermediation Snapshot: Summary Analysis for April 2009
(June 15, 2009) (online at www.financialstability.gov/docs/surveys/
SnapshotAnalysisApril2009.pdf)(hereinafter ``Treasury April Lending
Snapshot'').
\216\ Id.
\217\ Id.
FIGURE 8: LENDING BY THE LARGEST TARP-RECIPIENT BANKS
------------------------------------------------------------------------
Most recent
data Percent Percent
(April change change
Indicator 2009) since March since
(dollars in 2009 October
millions) 2008
------------------------------------------------------------------------
Total Loan Originations.......... $199,284 -9.48 -8.66
C&I New Commitments.............. 32,488 -37.15 -44.89
CRE New Commitments.............. 3,470 -30.78 -67.03
Mortgage Refinancing............. 49,009 -7.74 161.13
---------------------------
------------------------------------------------------------------------
Loans and Leases Outstanding of Domestically-
Chartered Banks. Weekly data from the Federal Reserve Board
track fluctuations among different categories of bank assets
and liabilities. The Federal Reserve Board data are useful in
that they separate out large domestic banks and small domestic
banks. Loans and leases outstanding for large and small
domestic banks both fell last month.\218\ However, total loans
and leases outstanding at small domestic banks remain slightly
above last October's level, while total loans and leases
outstanding at large banks have dropped by over 4.4 percent
since that time.\219\
---------------------------------------------------------------------------
\218\ Board of Governors of the Federal Reserve System, Federal
Reserve Statistical Release H.8: Assets and Liabilities of Commercial
Banks in the United States: Historical Data (Instrument: Assets and
Liabilities of Large Domestically Chartered Commercial Banks in the
United States, Seasonally adjusted, adjusted for mergers, billions of
dollars) (online at www.federalreserve.gov/releases/h8/data.htm)
(accessed July 9, 2009).
\219\ Board of Governors of the Federal Reserve System, Federal
Reserve Statistical Release H.8: Assets and Liabilities of Commercial
Banks in the United States: Historical Data (Instrument: Assets and
Liabilities of Small Domestically Chartered Commercial Banks in the
United States, Seasonally adjusted, adjusted for mergers, billions of
dollars) (online at www.federalreserve.gov/releases/h8/data.htm)
(accessed July 9, 2009).
FIGURE 9: LOANS AND LEASES OUTSTANDING
------------------------------------------------------------------------
Percent
Current Percent change
level (as change since ESSA
Indicator of 7/9/09) since last signed
(dollars in report (6/8/ into law
billions) 09) (10/3/08)
------------------------------------------------------------------------
Large Domestic Banks--Total Loans 3,939.9 -1.13 -4.41
and Leases......................
Small Domestic Banks--Total Loans 2,449.0 -1.26 0.09
and Leases......................
------------------------------------------------------------------------
Housing Indicators. Foreclosure filings fell by
roughly six percent from April to May, while remaining nearly
15 percent above the level of last October. Housing prices, as
illustrated by the S&P/Case-Shiller Composite 20 Index,
continued to dip in April. The index remains down over ten
percent since October 2008.
FIGURE 10: HOUSING INDICATORS
------------------------------------------------------------------------
Percent
change from Percent
Most recent data change
Indicator monthly available since
data at time of October
last report 2008
(6/8/09)
------------------------------------------------------------------------
Monthly Foreclosure Filings \220\ 321,480 -6.01 14.99
Housing Prices-S&P/Case-Shiller 140.1 -0.88 -10.82
Composite 20 Index \221\........
------------------------------------------------------------------------
\220\ RealtyTrac, Foreclosure Activity Press Releases (online at
www.realtytrac.com//ContentManagement/PressRelease.aspx) (accessed
July 9, 2009).
\221\ Standard & Poor's, S&P/Case-Shiller Home Price Indices
(Instrument: Seasonally Adjusted Composite 20 Index) (online at
www2.standardandpoors.com/spf/pdf/index/
SA_CSHomePrice_History_063055.xls (accessed July 9, 2009).
J. FINANCIAL UPDATE
In its April oversight report, the Panel assembled a
summary of the resources the federal government has committed
to economic stabilization. The following provides (1) an
updated accounting of the TARP, including a tally of dividend
income and repayments the program has received as of July 2,
2009, and (2) an update of the full federal resource commitment
as of July 2, 2009.
