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CONGRESSIONAL OVERSIGHT PANEL JUNE OVERSIGHT REPORT STRESS TESTING AND SHORING UP BANK CAPITAL JUNE 9, 2009.—Ordered to be printed VerDate Nov 24 2008 04:20 Jun 18, 2009 Jkt 050104 PO 00000 Frm 00001 Fmt 6012 Sfmt 6012 E:\HR\OC\A104.XXX A104 E:\Seals\Congress.#13 jbell on PROD1PC69 with REPORTS Submitted under Section 125(b)(1) of Title 1 of the Emergency Economic Stabilization Act of 2008, Pub. L. No. 110–343 jbell on PROD1PC69 with REPORTS CONGRESSIONAL OVERSIGHT PANEL JUNE OVERSIGHT REPORT VerDate Nov 24 2008 04:20 Jun 18, 2009 Jkt 050104 PO 00000 Frm 00002 Fmt 6019 Sfmt 6019 E:\HR\OC\A104.XXX A104 1 CONGRESSIONAL OVERSIGHT PANEL JUNE OVERSIGHT REPORT STRESS TESTING AND SHORING UP BANK CAPITAL JUNE 9, 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 WASHINGTON : 2009 For sale by the Superintendent of Documents, U.S. Government Printing Office Internet: bookstore.gpo.gov Phone: toll free (866) 512–1800; DC area (202) 512–1800 Fax: (202) 512–2104 Mail: Stop IDCC, Washington, DC 20402–0001 VerDate Nov 24 2008 04:20 Jun 18, 2009 Jkt 050104 PO 00000 Frm 00003 Fmt 5012 Sfmt 5012 E:\HR\OC\A104.XXX A104 E:\Seals\Congress.#13 jbell on PROD1PC69 with REPORTS U.S. GOVERNMENT PRINTING OFFICE 50–104 jbell on PROD1PC69 with REPORTS VerDate Nov 24 2008 04:20 Jun 18, 2009 Jkt 050104 PO 00000 Frm 00004 Fmt 5012 Sfmt 5012 E:\HR\OC\A104.XXX A104 CONTENTS Page jbell on PROD1PC69 with REPORTS Executive Summary ................................................................................................. Section One: Stress Testing and Shoring Up Bank Capital ................................. A. Overview ...................................................................................................... B. The Stress Tests .......................................................................................... C. Immediate Impact of the Stress Tests ...................................................... D. A Comment on the Supervisory Process ................................................... E. Specific Limitations of the Stress Tests .................................................... F. Independent Analysis of Stress Tests ........................................................ G. Next Steps ................................................................................................... H. Issues ........................................................................................................... I. Recommendations ........................................................................................ J. Conclusions .................................................................................................. K. Tables ........................................................................................................... Annex to Section One: The Supervisory Capital Assessment Program: An Appraisal ..................................................................................................... Section Two: Additional Views ............................................................................... Section Three: Correspondence With Treasury Update ....................................... Section Four: TARP Updates Since Last Report ................................................... Section Five: Oversight Activities .......................................................................... Section Six: About the Congressional Oversight Panel ........................................ Appendices: ............................................................................................................... Appendix I: Letter from Chair Elizabeth Warren to Federal Reserve Chairman Ben Bernanke Regarding the Capital Assistance Program, dated May 11, 2009 ................................................................................................................. Appendix II: Letter from Chair Elizabeth Warren to Secretary Timothy Geithner regarding the possibility of the Secretary appearing before a panel hearing in June, dated May 12, 2009 ................................................................. Appendix III: Letter from Chair Elizabeth Warren to Secretary Timothy Geithner and Federal Reserve Chairman Ben Bernanke regarding the Acquisition of Merrill Lynch by Bank of America, dated May 19, 2009 .............. Appendix IV: Letter from Chair Elizabeth Warren to Secretary Timothy Geithner regarding the Temporary Guarantee Program, dated May 26, 2009 ....................................................................................................................... (III) VerDate Nov 24 2008 04:20 Jun 18, 2009 Jkt 050104 PO 00000 Frm 00005 Fmt 5904 Sfmt 0483 E:\HR\OC\A104.XXX A104 3 6 6 13 27 29 30 31 35 38 48 49 50 57 117 131 132 149 151 152 159 161 164 jbell on PROD1PC69 with REPORTS VerDate Nov 24 2008 04:20 Jun 18, 2009 Jkt 050104 PO 00000 Frm 00006 Fmt 5904 Sfmt 0483 E:\HR\OC\A104.XXX A104 JUNE OVERSIGHT REPORT JUNE 9, 2009.—Ordered to be printed EXECUTIVE SUMMARY * Across the country, many American families have taken a hard look at their finances. They have considered how they would manage if the economy took a turn for the worse, if someone were laid off, if their homes plummeted in value, or if the retirement funds they had been counting on shrunk even more. If circumstances get worse, how would they make ends meet? These families have examined their resources to figure out if they could weather more difficult times—and what they could do now to be better prepared. In much the same spirit, federal banking regulators recently undertook ‘‘stress tests’’ to examine the ability of banks to ride out the financial storm, particularly if the economy gets worse. Treasury recognized the importance of understanding banks’ ability to remain well capitalized if the recession proved worse than expected. Thus, Treasury and the Federal Reserve announced the Supervisory Capital Assessment Program (SCAP) to conduct reviews or ‘‘stress tests’’ of the nineteen largest BHCs. Together these nineteen companies hold two-thirds of domestic BHC assets. As described by Treasury, the program is intended to ensure the continued ability of U.S. financial institutions to lend to creditworthy borrowers in the event of a weaker-than-expected economic environment and larger-than-estimated losses. The Emergency Economic Stabilization Act of 2008 (EESA) 1 specifically requires the Congressional Oversight Panel to examine the Secretary of the Treasury’s use of his authority, the impact of the Troubled Asset Relief Program (TARP) on the financial markets and financial institutions, and the extent to which the information made available on transactions under the TARP has contributed to market transparency. In this report, the Panel examines the steps Treasury has taken to assess the financial health of the nation’s largest banks, the impact of these steps on the financial markets, and the extent to which these steps have contributed to market jbell on PROD1PC69 with REPORTS * The Panel adopted this report with a unanimous 5–0 vote on June 8, 2009. 1 Emergency Economic Stabilization Act of 2008 (EESA), Pub. L. No. 110–343 (hereinafter ‘‘EESA’’). VerDate Nov 24 2008 04:20 Jun 18, 2009 Jkt 050104 PO 00000 Frm 00007 Fmt 6659 Sfmt 6602 E:\HR\OC\A104.XXX A104 jbell on PROD1PC69 with REPORTS 2 transparency. Understanding the recently completed stress tests helps shed light on the assumptions Treasury makes as it uses its authority under EESA. As Treasury uses the results of these tests to determine what additional assistance it might provide to financial institutions, the tests also help determine the effectiveness of the TARP in minimizing long-term costs to the taxpayers and maximizing taxpayer benefits, thus responding to another key mandate of the Panel. As part of their regular responsibilities, bank examiners determine whether the banks they supervise have adequate capital to see them through economic reversals. Typically, these bank supervisory examination results are kept strictly confidential. The stress tests built on the existing regulatory capital requirements, but, because the stress tests were undertaken in order to restore confidence in the banking system, they included an unprecedented release of information. The stress tests were conducted using two scenarios: one test based upon a consensus set of economic projections and another test using projections based on more adverse economic conditions. The only results that have been released are those based on the adverse scenario. These test results revealed that nine of the nineteen banks tested already hold sufficient capital to operate through 2010 under the projected adverse scenario; those banks will not be required to raise additional capital. Ten of the nineteen banks were found to need additional capital totaling nearly $75 billion in order to weather a more adverse economic scenario. Those banks that need additional capital were required to present a plan to Treasury by June 8, 2009, outlining their plans to raise additional capital. All additional capital required under the stress tests must be raised by November 9, 2009, six months after the announcement of the stress test results. Some BHCs have already successfully raised billions in additional capital. Like the case of the family conducting its own stress test of personal finances, the usefulness of the bank stress test results depends upon the methods used and the assumptions that went into conducting the examinations. To help assess the stress tests, the panel engaged two internationally renowned experts in risk analysis, Professor Eric Talley and Professor Johan Walden, to review the stress test methodology. Based on the available information, the professors found that the Federal Reserve used a conservative and reasonable model to test the banks, and that the model provides helpful information about the possible risks faced by BHCs and a constructive way to address those risks. The criteria used for assessing risk, and the assumptions used in calibrating the more adverse case, have typically erred on the side of caution and avoided many of the more dangerous simplifications present in some risk modeling. The professors also raised some serious concerns. They noted that there remain unanswered questions about the details of the stress tests. Without this information, it is not possible for anyone to replicate the tests to determine