1. TARP
a. Costs: Expenditures and Commitments
Through an array of programs used to purchase preferred
shares in financial institutions, offer loans to small
businesses and auto companies, and leverage Federal Reserve
loans for facilities designed to restart secondary
securitization markets, Treasury has committed to spend $645.5
billion, leaving $60.8 billion available for new programs or
other needs.\222\ Of the $645.5 billion that Treasury has
committed to spend, $441 billion has already been allocated and
counted against the statutory $698.7 billion limit.\223\ This
includes purchases of preferred shares, warrants and/or debt
obligations under the CPP, TIP, SSFI Program, and AIFP, a $20
billion loan to TALF LLC, the special purpose vehicle used to
guarantee Federal Reserve TALF loans, and the $5 billion
Citigroup asset guarantee already exchanged for a guarantee fee
composed of additional preferred shares and warrants.\224\
Additionally, Treasury has allocated $18 billion to the Home
Affordable Modification Program, out of a projected total
program level of $50 billion, but has not yet distributed any
of these funds. Treasury will release its next tranche report
when transactions under the TARP reach $450 billion.
---------------------------------------------------------------------------
\222\ EESA limits Treasury to $700 billion in purchasing authority
outstanding at any one time as calculated by the sum of the purchases
prices of all troubled assets held by Treasury. EESA, supra note 13,
Sec. 115(a)-(b) (codified at 12 U.S.C. 5225(a)-(b)); Helping Families
Save Their Homes Act of 2009, Pub. L. No. 111-22, sec. 402(f) (online
at frwebgate.access.gpo.gov/cgi-bin/
getdoc.cgi?dbname=111_cong_bills&docid=f:s896enr.txt.pdf) (reducing by
$1.26 billion the authority for the TARP originally set under EESA at
$700 billion).
\223\ This figure does not include the repurchases of CPP preferred
shares.
\224\ U.S. Department of the Treasury, Troubled Asset Relief
Program: Transactions Report For Period Ending June 30, 2009. (July 2,
2009) (online at www.financialstability.gov/docs/transaction-reports/
transactions-report_070209.pdf) (hereinafter ``July 2 TARP Transaction
Report'').
---------------------------------------------------------------------------
b. Income: Dividends and Repayments
Following the repayments of CPP infusions by nine of the
stress-tested BHCs, the total amount of TARP repayments surged
from just under $2 billion to over $70 billion.\225\ In
addition, Treasury's investment in preferred shares entitles it
to dividend payments from the institutions in which it invests,
usually five percent per annum for the first five years and
nine percent per annum thereafter.\226\ Treasury has not yet
begun to officially report dividend payments on its transaction
reports.
---------------------------------------------------------------------------
\225\ Id. See also Section One, Part F of this report (providing a
table with detailed information on repurchases to date).
\226\ See, e.g., Securities Purchase Agreement, supra note 15.
---------------------------------------------------------------------------
c. TARP Accounting as of July 2, 2009
FIGURE 11: TARP ACCOUNTING (AS OF July 2, 2009)
[Dollars in billions]
----------------------------------------------------------------------------------------------------------------
Announced Purchase
TARP Initiative Funding Price Repayments Dividend Income
----------------------------------------------------------------------------------------------------------------
Total............................................. 638 \227\ 441 \228\ 70.124 \229\ 6.651
CPP........................................... 218 203.2 70.124 5.255
TIP........................................... 40 40 0 1.128
SSFI Program.................................. 70 69.8 0 0
AIFP.......................................... 80 80 0 0.160
AGP........................................... 5 5 0 0.108
CAP........................................... TBD 0 0 0
TALF.......................................... 80 20 0 0
PPIP.......................................... 75 0 0 0
Supplier Support Program...................... 5 5 0 0
Unlocking SBA Lending......................... 15 0 0 0
HAMP.......................................... 50 \230\ 18.0 0 0
----------------------------------------------------------------------------------------------------------------
\227\ See July 2 TARP Transaction Report, supra note 224.
\228\ See July 2 TARP Transaction Report, supra note 224.
\229\ As of June 30, 2009. This information was provided to the Panel by Treasury staff.
\230\ Reflects the cap set on payments to each mortgage servicer. See July 2 TARP Transactions Report, supra
note 224.
2. OTHER FINANCIAL STABILITY EFFORTS
Federal Reserve, FDIC, and Other Programs
In addition to the more direct expenditures Treasury has
undertaken through the TARP, the federal government has also
engaged in a much broader program directed at stabilizing the
U.S. financial system. Many of these programs explicitly
augment Treasury funds, like FDIC guarantees of securitization
of PPIP Legacy Loans or asset guarantees for Citigroup, or
operate in tandem with Treasury programs, such as the
interaction between PPIP and TALF. Other programs, like the
Federal Reserve's extension of credit through its Sec. 13(3)
facilities and special purpose vehicles or the FDIC's Temporary
Liquidity Guarantee Program, stand independent of the TARP and
seek to accomplish different goals.
3. TOTAL FINANCIAL STABILITY RESOURCES AS OF JULY 2, 2009
Beginning in its April report, the Panel broadly classified
the resources that the federal government has devoted to
stabilizing the economy through a myriad of new programs and
initiatives, as outlays, loans, or guarantees. Although the
Panel has calculated the total value of these resources at over
$4 trillion, this would translate into the ultimate ``cost'' of
the stabilization effort only if: (1) assets do not appreciate,
(2) no dividends are received, no warrants are exercised, and
no TARP funds are repaid, (3) all loans default and are written
off, and (4) all guarantees are exercised and subsequently
written off.
FIGURE 12: FEDERAL GOVERNMENT FINANCIAL STABILITY EFFORT (AS OF JULY 2, 2009)
[Dollars in billions]
----------------------------------------------------------------------------------------------------------------
Treasury Federal
Program (TARP) Reserve FDIC Total
----------------------------------------------------------------------------------------------------------------
Total............................................... 698.7 2,197.2 1,372.7 \233\ 4,268.6
Outlays \231\................................... 516.6 0 37.7 554.3
Loans........................................... 36.3 1967.4 0 2,003.7
Guarantees \232\................................ 85 230 1,335 1,649.8
Uncommitted TARP Funds.......................... 60.8 0 0 60.8
AIG................................................. 70 100 0 170
Outlays......................................... \234\ 70 0 0 70
Loans........................................... 0 \235\ 100 0 100
Guarantees...................................... 0 0 0 0
Bank of America..................................... 45 0 0 45
Outlays......................................... \237\ 45 0 0 0
Loans........................................... 0 0 0 0
Guarantees \236\................................ 0 0 0 0
Citigroup........................................... 50 229.8 10 289.8
Outlays......................................... \238\ 45 0 0 45
Loans........................................... 0 0 0 0
Guarantees...................................... \239\ 5 \240\ 229.8 \241\ 10 244.8
Capital Purchase Program (Other).................... 168 0 0 168
Outlays......................................... \242\ 168 0 0 168
Loans........................................... 0 0 0 0
Guarantees...................................... 0 0 0 0
Capital Assistance Program.......................... TBD TBD TBD \243\ TBD
TALF................................................ 80 720 0 800
Outlays......................................... 0 0 0 0
Loans........................................... 0 \245\ 720 0 720
Guarantees...................................... \244\ 80 0 0 0
PPIF (Loans) \246\.................................. 45 0 540 585
Outlays......................................... 45 0 0 45
Loans........................................... 0 0 0 0
Guarantees...................................... 0 0 \247\ 540 540
PPIF (Securities)................................... 30 0 0 30
Outlays......................................... \248\ 12.5 0 0 12.5
Loans........................................... 17.5 0 0 17.5
Guarantees...................................... 0 0 0 0
Home Affordable Modification Program................ 50 0 0 \250\ 50
Outlays......................................... \249\ 50 0 0 50
Loans........................................... 0 0 0 0
Guarantees...................................... 0 0 0 0
Automotive Industry Financing Program............... \251\ 80 0 0 80
Outlays......................................... \252\ 66.1 0 0 66.1
Loans........................................... 13.8 0 0 13.8
Guarantees...................................... 0 0 0 0
Auto Supplier Support Program....................... 5 0 0 5
Outlays......................................... 0 0 0 0
Loans........................................... \253\ 5 0 0 5
Guarantees...................................... 0 0 0 0
Unlocking SBA Lending............................... 15 0 0 15
Outlays......................................... \254\15 0 0 15
Loans........................................... 0 0 0 0
Guarantees...................................... 0 0 0 0
Temporary Liquidity Guarantee Program............... 0 0 785 785
Outlays......................................... 0 0 0 0
Loans........................................... 0 0 0 0
Guarantees...................................... 0 0 \255\ 785 785
Deposit Insurance Fund.............................. 0 0 37.7 37.7
Outlays......................................... 0 0 \256\ 37.7 037.7
Loans........................................... 0 0 0 0
Guarantees...................................... 0 0 0 0
Other Federal Reserve Credit Expansion.............. 0 1,147.4 0 1,147.4
Outlays......................................... 0 0 0 0
Loans........................................... 0 \257\ 1,147.4 0 1,147.4
Guarantees...................................... 0 0 0 0
Uncommitted TARP Funds.............................. \258\ 60.8 0 0 60.8
----------------------------------------------------------------------------------------------------------------
\231\ The term ``outlays'' is used here to describe the use of Treasury funds under the TARP, which are broadly
classifiable as purchases of debt or equity securities (e.g., debentures, preferred stock, exercised warrants,
etc.). The outlays figures are based on: (1) Treasury's actual reported expenditures; and (2) Treasury's
anticipated funding levels as estimated by a variety of sources, including Treasury pronouncements and GAO
estimates. Anticipated funding levels are set at Treasury's discretion, have changed from initial
announcements, and are subject to further change. The outlays concept used here represents cash disbursements
and commitments to make cash disbursements and is not the same as budget outlays, which under Sec. 123 of
EESA are recorded on a ``credit reform'' basis.