how robust they are or to vary the assumptions to see whether different projections might yield very different results. There are key questions surrounding how the calculations were tailored for each institution and questions about the quality of the self-reported data. It is also important to VerDate Nov 24 2008 04:20 Jun 18, 2009 Jkt 050104 PO 00000 Frm 00008 Fmt 6659 Sfmt 6602 E:\HR\OC\A104.XXX A104 3 jbell on PROD1PC69 with REPORTS note that the stress test scenarios made projections only through 2010. While this time frame avoids the greater uncertainty associated with any projection further in the future, it may fail to capture substantial risks further out on the horizon. Based on the testimony by Deutsche Bank at the Panel’s May field hearing, the projected rise in the defaults of commercial real estate loans after 2010 raise concerns. In evaluating the useful information provided by the stress tests, as well as the remaining questions, the Panel offers several recommendations for consideration moving forward: • The unemployment rate climbed to 9.4 percent in May, bringing the average unemployment rate for 2009 to 8.5 percent. If the monthly rate continues to increase during the remainder of this year, it will likely exceed the 2009 average of 8.9 percent assumed under the more adverse scenario, suggesting that the stress tests should be repeated should that occur. • Stress testing should also be repeated so long as banks continue to hold large amounts of toxic assets on their books. • Between formal tests conducted by the regulators, banks should be required to run internal stress tests and should share the results with regulators. • Regulators should have the ability to use stress tests in the future when they believe that doing so would help to promote a healthy banking system. The Federal Reserve Board should be commended for releasing an unprecedented amount of bank supervisory information, but additional transparency would be helpful both to assess the strength of the banks and to restore confidence in the banking system. The Panel recommends that the Federal Reserve Board release more information on the results of the tests, including results under the baseline scenario. The Federal Reserve Board should also release more details about the test methodology so that analysts can replicate the tests under different economic assumptions or apply the tests to other financial institutions. Transparency will also be critical as financial institutions seek to repay their TARP loans, both to assess the strength of these institutions and to assure that the process by which these loans are repaid is fair. Finally, the Panel cautions that banks should not be forced into counterproductive ‘‘fire sales’’ of assets that will ultimately require the investment of even more taxpayer money. The need for strengthening the banks through capital increases must be tempered by sufficient flexibility to permit the banks to realize full value for their assets. VerDate Nov 24 2008 04:20 Jun 18, 2009 Jkt 050104 PO 00000 Frm 00009 Fmt 6659 Sfmt 6602 E:\HR\OC\A104.XXX A104 4 SECTION ONE: STRESS TESTING AND SHORING UP BANK CAPITAL A. OVERVIEW The stress test is one of the two core parts of Treasury’s Capital Assistance Program (CAP). It lays the foundation for the second part of the CAP, the infusion of TARP funds to support some of the nation’s largest financial institutions ‘‘as a bridge to private capital in the future.’’ 2 The publication of the results of the stress tests involves a rare release of supervisory information by the Federal Reserve Board. EESA specifically requires the Panel to, Examine [the] use by the Secretary [of the Treasury] of authority under this Act . . . [t]he impact of purchases made under the Act on the financial markets, and financial institutions, and [t]he extent to which the information made available on transactions under the [TARP] has contributed to market transparency.3 1. INTRODUCTION A banking organization’s capital is its economic foundation. It serves as a cushion against losses and limits a bank’s ability to grow, including by limiting the degree to which a bank can lend, how many deposits it can take, and how it can otherwise raise funds in the capital markets. The strength of a bank’s capital is a barometer of its health, and decreases in the strength of its capital or uncertainty about that strength can affect the willingness of other financial institutions to deal with it. When an individual bank’s capital is seriously depleted, it can fail. Bank failures and uncertainty about the soundness of other banks can spread financial contagion across a national financial system, freezing lending, fostering uncertainty in the capital markets, and perhaps even threatening the deposits of ordinary citizens, although, in the United States, the deposit insurance system managed by the Federal Deposit Insurance Corporation (FDIC) protects against that threat.4 A bank’s ability to lend is directly related to its capital strength.5 While government intervention has the potential to stabilize the system by shoring up bank capital, it can also risk further scaring away private capital by creating new forms of risk and uncertainty.6 jbell on PROD1PC69 with REPORTS 2 U.S. Department of the Treasury, Treasury White Paper: The Capital Assistance Program and its Role in the Financial Stability Plan, at 2 (online at www.treasury.gov/press/releases/reports/tg40lcapwhitepaper.pdf) (accessed May 15, 2009) (hereinafter ‘‘CAP White Paper’’). 3 EESA, supra note 1, at § 125(1)(A)(i)–(iii). 4 Deposit insurance—currently set at $250,000 per account—greatly reduces the risk of loss of deposits by individuals in banks operating in the United States. 5 Congressional Oversight Panel, Testimony of Vice-President of the Federal Reserve Bank of New York (FRBNY) Til Schuermann, Hearing on the Impact of Economic Recovery Efforts on Corporate and Commercial Real Estate Lending, at 2 (May 28, 2009) (online at cop.senate.gov/ documents/testimony-052809-schuermann.pdf). 6 Once the solvency of a bank is in question, private investors may fear that government interference will dilute private capital or that the government will pay below-market prices for assets. That, in turn, can have a chilling effect on a bank’s ability to attract private capital. Perhaps in order to mitigate that chilling effect, Treasury has signaled its intention: (1) to divest itself of the ownership stakes it may acquire in any private firm as quickly as practical; and (2) to exert minimal influence on day-to-day operations even if in a position to do so. See U.S. Department of the Treasury, Statement from Treasury Secretary Timothy Geithner Regarding the Treasury Capital Assistance Program and the Supervisory Capital Assessment Program (May 7, 2009) (online at www.ustreas.gov/press/releases/tg123.htm). VerDate Nov 24 2008 04:20 Jun 18, 2009 Jkt 050104 PO 00000 Frm 00010 Fmt 6602 Sfmt 6602 E:\HR\OC\A104.XXX A104 5 The danger of financial contagion surfaced early in the financial crisis. During 2008, two large banking institutions, IndyMac Bank ($32.01 billion in assets) 7 and Washington Mutual Savings and Loan ($307 billion) 8 were taken over by federal regulators, and three other banking institutions, Wachovia Bank ($812.4 billion),9 the nation’s fourth largest commercial bank, National City Corporation ($143.7 billion),10 and Countrywide Financial Corporation ($211 billion) 11 were in danger of failing when they were taken over by other institutions at the behest of the regulators.12 Within two weeks after the passage of EESA, Treasury began to make direct capital transfers ‘‘to stabilize the financial system by providing capital to viable financial institutions of all sizes throughout the nation.’’ The transfers were made through various TARP programs created under the authority of the EESA. As of June 3, $199.4 billion had been transferred to 436 banks under the TARP’s Capital Purchase Program (CPP).13 Two institutions, Citigroup and Bank of America, have received additional support outside of the CPP. Through the Targeted Investment Program (TIP), Treasury purchased from Citigroup $20 billion in preferred shares, as well as a warrant to purchase common stock. Treasury and the FDIC also guaranteed a pool of $306 billion of loans and securities.14 Bank of America also received capital and guarantees under the TIP. It received $20 billion in capital in exchange for preferred stock and a warrant. Treasury and the FDIC agreed to guarantee a pool of $118 billion in loans, in exchange for preferred stock.15 In early February, Treasury and the Federal Reserve Board announced an accelerated effort to conduct comprehensive and simultaneous reviews of the nation’s 19 largest BHCs 16—those with jbell on PROD1PC69 with REPORTS 7 Federal Deposit Insurance Corporation, FDIC Establishes IndyMac Federal Bank, FSB as Successor to IndyMac Bank, F.S.B., Pasadena, California (July 11, 2008) (online at www.fdic.gov/news/news/press/2008/pr08056.html). 8 Federal Deposit Insurance Corporation, JPMorgan Chase Acquires Banking Operations of Washington Mutual (Sept. 25, 2008) (online at www.fdic.gov/news//news/press/2008/ pr08085.html). 9 Wachovia Corporation, Form 8–K (Oct. 10, 2008) (online at www.sec.gov/Archives/edgar/data/ 36995/000119312508209190/d8k.htm). 10 PNC Financial Services Group, Inc., Form S–4 (Nov. 11, 2008) (online at www.sec.gov/Archives/edgar/data/713676/000095012308014864/y72384sv4.htm). 11 Countrywide Financial Corporation, Form 10–K (Feb. 29, 2008) (online at www.sec.gov/Archives/edgar/data/25191/000104746908002104/a2182824z10–k.htm) (latest asset report available). 12 This was in addition to the government-engineered takeover of the investment bank Bear Stearns by JPMorgan Chase & Co., the government-engineered takeover of Merrill Lynch by Bank of America, and the rescue of the American International Group (AIG) by the Federal Reserve Board and Treasury. PNC used $7.7 billion in Capital Purchase Program (CPP) funds to aid in financing its acquisition of National City Corporation. PNC Financial Services Group, Inc., Form 8–K (Oct. 24, 2008) (online at www.pnc.com/webapp/unsec/Requester?resource=/wcm/ resources/file/eb0fc043072db70/IRl8Kl102408lNCClAnnounce.pdf). 