\232\ While many of the guarantees may never be exercised or exercised only partially, the guarantee figures
included here represent the federal government's greatest possible financial exposure.
\233\ This figure differs substantially from the $2,476-2,976 billion range of ``Total Funds Subject to SIGTARP
Oversight'' reported during testimony before the Senate Finance Committee on March 31, 2009. Senate Committee
on Finance, Testimony of SIGTARP Neil Barofsky, TARP Oversight: A Six Month Update, 111th Cong. (Mar. 31,
2009). SIGTARP's accounting, designed to capture only those funds potentially under its oversight authority,
is both less and more inclusive than the Panel's, and thus the two are not directly comparable. Among the
differences, SIGTARP does not account for Federal Reserve credit extensions outside of the TALF or FDIC
guarantees under the Temporary Liquidity Guarantee Program and sets the maximum Federal Reserve guarantees
under the TALF at $1 trillion.
\234\ This number includes investments under the SSFI program: a $40 billion investment made on November 25,
2008, and a $30 billion investment committed on April 17, 2009 (less a reduction of $165 million representing
bonuses paid to AIG Financial Products employees). July 2 TARP Transaction Report, supra note 224.
\235\ This number represents the full $60 billion that is available to AIG through its revolving credit facility
with the Federal Reserve ($43.5 billion had been drawn down as of July 1) and the outstanding principle of the
loans extended to the Maiden Lane II and III special purpose vehicles (AIG SPVs) to buy AIG assets (as of July
1, $17.5 billion and $22.4 billion respectively). See Fed Balance Sheet July 2, supra note 69. The Panel
continues to calculate the exposure attributable to the revolving credit facility at $60 billion. However,
whereas previously the Panel had calculated the exposure attributable to the AIG SPVs at the initially
announced amount of Federal Reserve loans to the SPVs, we have changed our methodology. Based on its review of
new Federal Reserve documents, the Panel now believes that its previous methodology overstated the Federal
Reserve's exposure to AIG. The initially announced amount of loans was based on the Federal Reserve's
estimated cost to purchase a particular pool of AIG assets. However, the value of these assets declined by the
time the AIG SPVs purchased them, necessitating a smaller loan than was initially announced. Furthermore,
income from the purchased assets is used to pay down the loan, reducing the taxpayers' exposure to losses over
time. See Board of Governors of the Federal Reserve System, Federal Reserve System Monthly Report on Credit
and Liquidity Programs and the Balance Sheet, at 14-16 (June 2009) (online at www.federalreserve.gov/
newsevents/monthlyclbsreport200906.pdf ); Letter from Federal Reserve Chairman Benjamin Bernanke to
Congressional Oversight Panel Chair Elizabeth Warren (June 26, 2009).
\236\ Based on its review of newly available information from the Federal Reserve, the Panel has revised its
calculation of support provided to Bank of America by excluding from the total the $118 billion asset
guarantee agreement between Bank of America, the Federal Reserve, Treasury, and the FDIC. U.S. Department of
the Treasury, Summary of Terms: Eligible Asset Guarantee (Jan. 15, 2009) (online at www.treas.gov/press/
releases/reports/011508bofatermsheet.pdf). The reason for the change is that it is now clear that, despite
preliminary agreement, the asset guarantee was never signed; it is not currently in effect, and will likely
not be consummated. House Committee on Oversight and Government Reform, Testimony of Federal Reserve Chairman
Ben Bernanke, Bank of America and Merrill Lynch: How Did a Private Deal Turn Into a Federal Bailout? Part II,
111th Cong. (June 25, 2009).
\237\ July 2 TARP Transaction Report, supra note 224. This figure includes: (1) a $15 billion investment made by
Treasury on October 28, 2008 under the CPP; (2) a $10 billion investment made by Treasury on January 9, 2009
also under the CPP; and (3) a $20 billion investment made by Treasury under the TIP on January 16, 2009.
\238\ July 2 TARP Transaction Report, supra note 224. This figure includes: (1) a $25 billion investment made by
Treasury under the CPP on October 28, 2008; and (2) a $20 billion investment made by Treasury under TIP on
December 31, 2008.
\239\ Citigroup Asset Guarantee (granting a 90 percent federal guarantee on all losses over $29 billion of a
$306 billion pool of Citigroup assets, with the first $5 billion of the cost of the guarantee borne by
Treasury, the next $10 billion by FDIC, and the remainder by the Federal Reserve). See also U.S. Department of
the Treasury, U.S. Government Finalizes Terms of Citi Guarantee Announced in November (Jan. 16, 2009) (online
at www.treas.gov/press/releases/hp1358.htm) (reducing the size of the asset pool from $306 billion to $301
billion).
\240\ Id.
\241\ Id.
\242\ This figure represents the $218 billion Treasury has anticipated spending under the CPP, minus the $50
billion investment in Citigroup ($25 billion) and Bank of America ($25 billion) identified above. This figure
does not account for anticipated repayments or redemptions of CPP investments, nor does it account for
dividend payments from CPP investments.
\243\ Funding levels for the CAP have not yet been announced but will likely constitute a significant portion of
the remaining $60.8 billion of TARP funds.
\244\ Senate Committee on Banking, Housing, and Urban Affairs, Testimony of Secretary Geithner, Oversight of the
Troubled Asset Relief Program, 111th Cong., at 1 (May 20, 2009) (online at banking.senate.gov/public/
index.cfm?FuseAction=Files.View&FileStore_id=b64da0f5-9f9b-448a-a352-ad0590543ef9) (hereinafter ``May 20
Geithner Testimony''); July 2 TARP Transactions Report, supra note 224. This figure represents: a $20 billion
allocation to the TALF special purpose vehicle on March 3, 2009; Treasury's announcement of an additional $35
billion dedicated to the TALF; and $25 billion dedicated to supporting TALF loans to purchase legacy
securities under the PPIP.
\245\ This number derives from the unofficial 1:10 ratio of the value of Treasury loan guarantees to the value
of Federal Reserve loans under the TALF. See U.S. Department of the Treasury, Fact Sheet: Financial Stability
Plan (Feb. 10, 2009) (online at www.financialstability.gov/docs/fact-sheet.pdf) (describing the initial $20
billion Treasury contribution tied to $200 billion in Federal Reserve loans and announcing potential expansion
to a $100 billion Treasury contribution tied to $1 trillion in Federal Reserve loans). Because Treasury is
responsible for reimbursing the Federal Reserve Board for $80 billion of losses on its $800 billion in loans,
the Federal Reserve Board's maximum potential exposure under the TALF is $720 billion.
\246\ Because PPIP funding arrangements for loans and securities differ substantially, the Panel accounts for
them separately. Treasury has not formally announced either total program funding level or the allocation of
funding between the PPIP Legacy Loans Program and Legacy Securities Program. Treasury has indicated that, of
the $100 billion maximum allocation to the PPIP, it plans to disburse $25 billion to the TALF for the
financing of the PPIP Legacy Securities program, and $30 billion to the Legacy Securities Program as initial
equity and debt funding (leaving at most $45 billion to be allocated to the Legacy Loans Program). U.S.