13 U.S. Department of the Treasury, Troubled Asset Relief Program Transactions Report for Period Ending June 3, 2009 (June 5, 2009) (online at www.financialstability.gov/docs/transaction-reports/transactions-report-060509.pdf) (hereinafter ‘‘June 5 TARP Transactions Report’’). An additional $69.8 billion was transferred under the TARP to rescue AIG. 14 U.S. Department of the Treasury, Joint Statement by Treasury, Federal Reserve and the FDIC on Citigroup (Nov. 23, 2008) (online at www.treas.gov/press/releases/hp1287.htm). 15 Board of Governors of the Federal Reserve System, Treasury, Federal Reserve, and the FDIC Provide Assistance to Bank of America (Jan. 16, 2009) (online at www.federalreserve.gov/ newsevents/press/bcreg/20090116a.htm). 16 A BHC is essentially a corporation that owns one or more banks, but does not itself carry out the functions of a bank. The advantage of this type of structure is that it allows the BHC to raise capital more easily through, for instance, public offerings. Although Federal Reserve Board regulations refer formally to BHCs as ‘‘banking organizations,’’ the Federal Reserve Board Continued VerDate Nov 24 2008 04:20 Jun 18, 2009 Jkt 050104 PO 00000 Frm 00011 Fmt 6602 Sfmt 6602 E:\HR\OC\A104.XXX A104 6 more than $100 billion in assets—to determine their ability to remain well capitalized if the recession led to deeper than expected losses in the face of the nation’s increasing economic difficulties. The effort, formally called the SCAP, is referred to more informally as the ‘‘stress tests.’’ It is part of the broader CAP that is to be a primary mechanism for direct capital assistance to the nation’s largest BHCs for the remainder of the financial crisis. While federal bank supervisors enforce various capital requirements even in times of economic growth,17 SCAP represents a special supervisory exercise tailored to the current crisis. The term ‘‘stress test’’ itself sums up the government’s objective—to create a set of economic and operating assumptions to see how much ‘‘stress’’ the assumptions would place on each BHC’s capital position if they came to pass. The tests were designed to: evaluat[e] expected losses and [whether the stress-tested BHCs have] the resources to absorb those losses if economic conditions were to be more adverse than generally expected [,] . . . determine whether an additional capital buffer today, particularly one that strengthens the composition of capital, is needed for the banking organization to comfortably absorb losses and continue lending even in a more adverse environment.18 BHCs in need of a buffer have six months to raise the necessary capital; the capital can in some cases come from additional TARP investments made under the CAP. The results of the stress tests were released in early May. The Panel is devoting its June report to the details and results of the tests for several reasons. The first is the crucial one: the weaknesses of America’s large banks, among other things, are at the core of the financial crisis and the breakdown in lending that was the immediate result of the crisis; while some believe that government policies contributed to the crisis, it is critical that government policies to deal with this weakness are soundly conceived and wellexecuted. There are several additional reasons to examine the stress tests. These include the perspective they provide on the manner in which the government is dealing with the country’s major lending institutions, as well as the information they have generated about the condition of the BHCs themselves at a time when economic conditions continue to deteriorate. Thus, the report sets out the way the stress tests work and the assumptions on which they rest, evaluates those assumptions and the models used to conduct the tests, seeks to understand the stress test results, and makes recommendations about the future of the testing process. jbell on PROD1PC69 with REPORTS uses the less formal designation in the document relating to the SCAP, as does this report. See 12 CFR Part 225, at Appendix A § 1. 17 A corporation’s capital consists simply of the amount by which the value of its assets exceeds the value of its obligations. See Annex to Section One of this report. Specific capital requirements for banks, insurance companies, securities broker-dealers, and other regulated industries fix a level of capital above that simple margin to create a level of safety to help ensure that the regulated companies can meet their obligations and avoid failures that spill over into the economic system. 18 CAP White Paper, supra note 2, at 2. VerDate Nov 24 2008 04:20 Jun 18, 2009 Jkt 050104 PO 00000 Frm 00012 Fmt 6602 Sfmt 6602 E:\HR\OC\A104.XXX A104 7 2. BACKGROUND a. Capital requirements Capital requirements exist to protect against bank insolvency and to reduce systemic risk. By enforcing these requirements, regulators: (1) ensure that banks have adequate capital to weather unexpected losses; (2) counteract market pressures on banks to take excessive risks; (3) promote confidence among bank investors, creditors, and counterparties; and (4) minimize the scale and length of economic downturns. Capital requirements also protect against what is called ‘‘moral hazard,’’ that is, the risk that a bank will take undue risks because it believes any benefits will go to the BHC executives and shareholders and any losses it suffers will be covered either by deposit insurance or by the notion that the institution will be supported with government funds rather than allowed to fail.19 Because the stress tests focus on the adequacy of BHC capital, a short look at how BHC capital works is appropriate. A BHC’s capital is generally measured as the ratio of specified core (tier 1) and supplementary (tier 2) capital elements on the firm’s consolidated balance sheet to its total assets. To compute the tier 1 ratio, for instance, the firm’s tier 1 capital elements are included in the numerator and the ‘‘risk-weighted’’ value of its assets are included in the denominator. For this purpose, tier 1 (core) capital is the sum of the following capital elements: (1) common stockholders’ equity; (2) perpetual preferred stock; (3) senior perpetual preferred stock issued by Treasury under the TARP; (4) certain minority interests in other banks; (5) qualifying trust preferred securities; and (6) a limited amount of other securities. Tier 2 (supplementary) capital is made up of the following capital elements: (1) the amount of certain reserves established against losses; (2) perpetual cumulative or noncumulative preferred stock; (3) certain types of convertible securities; (4) certain types of long-, medium-, and short-term debt securities; and (5) a percentage of unrealized gains from certain investment assets. The SCAP capital buffer includes a four percent tier 1 common capital ratio. Federal Reserve Board rules do not specifically define tier 1 common capital, but this is the element of tier 1 capital that is voting common stockholders’ equity (i.e., it excludes qualifying trust and perpetual preferred stock, and qualifying minority interests). The supervisors have encouraged BHCs to hold as much of their tier 1 capital in the form of common shareholder equity as possible as this is the ‘‘most desirable capital element from a supervisory standpoint.’’ 20 The risk-weighted assets of an institution, which form the denominator of the capital ratio, represent the value of the institu- jbell on PROD1PC69 with REPORTS 19 Minimum capital ratios are used by banking regulators to assign banks to one of five categories: (1) well capitalized; (2) adequately capitalized; (3) undercapitalized; (4) seriously undercapitalized; and (5) critically undercapitalized. Under banking regulations, insured depository institutions falling in the last three categories are subject to a variety of ‘‘prompt corrective actions.’’ However, BHCs are not currently subject to the prompt corrective action regimen. 20 Board of Governors of the Federal Reserve System, BHC Supervision Manual, at 4060.3.2.1.1.3, 1281 (Jan. 2008) (online at www.federalreserve.gov/boarddocs/SupManual/bhc/ 200807/bhc0708.pdf). VerDate Nov 24 2008 04:20 Jun 18, 2009 Jkt 050104 PO 00000 Frm 00013 Fmt 6602 Sfmt 6602 E:\HR\OC\A104.XXX A104 8 tion’s assets, adjusted in some cases to reflect possibilities that the assets will lose value after the computation is made. For example, cash is assigned no risk ‘‘haircut,’’ because its face value cannot vary. Similar adjustments are made for certain portions of an institution’s capital elements.21 General regulatory rules require a BHC to have a tier 1 capital ratio of four percent, and a total (tier 1 plus tier 2) capital ratio of eight percent of the holding company’s risk-weighted assets.22 b. Efforts to shore up bank capital under the TARP The initial method chosen by Treasury to shore up bank capital emphasized the direct transfer of TARP funds to BHCs in exchange for preferred stock. A special change in banking regulations permits preferred stock purchased under the TARP to count as tier 1 capital.23 It does not, however, count as tier 1 common capital, which the banking regulators are looking to bolster through the stress tests.24 The first set of programs—the CPP, the Systemically Significant Failing Institutions (SSFI) program, and the TIP—followed that model. While the CPP was described as the ‘‘Healthy Banks Program,’’ it was in fact targeted at a broader range of banks. In contrast, the SSFI program and the TIP targeted institutions in financial distress.25 In February 2009, Secretary of the Treasury Geithner introduced the CAP as a key component of the new Administration’s Financial Stability Plan.26 The CAP has two fundamental components. The CAP introduces a new, additional mechanism for Treasury to make capital infusions. In exchange for capital injections through the 21 See jbell on PROD1PC69 with REPORTS 12 CFR Part 225, at Appendix A III.C, Appendix E, Appendix G. 22 See 12 CFR Part 225, at Appendix A IV.A. BHCs are also required to maintain a leverage ratio of three percent of tier 1 capital to total capital. 23 Board of Governors of the Federal Reserve System, Capital Adequacy Guidelines: Treatment of Perpetual Preferred Stock Issued to the United States Treasury Under the Emergency Economic Stabilization Act of 2008, 74 Fed. Reg. 26081 (June 1, 2009) (final rule) (online at edocket.access.gpo.gov/2009/pdf/E9–12628.pdf). 24 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) (hereinafter ‘‘SCAP Results’’). 