Department of the Treasury, Joint Statement By Secretary Of The Treasury Timothy F. Geithner, Chairman Of The
Board Of Governors Of The Federal Reserve System Ben S. Bernanke, And Chairman Of The Federal Deposit
Insurance Corporation Sheila Bair: Legacy Asset Program (July 8, 2009) (online at www.financialstability.gov/
latest/tg_07082009.html). However, the FDIC has postponed the implementation of the Legacy Loans program, see
Federal Deposit Insurance Corporation, FDIC Statement on the Status of the Legacy Loans Program (June 3, 2009)
(online at www.fdic.gov/news/news/press/2009/pr09084.html). It is not yet clear how this postponement will
affect the allocation of TARP funds for the PPIP.
\247\ Id at 2-3 (explaining that, for every $1 Treasury contributes in equity matching $1 of private
contributions to public-private asset pools created under the Legacy Loans Program, FDIC will guarantee up to
$12 of financing for the transaction to create a 6:1 debt to equity ratio). If Treasury ultimately allocates a
smaller proportion of funds to the Legacy Loans Program (i.e., less than $45 billion), the amount of FDIC loan
guarantees will be reduced proportionally.
\248\ Id at 4-5 (outlining that, for each $1 of private investment into a fund created under the Legacy
Securities Program, Treasury will provide a matching $1 in equity to the investment fund; a $1 loan to the
fund; and, at Treasury's discretion, an additional loan up to $1). In the absence of further Treasury
guidance, this analysis assumes that Treasury will allocate funds for equity co-investments and loans at a
1:1.5 ratio, a formula that estimates that Treasury will frequently exercise its discretion to provide
additional financing.
\249\ Government Accountability Office, Troubled Asset Relief Program: June 2009 Status of Efforts to Address
Transparency and Accountability Issues, at 2 (June 17, 2009) (GAO09/658) (online at www.gao.gov/new.items/
d09658.pdf). Of the $50 billion in announced TARP funding for this program, only $18.0 billion has been
allocated as of June 30, and no funds have yet been disbursed. See July 2 TARP Transactions Report, supra note
224.
\250\ Fannie Mae and Freddie Mac, government-sponsored entities (GSEs) that were placed in conservatorship of
the Federal Housing Finance Housing Agency on September 7, 2009, will also contribute up to $25 billion to the
Making Home Affordable Program, of which the HAMP is a key component. See U.S. Department of the Treasury,
Making Home Affordable: Updated Detailed Program Description (Mar. 4, 2009) (online at www.treas.gov/press/
releases/reports/housing_fact_sheet.pdf).
\251\ Figures do not total due to rounding.
\252\ July 2 TARP Transactions Report, supra note 224. A substantial portion of the total $80.0 billion in loans
extended under the AIFP has since been converted to common equity and preferred shares in restructured
companies. Only $13.8 billion has been retained as first lien debt (with $6.7 billion committed to GM and $7.1
billion to Chrysler), which is classified below as loans.
\253\ July 2 TARP Transactions Report, supra note 224.
\254\ May 20 Geithner Testimony, supra note 244, at 15.
\255\ This figure represents the current maximum aggregate debt guarantees that could be made under the program,
which, in turn, is a function of the number and size of individual financial institutions participating.
$345.8 billion of debt subject to the guarantee has been issued to date, which represents about 44 percent of
the current cap. Federal Deposit Insurance Corporation, Monthly Reports on Debt Issuance Under the Temporary
Liquidity Guarantee Program: Debt Issuance Under Guarantee Program (May 31, 2009) (online at www.fdic.gov/
regulations/resources/TLGP/total_issuance5-09.html) (updated June 17, 2009).
\256\ This figure represents the FDIC's provision for losses to its deposit insurance fund attributable to bank
failures in the third and fourth quarters of 2008 and the first quarter of 2009. See Federal Deposit Insurance
Corporation, Chief Financial Officer's (CFO) Report to the Board: DIF Income Statement (Fourth Quarter 2008)
(online at www.fdic.gov/about/strategic/corporate/cfo_report_4qtr_08/income.html); Federal Deposit Insurance
Corporation, Chief Financial Officer's (CFO) Report to the Board: DIF Income Statement (Third Quarter 2008)
(online at www.fdic.gov/about/strategic/corporate/cfo_report_3rdqtr_08/income.html); Federal Deposit Insurance
Corporation, Chief Financial Officer's (CFO) Report to the Board: DIF Income Statement (First Quarter 2009)
(online at www.fdic.gov/about/strategic/corporate/cfo_report_1stqtr_09/income.html).
\257\ This figure is derived from adding the total credit the Federal Reserve Board has extended as of June 3,
2009 through the Term Auction Facility (Term Auction Credit), Discount Window (Primary Credit), Primary Dealer
Credit Facility (Primary Dealer and Other Broker-Dealer Credit), Central Bank Liquidity Swaps, loans
outstanding to Bear Stearns (Maiden Lane I LLC), GSE Debt (Federal Agency Debt Securities), Mortgage Backed
Securities Issued by GSEs, Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility, and
Commercial Paper Funding Facility LLC. See Fed Balance Sheet July 2, supra note 69. The level of Federal
Reserve lending under these facilities will fluctuate in response to market conditions and independent of any
federal policy decisions.
\258\ One potential use of uncommitted funds is Treasury's obligation to reimburse the Exchange Stabilization
Fund (ESF), currently valued at $52.1 billion. See U.S. Department of Treasury, Exchange Stabilization Fund,
Statement of Financial Position, as of May 31, 2009 (online at www.ustreas.gov/offices/international-affairs/
esf/esf-monthly-statement.pdf) (accessed July 2, 2009). Treasury must reimburse any use of the fund to
guarantee money market mutual funds from TARP money. See EESA, supra note 13, at Sec. 131. In September 2008,
Treasury opened its Temporary Guarantee Program for Money Mutual Funds, U.S. Department of Treasury, Treasury
Announces Temporary Guarantee Program for Money Market Mutual Funds (Sept. 29, 2008) (online at www.treas.gov/
press/releases/hp1161.htm). This program uses assets of the ESF to guarantee the net asset value of
participating money market mutual funds. Id. Sec. 131 of EESA protected the ESF from incurring any losses
from the program by requiring that Treasury reimburse the ESF for any funds used in the exercise of the
guarantees under the program, which has been extended through September 18, 2009. U.S. Department of Treasury,
Treasury Announces Extension of Temporary Guarantee Program for Money Market Funds (Mar. 31, 2009) (online at
www.treas.gov/press/releases/tg76.htm).
SECTION FIVE: OVERSIGHT ACTIVITIES
The Congressional Oversight Panel was established as part
of EESA and formed on November 26, 2008. Since then, the Panel
has issued seven oversight reports, as well as its special
report on regulatory reform, which was issued on January 29,
2009. Since the release of the Panel's June oversight report,
the following developments pertaining to the Panel's oversight
of the TARP took place:
Chair Elizabeth Warren, on behalf of the Panel,
and Special Inspector General for the Troubled Asset Relief
Program Neil M. Barofsky sent a joint letter on June 10, 2009
to Chairman Christopher J. Dodd and Ranking Member Richard C.
Shelby of the Senate Committee on Banking, Housing, and Urban
Affairs, and Chairman Barney Frank and Ranking Member Spencer
Bachus of the House Financial Services Committee, to notify
them of a special coordinated effort between SIGTARP and the
Panel to examine the pricing of warrants in the context of the
repayment of TARP funds by TARP-recipient institutions.\259\
The letter discusses the Panel's plans to release its valuation
estimates and analysis relating to the pricing of warrants
which Treasury holds in relation to its Capital Purchase
Program (``CPP'') investments with its July monthly report, and
SIGTARP's plans to conduct an audit of Treasury's warrant
repurchase/sale process.
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\259\ See Appendix IV of this report, infra.
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The Panel held a hearing on June 24, 2009 with
newly confirmed Assistant Secretary of the Treasury for
Financial Stability Herbert Allison regarding the Troubled
Asset Relief Program. Written testimony and video from the
hearing can be found on the Panel's website at http://
cop.senate.gov/hearings/library/hearing-062409-allison.cfm.
The Helping Families Save Their Homes Act of 2009
(P.L. 111-22), signed into law on May 20, 2009, requires the
Congressional Oversight Panel to issue a special report on farm
loan restructuring. To assist in this mandate, the Panel held a
hearing on July 7, 2009 in Greeley, Colorado, on the subject of
commercial farm credit markets and the use of farm loan
restructuring as an alternative to foreclosure. It heard
testimony from representatives of the USDA, farm credit
lenders, and farmers themselves. It also had the opportunity to
hear from the Greeley community on issues related to farm
credit. Written testimony and audio from the hearing can be
found on the Panel's website at http://cop.senate.gov/hearings/
library/hearing-070709-farmcredit.cfm.