25 In addition to equity purchases, which are designed to shore up the capital position of troubled institutions, Treasury’s strategy includes programs that directly address the assets affecting bank balance sheets. One of the primary reasons banks are currently constrained in their ability to lend to creditworthy borrowers is that they have a number of assets on their books that have lost, or could lose, substantial value. In effect, they are conserving funds to cover these losses (and thereby limiting the availability of credit in the economy). The Public-Private Investment Program (PPIP) is basically designed to get these bad or ‘‘toxic’’ assets off the banks’’ balance sheets. Under the program, a number of investment funds will be created with a combination of TARP funds and private capital; these funds will then buy existing, bad assets from banks. There will be two kinds of investment funds under PPIP: one backed by FDIC guarantees that will purchase legacy loans; another that will be able to borrow from the Federal Reserve Board in order to purchase legacy securities. The FDIC recently announced it would postpone the implementation of the legacy loans program, and it is not yet clear when this program will be put into effect. 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) (hereinafter ‘‘FDIC Loans Program Statement’’). Another part of Treasury’s strategy is the Term Asset-Backed Securities Loan Facility (TALF), a joint program between Treasury and the Federal Reserve Board. Through the TALF, the Federal Reserve Board provides loans to investors that are secured by newly-issued, asset-backed securities (that are surrendered to the Federal Reserve Board if the borrower defaults). In case of default, Treasury buys the surrendered securities from the Federal Reserve Board, in effect guaranteeing a certain amount of losses the Federal Reserve Board potentially faces. 26 U.S. Department of the Treasury, Fact Sheet: Financial Stability Plan (online at www.financialstability.gov/docs/fact-sheet.pdf) (accessed May 15, 2009) (hereinafter ‘‘Financial Stability Plan Fact Sheet’’); U.S. Department of the Treasury, U.S. Treasury Releases Terms of Capital Assistance Program (Feb. 25, 2009) (online at www.ustreas.gov/press/releases/tg40.htm). VerDate Nov 24 2008 04:20 Jun 18, 2009 Jkt 050104 PO 00000 Frm 00014 Fmt 6602 Sfmt 6602 E:\HR\OC\A104.XXX A104 9 CPP, Treasury generally receives preferred stock and warrants to purchase common stock. In exchange for capital injections through the CAP, Treasury will receive mandatory convertible preferred securities (i.e., securities that the recipient bank can convert into common equity), as well as warrants to buy additional common stock of the institution receiving the infusion.27 Through conversion, recipient banks will be able to increase their tier 1 common capital position as necessary if economic conditions deteriorate. The ability to convert preferred stock to common equity is intended to help institutions weather continued turbulence, but it also increases taxpayer risk without adding any new capital to the banks, since the conversion is essentially a reorganization of a BHC’s capital structure moving the former preferred stockholders to a lower priority of payment in the event the BHC is liquidated. The other component of the CAP, and the basis upon which decisions regarding the need for capital infusions will be made, is the stress tests under the SCAP. The stress tests are essential to the CAP because they allow regulators to determine which institutions may need additional capital over the next two year period and require the institutions that may need more capital to obtain that capital now. Equally important, they increase the level and composition of the capital required, building banks’ capital buffers ‘‘to ensure the continued ability of U.S. financial institutions to lend to creditworthy borrowers in the face of a weaker than expected economic environment and larger than expected potential losses.’’ 28 The stated purpose of CPP infusions is to build up the capital bases of BHCs so they can continue lending.29 CAP infusions are specifically aimed at increasing capital buffers—in some cases beyond existing regulatory requirements—to safeguard against worse-than-expected economic conditions.30 It is not yet clear, however, exactly how that more focused objective will affect Treasury’s criteria for selecting recipients of infusions under the CAP.31 Nonetheless, what is clear is that Treasury is no longer applying the same approach toward all BHCs (or at least those not in danger of imminent collapse), as it did in its initial rounds of CPP infusions. Instead, Treasury is seeking to distinguish BHCs with weak capital positions from BHCs with strong capital positions so that it can tailor its actions accordingly. The key to the CAP is the effort to measure bank capital, through the stress tests, and then to shore up that capital before more is needed. It is to the stress tests themselves that the report now turns. jbell on PROD1PC69 with REPORTS 27 Financial Stability Plan Fact Sheet, supra note 26, at 3. The issuance of warrants to purchase common stock in any financial institution receiving assistance under the TARP is required by EESA, supra note 1, at 114(d). 28 CAP White Paper, supra note 2, at 1. 29 U.S. Department of the Treasury, Treasury Releases March Monthly Bank Lending Survey (May 15, 2009) (online at www.treas.gov/press/releases/tg135.htm). 30 The bank supervisors will also require CAP applicants to submit a plan for how they intend to use taxpayer funds. This requirement did not exist for CPP infusions. 31 The Panel has called on Treasury to be clearer about its criteria for selecting TARP recipients since its first report in December 2008. See Congressional Oversight Panel, Questions About the $700 Billion Emergency Economic Stabilization Funds, at 4–8 (Dec. 10, 2008) (online at cop.senate.gov/reports/library/report-121008-cop.cfm). VerDate Nov 24 2008 04:20 Jun 18, 2009 Jkt 050104 PO 00000 Frm 00015 Fmt 6602 Sfmt 6602 E:\HR\OC\A104.XXX A104 10 B. THE STRESS TESTS 1. PURPOSE According to the bank supervisors, and in some cases only after very large infusions of capital by the U.S. taxpayer, most U.S. banks now have capital levels in excess of the amounts required under banking rules, though in the case of Citigroup and Bank of America among others, only after large infusions of capital and even larger asset guarantees from the federal government through the TARP.32 Nonetheless, the realized and prospective losses created by the financial crisis and the impact of the country’s economic condition on banks’ revenues have substantially reduced, and are expected to further reduce, the capital of some major banks. Falling capital levels at major banks can lead to a broad loss of confidence in bank solvency, particularly if there is a lack of clear information as to the financial condition of the major banks. Loss of confidence can become a self-fulfilling prophecy, leading to the reluctance of banks to lend to one another (a key component of the banking system’s operation), causing individual banks to tighten credit by cutting back on lending in general, and forcing regulators to pump funds into one bank or BHC after another on an ad hoc basis. Treasury has described the stress testing program as a response to these threats. First, it looks ahead, to build up bank capital in advance to provide additional levels of protection against future potential losses. Second, by providing clear statements of the prospective condition of the BHCs tested—a departure from the past practice of keeping supervisory examination results strictly confidential—Treasury sought to restore confidence in the nation’s largest banking organizations. Ultimately, stress testing has the potential to: (1) establish confidence that BHCs with weaker capital positions will be better equipped to weather future turbulence; and (2) signal to the capital markets that some BHCs have strong capital positions. 2. THE ENTITIES TESTED The SCAP applied exclusively to the 19 largest BHCs.33 Treasury and the Federal Reserve Board state that they believe that those institutions, which the agencies estimate hold approximately twothirds of domestic BHC assets and over one-half of the loans in the U.S. banking system, must be strong if the ‘‘banking system [is] to play its role in supporting a stronger, faster, and more sustainable economic recovery.’’ 34 (The regulators have announced that they do jbell on PROD1PC69 with REPORTS 32 Board of Governors of the Federal Reserve System, The Supervisory Capital Assessment: Design and Implementation, at 3 (Apr. 24, 2009) (online at www.federalreserve.gov/newsevents/ speech/bcreg20090424a1.pdf) (hereinafter ‘‘SCAP Design Report’’). Views that major U.S. banks are not in fact well capitalized lie at the heart of disputes about the health of the nation’s financial system. These disputes are discussed further in Part H of Section One of this report. 33 Id. at 1. 34 SCAP Results, supra note 24, at 5; SCAP Design Report, supra note 32, at 4 (‘‘This capital buffer should position the largest BHCs to continue to play their critical role as intermediaries, even in a more challenging economic environment.’’). Among the BHCs subject to the stress tests were several companies that had recently concluded significant mergers or acquisitions, including acquisitions of troubled institutions with the potential to impact the capital reserves of the BHCs participating in the stress tests. This group included: (1) Bank of America, which acquired Merrill Lynch in September 2008 and had purchased Countrywide Financial earlier last year; VerDate Nov 24 2008 04:20 Jun 18, 2009 Jkt 050104 PO 00000 Frm 00016 Fmt 6602 Sfmt 6602 E:\HR\OC\A104.XXX A104 11 not intend to conduct stress tests for smaller BHCs, stating in joint comments on the results of the stress tests that ‘‘smaller financial institutions generally maintain capital levels, especially common equity, well above regulatory capital standards.’’ Regulators should nevertheless continue to closely monitor capital levels at the smaller institutions as part of the supervisory process, especially in light of the failures of small banks that have already occurred.35) While the majority of institutions to whom stress tests were applied are traditional BHCs, several others are not. Two of the largest ones, Goldman Sachs and Morgan Stanley, are investment banking organizations that became BHCs in September 2008, at the height of the financial crisis, in order to access the increased capital that BHCs can obtain from the Federal Reserve Banks. However, the primary activity of these companies remains investment rather than commercial banking.36 The credit card company American Express and the former financial services arm of General Motors, GMAC, also converted to BHCs for similar reasons in November and December of 2008, respectively, and qualified for the stress tests based on their total assets at the end of 2008.37 In addition, the insurance company MetLife qualified as one of the largest BHCs, having become a BHC in 2001.38 Of course, by becoming BHCs, these institutions subjected themselves to the more stringent capital requirements that apply to banks and to which they were not previously subject. The 19 BHCs taking part in the stress tests as part of the CAP have already been the recipients of $217 billion in assistance through various TARP programs. These include the CPP, and, in the case of Citigroup and Bank of America, the TIP, and, in the case of GMAC, the Automotive Industry Financing Program,39 although it should be noted that there are reports indicating that not all of them actively sought such funds.40 (MetLife was the only BHC that participated in the stress test that has not received TARP aid.) In addition, Bank of America and Citigroup have received government guarantees on pools of their assets—totaling up to $97.2 billion in the case of Bank of America and up to $244.8 jbell on PROD1PC69 with REPORTS (2) JPMorgan Chase, which bought Bear Stearns and Washington Mutual; (3) Wells Fargo, which currently holds Wachovia; and (4) PNC, which acquired National City Bank. 35 See Parts C and H of Section One of this report; Robert B. Albertson, Stress Test Consequences, Sandler O’Neill Partners (May 11, 2009) (online at www.sandleroneill.com/pdf/financialsl051109.pdf) (hereinafter ‘‘Stress Test Consequences’’). Fifty-one banks have failed since September 2008. Federal Deposit Insurance Corporation, Failed Bank List (June 4, 2009) (online at www.fdic.gov/bank/individual/failed/banklist.html). 36 Board of Governors of the Federal Reserve System, Press Release (Sept. 21, 2008) (online at www.federalreserve.gov/newsevents/press/bcreg/20080921a.htm) (approving the applications of Goldman Sachs and Morgan Stanley to become BHCs). 37 Board of Governors of the Federal Reserve System, Press Release (Nov. 10, 2008) (online at www.federalreserve.gov/newsevents/press/orders/20081110a.htm) (approving the application of American Express to become a BHC); Board of Governors of the Federal Reserve System, Press Release (Dec. 24, 2008) (online at www.federalreserve.gov/newsevents/press/orders/ 20081224a.htm) (approving the application of GMAC to become a BHC). 38 Board of Governors of the Federal Reserve System, Order Approving Formation of a Bank Holding Company and Determination on a Financial Holding Company Election, at 7 (Feb. 12, 2001) (online at www.federalreserve.gov/boarddocs/press/BHC/2001/20010212/attachment.pdf). 39 See June 5 TARP Transactions Report, supra note 13. See also Part J of Section Two of this report. 40 See, e.g., Damian Paletta, et al., At Moment of Truth, U.S. Forced Big Bankers to Blink, Wall Street Journal (Oct. 15, 2008) (online at online.wsj.com/article/ SB122402486344034247.html). VerDate Nov 24 2008 04:20 Jun 18, 2009 Jkt 050104 PO 00000 Frm 00017 Fmt 6602 Sfmt 6602 E:\HR\OC\A104.XXX A104 12 billion for Citigroup.41 A significant share of the preferred stock that Treasury purchased in Citigroup is expected to be converted to common equity in order to strengthen that company’s capital structure.42 3. HOW THE STRESS TESTS WORKED a. Overview The stress tests first estimated the losses that the 19 BHCs would likely suffer between now and the end of 2010 based on specified economic assumptions, resulting from: • debtors defaulting on loans the BHCs had made to them; • decreases in value in the securities the BHCs held as investments; • (for the BHCs with large securities trading businesses) losses on the trading of securities; 43 and • the impact of revenues of falling transactional volume on a fixed cost base, such as in the credit card market. The tests then projected how much capital each BHC would have after absorbing the estimated losses, at the end of 2010. It was at this point that the supervisors determined the need for a capital buffer. If the test resulted in tier 1 capital being less than six percent of risk-weighted assets, or tier 1 common capital being less than four percent for a particular institution, that institution was required to obtain additional capital by November 2009.44 The process builds on existing regulatory and accounting requirements 45 and does not introduce new measures of risk or change the way banks’ risk is measured. The tests were affected only to a limited extent by new accounting rules. Recent accounting guidance that allows more flexibility in calculating the value of securi- jbell on PROD1PC69 with REPORTS 41 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) (hereinafter ‘‘Bank of America Asset Guarantee’’) (granting a $118 billion pool of Bank of America assets a 90 percent federal guarantee of all losses over $10 billion, the first $10 billion in federal liability to be split 75/25 between Treasury and the FDIC and the remaining federal liability to be borne by the Federal Reserve Board); U.S. Department of the Treasury, Summary of Terms: Eligible Asset Guarantee (Nov. 23, 2008) (online at www.treasury.gov/press/releases/reports/ cititermsheetl112308.pdf) (hereinafter ‘‘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 Board). 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) (hereinafter ‘‘Final Citi Guarantee Terms’’) (reducing the size of the asset pool from $306 billion to $301 billion). 42 U.S. Department of the Treasury, Treasury Announces Participation in Citigroup’s Exchange Offering (Feb. 27, 2009) (online at www.financialstability.gov/latest/tg41.html). 43 These calculations included (under accepted accounting rules) the results of other entities and businesses that the BHCs had recently acquired. 44 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, Chairman of the Federal Deposit Insurance Corporation Sheila Bair, and Comptroller of the Currency John C. Dugan: The Treasury Capital Assistance Program and the Supervisory Capital Assessment Program (May 6, 2009) (online at www.ustreas.gov/press/releases/tg121.htm). The various general components of capital are described supra. 45 This issue is discussed supra in Part A of Section One of this report. See also 12 CFR Part 225, at Appendix E § 4(b)(3). VerDate Nov 24 2008 04:20 Jun 18, 2009 Jkt 050104 PO 00000 Frm 00018 Fmt 6602 Sfmt 6602 E:\HR\OC\A104.XXX A104 13 ties portfolios 46 was not taken into account in estimating losses. 47 On the other hand, accounting rules not yet in effect that will require off-balance sheet assets (such as special-purpose vehicles formed to securitize banks’ assets) to be brought onto banks’ balance sheets were treated as already in effect, resulting in a more conservative calculation.48 In estimating the losses, the banking supervisors took a ‘‘horizontal’’ approach, with specialized teams of personnel assessing losses with respect to the same asset classes across all institutions, in order to ensure that comparable assets were valued the same way (or that differences were consistently and rationally applied) for each BHC.49 b. Economic assumptions The process used two sets of economic assumptions to create the scenarios against which BHCs were ‘‘stress tested.’’ These were: a ‘‘baseline’’ scenario that assumed that economic conditions during 2009 and 2010 would follow the February 2009 ‘‘consensus estimate’’ of those conditions and a ‘‘more adverse’’ scenario that assumed that those conditions would be worse. The two scenarios used different assumptions for the following macroeconomic metrics: real Gross Domestic Product (GDP) growth, unemployment rate, and housing price changes. FIGURE 1: ECONOMIC SCENARIOS: BASELINE AND MORE ADVERSE ALTERNATIVES 50 2009 Real GDP Growth: Average baseline 51 .......................................................................................................................... Consensus Forecasts .............................................................................................................. Blue Chip ................................................................................................................................ Survey of Professional Forecasters ......................................................................................... Alternative more adverse ................................................................................................................. Civilian unemployment rate: 52 Average baseline ............................................................................................................................. Consensus forecasts ............................................................................................................... Blue Chip ................................................................................................................................ Survey of Professional Forecasters ......................................................................................... Alternative more adverse ................................................................................................................. House Prices: 53 Baseline ........................................................................................................................................... Alternative more adverse ................................................................................................................. 2010 ¥2.0 ¥2.1 ¥1.9 ¥2.0 ¥3.3 ¥2.1 2.0 2.1 2.2 0.5 8.4 8.4 8.3 8.4 8.9 8.8 9.0 8.7 8.8 10.3 ¥14 ¥22 ¥4 ¥7 50 SCAP Design Report, supra note 32, at 51 Baseline forecasts for real GDP growth 6. and the unemployment rate equal the average of the projections released by Consensus Forecasts, Blue Chip, and Survey of Professional Forecasters in February. jbell on PROD1PC69 with REPORTS 46 Financial Accounting Standards Board, Determining Fair Value When the Volume and Level of Activity for the Assets or Liability Have Significantly Decreased and Identifying Transactions That Are Not Orderly (Apr. 9, 2009) (FSP FAS 157–4) (online at www.fasb.org/cs/BlobServer ?blobcol=urldata &blobtable=MungoBlobs &blobkey=id&blobwhere= 1175818748755 &blobheader= application%2Fpdf) (hereinafter ‘‘FASB Fair Value Staff Position’’); Financial Accounting Standards Board, Recognition and Presentation of Other-Than-Temporary Impairments (Apr. 9, 2009) (FSP FAS 115–2 and FAS 124–2) (online at www.fasb.org /cs/BlobServer ?blobcol=urldata &blobtable= MungoBlobs&blobkey= id&blobwhere= 1175818748856 &blobheader= application%2Fpdf). 