At a Panel hearing on April 21, 2009, Secretary
Geithner pledged to arrange weekly Treasury briefings on TARP
activities for Panel staff. Based on the Secretary's pledge,
Panel staff has since received numerous briefings on topics
including banks' repayment of preferred shares and warrants,
TALF and PPIP, the stress tests, and Treasury's plan to
purchase directly securities backed by Small Business
Administration (SBA) 7(a) loans.
Panel staff has reviewed documents pertaining to
the stress tests, provided by both Treasury and the Federal
Reserve Board of Governors. Several other document requests
sent to Treasury are still pending.
The Panel has sent letters to the largest mortgage
servicing companies that have not yet signed a contract to
formally participate in the Making Home Affordable foreclosure
mitigation program. This letter inquires, among other things,
if the servicer intends to participate, how it is handling loan
modifications, and what barriers and obstacles might limit
participation in the program. This is part of the Panel's
continuing oversight of foreclosure mitigation efforts.
Upcoming Reports and Hearings
The Panel will release its next oversight report
in August. The report will provide an updated review of TARP
activities and continue to assess the program's overall
effectiveness. The report will also examine the issue of
troubled assets, their role in the economic crisis, and how the
TARP addresses them.
On July 21, 2009, the Panel will release a report
in which it provides an analysis of the state of the commercial
farm credit markets and considers the use of farm loan
restructuring as an alternative to foreclosure. This report is
pursuant to section 501 of the Helping Families Save Their
Homes Act of 2009 (P.L. 111-22).
The Panel is planning a field hearing in Detroit
on July 27, 2009 to hear testimony on Treasury's administration
of the Automotive Industry Financing Program.
SECTION SIX: ABOUT THE CONGRESSIONAL OVERSIGHT PANEL
In response to the escalating crisis, on October 3, 2008,
Congress provided Treasury with the authority to spend $700
billion to stabilize the U.S. economy, preserve home ownership,
and promote economic growth. Congress created the Office of
Financial Stabilization (OFS) within Treasury to implement a
Troubled Asset Relief Program. At the same time, Congress
created the Congressional Oversight Panel to ``review the
current state of financial markets and the regulatory system.''
The Panel is empowered to hold hearings, review official data,
and write reports on actions taken by Treasury and financial
institutions and their effect on the economy. Through regular
reports, the Panel must oversee Treasury's actions, assess the
impact of spending to stabilize the economy, evaluate market
transparency, ensure effective foreclosure mitigation efforts,
and guarantee that Treasury's actions are in the best interests
of the American people. In addition, Congress instructed the
Panel to produce a special report on regulatory reform that
analyzes ``the current state of the regulatory system and its
effectiveness at overseeing the participants in the financial
system and protecting consumers.'' The Panel issued this report
in January 2009.
On November 14, 2008, Senate Majority Leader Harry Reid and
the Speaker of the House Nancy Pelosi appointed Richard H.
Neiman, Superintendent of Banks for the State of New York,
Damon Silvers, Associate General Counsel of the American
Federation of Labor and Congress of Industrial Organizations
(AFL-CIO), and Elizabeth Warren, Leo Gottlieb Professor of Law
at Harvard Law School to the Panel. With the appointment on
November 19 of Congressman Jeb Hensarling to the Panel by House
Minority Leader John Boehner, the Panel had a quorum and met
for the first time on November 26, 2008, electing Professor
Warren as its chair. On December 16, 2008, Senate Minority
Leader Mitch McConnell named Senator John E. Sununu to the
Panel, completing the Panel's membership.
APPENDIX I: LETTER FROM CHAIR ELIZABETH WARREN TO SECRETARY TIMOTHY
GEITHNER REQUESTING INFORMATION ON THE REPAYMENT OF TARP ASSISTANCE,
DATED JUNE 12, 2009
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
APPENDIX II: LETTER FROM SECRETARY TIMOTHY GEITHNER IN RESPONSE TO
CHAIR WARREN'S LETTER REQUESTING INFORMATION ON THE REPAYMENT OF TARP
ASSISTANCE, DATED JULY 1, 2009
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
APPENDIX III: LETTER FROM CHAIR ELIZABETH WARREN AND PANEL MEMBER
RICHARD NEIMAN TO SECRETARY TIMOTHY GEITHNER REQUESTING ASSISTANCE WITH
THE PANEL'S OVERSIGHT OF FEDERAL FORECLOSURE MITIGATION EFFORTS, DATED
JUNE 29, 2009
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]