47 The accounting guidance did affect the reduction in estimated capital required for those BHCs whose first quarter performance exceeded original estimates, but the aggregate impact of the accounting change appears to be limited. See further discussion later in this report, infra note 79. 48 Financial Accounting Standards Board, Briefing Document: FASB Statement 140 and FIN 46 (May 18, 2009) (online at www.fasb.org/news/ 051809lfas140l andl fin46r.shtml); SCAP Results, supra note 24, at 16. 49 Id. at 4. VerDate Nov 24 2008 04:20 Jun 18, 2009 Jkt 050104 PO 00000 Frm 00019 Fmt 6602 Sfmt 6602 E:\HR\OC\A104.XXX A104 14 52 Unemployment data is collected monthly; the rates used here are projected averages for the year. 53 Percent change in the Case-Shiller 10-City Composite index from the fourth quarter of the previous year to the fourth quarter of the year indicated. As noted above, the baseline scenario was based on consensus economic forecasts available in February 2009, and the adverse scenario was projected from that baseline. As further discussed below, there was some criticism that both sets of assumptions were too optimistic at the time, and there was additional criticism when the economy deteriorated further after the SCAP exercise began.54 The final SCAP results were primarily reported on the basis of the ‘‘more adverse’’ scenario. While the Federal Reserve Board’s paper on the methodology of the SCAP states that ‘‘[p]rojections under two alternative scenarios allow for analysis of the sensitivity of a firm’s business to changes in economic conditions,’’ 55 it is not clear whether, with only one set of data, there is sufficient information for analysts to run their own models based on alternative macroeconomic assumptions. While the stress tests assumed stronger BHC future earnings than the International Monetary Fund (IMF) has projected, the tests adopted loan loss assumptions that were more conservative than those used in the IMF model.56 The differences between various projections are summarized in Figure 2. FIGURE 2: ALTERNATIVE ECONOMIC ASSUMPTIONS Baseline Metric 2009 GDP Growth ...................... Unemployment ................. IMF projections 57 More adverse 2010 ¥2.0 8.4 2009 2.1 8.8 2010 ¥3.3 8.9 0.5 10.3 2009 ¥2.8 8.9 2010 Current data 58 (Most recent) ¥5.7 59 9.4 60 0.0 10.1 57 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). 58 Because the baseline and adverse scenarios are projected as annual averages, they are not directly comparable to monthly or quarterly data. 59 First quarter 2009, percent change from preceding quarter in chained 2000 dollars (preliminary figure). U.S. Department of Commerce, Bureau of Economic Analysis, Gross Domestic Product, 1st quarter 2009 (preliminary) (May 29, 2009) (online at www.bea.gov/newsreleases/national/gdp/2009/gdp109p.htm) (hereinafter ‘‘Gross Domestic Product’’). This figure is up from the 6.3 percent decline in the fourth quarter of 2008. Id. 60 U.S. Department of Labor, Bureau of Labor Statistics, The Employment Situation: May 2009 (June 5, 2009) (USDL 09–0588) (online at www.bls.gov/news.release/pdf/empsit.pdf) (hereinafter ‘‘Employment Situation’’). This figure is the unemployment rate through April 2009, the last month for which data is available. The year-to-date average unemployment rate stands at 8.5 percent. See id. at 10. The stress-tested BHCs were told to adapt the scenarios’ macroeconomic assumptions to their specific business activities when projecting their own losses and resources over 2009 and 2010. This process included adapting assumptions for housing price changes to account for local conditions, and, where the BHCs had international operations, adjusting the assumption that international conditions would be as bad as those assumed for the United States. jbell on PROD1PC69 with REPORTS 54 See, e.g., Ari Levy. ‘Stress Testing’ for U.S. Banking Industry May Not Live Up to Name, Bloomberg (Feb. 26, 2009) (online at www.bloomberg. com/apps/news?pid=20601110&sid =a.DoUvyCa0cE); John W. Schoen, Bank ‘Stress Test’ Draws Fire From Critics, MSNBC (Apr. 24, 2009) (online at www.msnbc.msn.com/id/30368110); Nouriel Roubini, Stress Testing the Stress Test Scenarios: Actual Macro Data Are Already Worse than the More Adverse Scenario for 2009 in the Stress Tests. So the Stress Tests Fail the Basic Criterion of Reality Check Even Before They Are Concluded (Apr. 13, 2009) (online at www.rgemonitor.com/roubinil monitor/ 256382/stressl testingl thel stressl testl scenariosl actuall macrol datal arel alreadyl worsel thanl thel morel adversel scenariol forl 2009l inl thel stressl testsl sol thel stressl testsl faill thel basicl criterionl ofl realityl checkl evenl beforel theyl arel concluded). See also Part H of Section One of this report. 55 SCAP Design Report, supra note 32, at 5. 56 See generally Douglas J. Elliot, Implications of the Bank Stress Tests, Brookings Institution, at 8–9 (May 11, 2009) (online at brookings.edu//media/Files/rc/papers/2009/0511l bankl stressl testsl elliott/0511l bankl stressl testsl elliott.pdf). VerDate Nov 24 2008 04:20 Jun 18, 2009 Jkt 050104 PO 00000 Frm 00020 Fmt 6602 Sfmt 6602 E:\HR\OC\A104.XXX A104 15 In making these adaptations, the institutions were encouraged to make additional appropriate assumptions of macroeconomic conditions based on the three governing metrics, and several BHCs developed their own assumptions as to interest rates, yield curves, etc. c. Loan loss projections The BHCs were instructed by the supervisors to estimate losses from failure to pay obligations through the end of 2012 for 12 separate loan categories,61 based on the value of the loans shown on the BHCs’ books at the end of 2008. Accounting and banking rules require that banks carry loans on their books at their unpaid principal amount, reduced by a percentage reflecting the credit history of the borrower and the general risk of nonpayment for loans of the particular type. The remaining principal amount, less these provisions, is the amount that a BHC shows as assets on its balance sheet. Loans are not ‘‘marked-to-market,’’ that is, they are not revalued by estimating what a BHC could receive for those loans if it sold them. Thus, the losses the BHCs were required to estimate were losses arising from borrowers’ failure to pay their obligations, not losses arising from a drop in market value of existing loans, and the use of a different valuation method for these loans might have resulted in a rather different estimate of the required capital buffer.62 With respect to this method of valuation of loans, see commentary in the Panel’s April Oversight Report: Treasury has not explained its assumption that the proper values for these assets are their book values—in the case, for example, of land or whole mortgages—and more than their ‘‘mark-to-market’’ value in the case of ABSs, CDOs, and like securities; if values fall below those floors, the banks involved may be insolvent in any event.63 In assessing their loan losses, the BHCs were told to add to their loan inventory potential additional loans that could result from the drawing down of existing credit lines by borrowers, and to add to their balance sheets liabilities held in ‘‘special purpose vehicles’’ (SPVs) that had previously been excluded from capital calculations and that might have to be taken back onto the balance sheets in a stressed economic environment or due to accounting changes.64 It should be noted that the unanticipated on-boarding of off-balance sheet assets played a significant role in the current financial crisis,65 and with consumer defaults rising, on-boarding SPVs might be expected to account for a large proportion of estimated losses. jbell on PROD1PC69 with REPORTS 61 These categories were: first lien (1) prime, (2) Alt-A, and (3) subprime mortgages; (4) closedend junior liens; (5) home equity lines of credit; (6) commercial & industrial loans; commercial real estate (7) construction, (8) multifamily, and (9) non-farm, non residential loans; (10) credit card loans; (11) other consumer loans; and (12) other loans. SCAP Design Report, supra note 32, at 18. 62 See Part H of Section One of this report. 63 Congressional Oversight Panel, April Oversight Report: Assessing Treasury’s Strategy: Six Months of TARP, at 75 (Apr. 7, 2009) (online at cop.senate.gov/reports/library/report-040709cop.cfm) (hereinafter ‘‘Panel April Oversight Report’’). 64 SCAP Results, supra note 24. 65 See, e.g. Citigroup Inc., Citigroup’s 2008 Annual Report on Form 10–K, at 6–18 (online at www.citigroup.com/citi/fin/data/k08c.pdf?ieNocache=677). VerDate Nov 24 2008 04:20 Jun 18, 2009 Jkt 050104 PO 00000 Frm 00021 Fmt 6602 Sfmt 6602 E:\HR\OC\A104.XXX A104 16 The proportion of estimated losses due to on-boarding SPVs was not disclosed by the supervisors. Against this expanded loan inventory, BHCs were required to estimate their losses in each of the 12 loan categories under both scenarios. The banking supervisors provided the BHCs with a range of indicative two-year cumulative loss rates for each category and each scenario to guide their projections. For example, the supervisors provided an indicative loan loss rate of 7–8.5 percent for first lien mortgages in the more adverse scenario. The BHCs adapted this guidance to their particular situations to estimate the loan losses they would suffer in each category of loans under each scenario. These estimates were provided to supervisors. In addition, the BHCs were required to provide granular data about the particular characteristics of their portfolios (such as underwriting practices, FICO scores and refreshed LTV information) so that the supervisors could assess the reasonableness of the BHCs’ loan loss estimates. BHCs were permitted to predict loss rates outside the indicative ranges if they could provide strong supporting evidence for the deviation, especially if their loan loss estimate fell below the range minimum. Therefore, in certain categories and scenarios some BHCs estimated that their loan loss rates would be above the indicative range, while others ended up making estimates that fell below the range. Using the data presented by the BHCs, the supervisors made their own estimates of loan losses on an asset-class-by-asset-class basis, comparing loss projections for similar asset classes across institutions so that, for example, losses with respect to subprime loans in a particular area originated in a particular period would be estimated at the same rate for different BHCs, even if those BHCs’ own estimates differed. Therefore, a divergence in loss rates between BHCs in a given category of loans should indicate differences in portfolios, not differences in the BHCs’ own estimates. Each BHC’s loss estimates ultimately relied on portfolio-specific data regarding past performance, origination year, borrower characteristics and geographic distribution. These differences led to significant variation between BHCs in the ultimate loan loss estimates used by supervisors. For example, Capital One’s estimated loss rate for first lien mortgages was 10.7 percent and BB&T Corporation’s rate was 4.5 percent.66 d. Projections of losses on securities The BHCs were also required to estimate the losses that their securities portfolios would suffer through 2010 under both economic scenarios. The way securities are valued on a BHC’s balance sheet differs from the way loans are treated and depends on what the BHC intends to do with those securities. Securities may be categorized as: (1) ‘‘held to maturity’’ (HTM); (2) trading, that is, held for sale in the near future; or (3) ‘‘available for sale’’ (AFS). Securities held to maturity are carried on the BHC’s balance sheet at ‘‘amortized’’ cost (roughly, principal minus repayments), with that value further reduced if the value of the security is considered subject to ‘‘other jbell on PROD1PC69 with REPORTS 66 SCAP VerDate Nov 24 2008 04:20 Jun 18, 2009 Results, supra note 24, at 21, 23. Jkt 050104 PO 00000 Frm 00022 Fmt 6602 Sfmt 6602 E:\HR\OC\A104.XXX A104 17 than temporary impairment’’ (OTTI). Securities available for sale or in the trading portfolio are carried at ‘‘fair value,’’ which means market value if there is a trading market for them, or at a value estimated by the BHC if there is not.67 All 19 BHCs were instructed to estimate possible impairment with respect to net unrealized losses on securities that they categorized as held to maturity and securities that they classified as available for sale under both scenarios. For this analysis, securities carried at fair value were marked to market as of December 31, 2008. Since a loss from impairment when a security is marked down is recorded on the BHC’s income statement as a charge to income, the BHCs were also told to estimate the decrease in income that would result from these devaluations.68 The recent FASB guidance on establishing ‘‘fair value’’ in illiquid markets, which gave BHCs greater flexibility in valuing securities, was not taken into account in estimating losses under the more adverse scenario in order to reflect greater uncertainty about realizable losses in stressful conditions.69 (The FASB guidance was taken into account in estimating losses in the baseline scenario, but the baseline scenario results were not published.) 70 BHCs with trading securities of $100 billion or more—Bank of America, Citigroup, Goldman Sachs, JP Morgan Chase, and Morgan Stanley—were asked to provide projections of trading-related losses for the more adverse scenario, including losses from their ‘‘counterparty’’ exposure risk with regard to credit default swap and similar transactions. To calculate these losses, the BHCs conducted a stress test of their trading book positions and counterparty exposures as of market close on February 20, 2009. BHCs were told to disclose the positions that they included in this analysis, the risk factors that were stressed, and the changes in jbell on PROD1PC69 with REPORTS 67 ‘‘Fair value’’ is established in accordance with accounting rules. Where there is a market for the securities, that market value is used. Where the market is illiquid, the rules permit the owner to use other inputs to establish a price for its securities, taking into account current market pricing and conditions. In the recent market turmoil, the need to take market conditions into account in creating valuation models for their securities meant that some institutions had to realize significant losses on their portfolios of securities such as mortgage-backed ABSs, even though those securities were still continuing to generate cash flow. In response to this situation, the accounting authorities released guidance in April 2009, that permitted more flexibility in the valuation of securities for which there was no liquid market. FASB Fair Value Staff Position, supra note 46. This guidance applied to financial statements for periods after June 15, 2009, with an early-adoption provision for periods ending no earlier than March 15, 2009. Thus, the BHCs’ financial statements for the year ending December 31, 2008, were not affected by the April FASB guidance. 68 SCAP Design Report, supra note 32, at 8. In deciding which securities should be treated as having suffered an OTTI and thus need to be revalued at fair value as of December 31, 2008, the supervisors took a conservative approach in the more adverse scenario, in that BHCs were required to take into account the possibility that in adverse economic conditions they might not be able to hold all their HTM securities until they matured, and may need to sell them before recovery of their cost basis. The total impact of this requirement was small, as most HTM securities in the BHCs’ portfolios were low-risk Treasury securities and the like, but this approach illustrates the conservative approach taken by the supervisors. 69 Critics have argued that the principal effect of the FASB rule change would be to allow BHCs to simply avoid recording decreases in the value of their assets, undermining investor confidence and perhaps prolonging the crisis. See, e.g., House Committee on Financial Services, Subcommittee on Capital Markets, Insurance and Government Sponsored Enterprises, Testimony of Executive Director of the Center for Audit Quality Cynthia Fornelli, Mark-to-Market Accounting: Problems and Implications, 111th Cong. (Mar. 12, 2009) (online at www.house.gov/ apps/list/hearing/financialsvcsldem/fornelli031209.pdf). In other words, the rule change may allow BHCs that are actually insolvent to continue operating, a situation analogous to Japan’s elimination of mark-to-market accounting early in its so-called ‘‘Lost Decade.’’ Id. However, this debate largely turns on the question of whether the fundamental problem facing the financial system is one of liquidity or valuation. 70 SCAP Design Report, supra note 32, at 14. VerDate Nov 24 2008 04:20 Jun 18, 2009 Jkt 050104 PO 00000 Frm 00023 Fmt 6602 Sfmt 6602 E:\HR\OC\A104.XXX A104 18 variables that they used (such as changes in interest rates, spreads, exchange rates, etc.).71 As with estimates of loan losses, the supervisors made their ultimate estimates of losses from securities portfolios using the estimates provided by the BHCs and applying ‘‘horizontal testing’’ across asset classes to ensure consistency. e. Resources available to absorb losses In addition to drawing on their capital, banks can absorb losses with offsetting income and loss reserves set up precisely for that purpose. The tests ‘‘stressed’’ both items. The BHCs were instructed to project the main components of their ‘‘pre-provision net revenue’’ (PPNR), which is net interest income plus non-interest income minus non-interest expense, under both economic scenarios. The stress test review required BHCs to explain in detail the assumptions they made in computing PPNR, especially if those assumptions included an increase in business, and any projections in excess of 2008 levels required strong supporting evidence. A bank sets aside reserves in a current period to absorb anticipated future loan losses so that those losses do not affect overall capital in the future period. The BHCs were instructed to estimate the resources they would have available to absorb projected losses. This would include the revenue that they earned in 2009 and 2010, the reserves that they had set aside for losses at the end of 2008, and any additions to those reserves projected to be made during 2009 and 2010. They were then asked to estimate the portion of the year-end 2008 reserves that they would need to absorb credit losses on their loan portfolio under each scenario while still ending up on December 31, 2010, with sufficient reserves in light of their loan portfolio on that date to absorb future losses at an elevated (that is, stressed) rate. To the extent additional reserves would likely be needed, income available to absorb losses (i.e., PPNR) was reduced accordingly. f. Adjustments At the end of the first stage of the stress testing, the supervisors translated the gains and losses they projected for each BHC into changes in that BHC’s projected capital levels. These amounts were first calculated on the basis of the BHCs’ results to December 31, 2008. As discussed in more detail below, the initial results suggested that the aggregate capital needed for the 19 BHCs to reach capital buffer targets in the more adverse scenario would be $185 billion, ‘‘much of which’’ would have to be in the form of tier 1 common capital.72 jbell on PROD1PC69 with REPORTS 71 The estimates of losses took into account the severe market stresses that occurred between June 30, 2008 and December 31, 2008. This process goes beyond usual mark-to-market rules and, in requiring the use of data from the most stressed markets in recent decades, might be termed ‘‘mark to mayhem.’’ 72 The summary of SCAP results does not specify the amounts of tier 1 common and other tier 1 capital that comprise each holding company’s required buffer. The release says simply that: [c]apital needs are mainly in the form of tier 1 common capital, which reflects the fact that while many institutions have a sufficient amount of capital, they need to take steps to improve the quality of that capital . . . For ten of the participating BHCs, supervisors expect these firms to raise additional capital or change the composition of their capital. As noted above, much VerDate Nov 24 2008 04:20 Jun 18, 2009 Jkt 050104 PO 00000 Frm 00024 Fmt 6602 Sfmt 6602 E:\HR\OC\A104.XXX A104 19 The final calculation of the capital buffers reflected the effects of acquisitions, new capital raised, and operating performance in the first three months of 2009. These adjustments were substantial, and reflected actions taken by some BHCs prior to the conclusion of the stress tests to raise capital by selling subsidiaries or businesses, converting preferred stock into common stock or issuing common shares, and, to a lesser extent, strong operating results generated by some BHCs during the first quarter.73 Where a BHC’s first quarter performance exceeded the supervisors’ estimate of PPNR for that period, the amount by which it exceeded estimates was added to the estimate of resources available to absorb losses, thus decreasing the required capital buffer.74 The impact of ‘‘Capital Actions and Effects of Q1 Results’’ is presented on a net basis for each BHC, so it is not possible to see the specific effect of each of these actions or results on a BHC’s capital or even whether a particular BHC experienced an adjustment because of its operating results.75 For the 19 BHCs, the total impact of Q1 2009 adjustments was to reduce the capital buffer needed by $110 billion, $87.1 billion of which was attributable to Citigroup, Inc.76 The adjustments for the additional three months reflects certain accounting changes adopted in April 2009, to provide flexibility as to the ‘‘fair value’’ that must be assigned to securities for which no liquid market exists (for example, asset-backed securities for which there is no market, or over-the-counter credit default swaps). Seven BHCs adopted these accounting changes for their first quarter financial statements.77 Some securities that those BHCs had been carrying on their books at ‘‘fair value’’ were revalued at a higher price in light of the accounting changes, and the increase in these values was recognized as income. On the other hand, some liabilities of those BHCs were also revalued as a result of the accounting change, and the increase in these liabilities decreased the BHCs’ income. Where a BHC’s income for the first quarter of 2009 exceeded the supervisors’ original estimates for its revenues, as discussed above,78 these revaluation-related increases (or decreases) would have decreased (or increased) the amount of the capital buffer required. It is not possible to quantify the impact of these changes on the basis of the information published, however. Because adjustments to the required capital buffer resulting from first quarter performance are presented on a net basis, reflecting both revenues and capital actions, it is not possible to identify which BHCs had their buffer requirement reduced due to first quarter performance, and thus whether any members of that group of BHCs adopted the accounting guidance. It appears that the maximum possible impact jbell on PROD1PC69 with REPORTS of this need is for additional tier 1 common. For all of these firms, a raise of new common equity of the amount indicated would be sufficient to ensure they will also have at least a six percent tier 1 ratio at the end of 2010. SCAP Results, supra note 24, at 16, 17. 73 Federal Reserve Board officials have informed Panel staff that the aggregate impact of all first quarter 2009 PPNR on the required capital buffer was only $20 billion. 74 Id. 75 See Part H of Section One of this report. 76 This issue is discussed infra in Part B of Section One of this report. 77 These BHCs are: Bank of America, Bank of New York Mellon, Citigroup, JPMorgan Chase, PNC, U.S. Bancorp, and Wells Fargo. The 19 BHCs tested report to the Securities and Exchange Commission (SEC) and thus their financial statements are publicly available. 78 This issue is discussed infra in Part B of Section One of this report. VerDate Nov 24 2008 04:20 Jun 18, 2009 Jkt 050104 PO 00000 Frm 00025 Fmt 6602 Sfmt 6602 E:\HR\OC\A104.XXX A104 20 of the accounting changes on required capital buffers would have been approximately $5.6 billion.79 While several BHCs published income statements for the first quarter of 2009 that included as revenue credit value adjustments (CVA) resulting from the revaluation of their own debt, this ephemeral ‘‘revenue’’ was not included in the calculation of the PPNR available to absorb losses.80 g. Calculation of the SCAP buffer After making the adjustments just described, the supervisors computed the additional amount, if any, required so that the BHCs would reach the capital buffer ratio of six percent tier 1 capital and four percent tier 1 common capital. The computation began with measures of these capital elements at December 31, 2008, calculated in accordance with Federal Reserve Board rules.81 Using the loss and revenue estimates discussed above, the supervisors calculated the necessary capital buffer. In doing so, they examined a range of capital metrics and factors, including tier 1 common and overall capital, and including the composition of capital. The initial assessment of capital need (relating to the BHCs’ capital position as of December 31, 2008) was communicated to the BHCs in late April. As discussed below, Treasury released the results of the stress tests on May 7, 2009. The reason for the time lag between communication to the banks and release of the results publicly may have been due to the need to check for errors, omissions, and double counting, but the Panel has not had access to documents that would establish this fact. Nor is it possible to tell whether, or to what extent, the numbers communicated to the banks in late April differed from those released publicly. 4. RESULTS OF THE STRESS TESTS On May 7, 2009, Treasury released the results of the stress tests.82 (The results released dealt only with the impact of the ‘‘more adverse’’ economic scenario, not the baseline scenario.) Those results showed that ten of the 19 BHCs required additional capital to weather a ‘‘more adverse’’ economic scenario and that nine of the 19 BHCs already held a sufficient capital buffer and would not be required to raise additional capital as a result of the stress test.83 jbell on PROD1PC69 with REPORTS 79 Based on SEC filings by the BHCs, which do not present such data in a standardized form, the possible aggregate impact on required capital buffer ranges from an increase of approximately $240 million (if only the BHCs that recognized losses resulting from the accounting change were allowed adjustments due to first quarter performance) to a decrease of approximately $5.6 billion (if only the BHCs that recognized income from accounting changes were allowed such adjustments. Of the latter figure, approximately $5 billion relates to Wells Fargo alone. It should be noted that because the FASB guidance was not taken into account in estimating losses under the more adverse scenario (which was the only scenario for which results were reported), the impact of the FASB guidance is limited to this measure alone (the increased resources available to absorb losses) and only to the BHCs whose PPNR for the first quarter of 2009 exceeded the supervisors’ estimates. 80 Revenue from such CVAs is routinely excluded from the calculation of tier 1 capital. See generally 12 CFR part 225, at Appendix A § II. 81 This calculation starts with shareholders’ capital adjusted to remove certain accounting adjustments that may obscure the true value of shareholder equity. See 12 CFR part 225, Appendix A § II. 82 SCAP Results, supra note 24. 83 These nine banks are American Express, BB&T, Bank of New York Mellon, Capital One, Goldman Sachs, J.P. Morgan Chase, MetLife, State Street, and USB. VerDate Nov 24 2008 04:20 Jun 18, 2009 Jkt 050104 PO 00000 Frm 00026 Fmt 6602 Sfmt 6602 E:\HR\OC\A104.XXX A104 21 The results estimated that in aggregate the 19 BHCs included in the SCAP would incur approximately $600 billion of additional losses by the end of 2010.84 Residential mortgage and consumer loans accounted for $322 billion, or 53.7 percent, of this $600 billion.85 The ten BHCs requiring capital are: Bank of America ($33.9 billion), Citigroup ($5.5 billion), Fifth Third Bancorp ($1.1 billion), GMAC ($11.5 billion), KeyCorp ($1.8 billion), Morgan Stanley ($1.8 billion), PNC ($600 million), Regions Financial Corporation ($2.5 billion), SunTrust ($2.2 billion), and Wells Fargo & Company ($13.7 billion).86 These BHCs must raise the capital by November 9, 2009, six months after the announcement of the test results, and they must submit a capital plan to their supervisors in early June outlining how they will do so. The supervisors broke BHCs’ assets into categories, or ‘‘buckets,’’ and disclosed the BHCs’ estimated losses for each bucket. Besides first lien mortgages, the other buckets were second/junior lien mortgages, commercial and industrial loans, commercial real estate loans, credit card loans, securities (AFS and HTM), trading and counterparty, and other, which included ‘‘other consumer and nonconsumer loans and miscellaneous commitments and obligations.’’ 87 Loss estimates within each bucket varied significantly between the BHCs. For example, as noted above, BB&T’s estimated loss rate on first lien mortgages through the end of 2010 was 4.5 percent, while Capital One was estimated to have a 10.7 percent loss rate. This translated into an estimated loss for BB&T on first lien mortgages of $1.1 billion, while Capital One was estimated to have a $1.8 billion loss on its first lien book.88 The median loss rate on first lien mortgages for all 19 participants was eight percent.89 The Federal Reserve Board explained that such variations reflected ‘‘substantial differences in the portfolios across the BHCs, by borrower characteristics such as FICO scores, and loan characteristics such as loan-to-value ratio, year of origination, and geography.’’ 90 An element of judgment was necessary in determining these loss rates. It allowed the testing, for example, to reflect local conditions with greater accuracy. However, because of the judgment involved, the calculations cannot be reviewed or replicated. This diminishes the reliability of the tests and the confidence that the public is able to place in them. The original testing measured capital levels as of the end of 2008. Since that time, a number of BHCs have taken steps that have increased their capital, and thus, as discussed above, decreased the amount of capital buffer that they must raise. As of the end of 2008, the 19 BHCs would have had to have raised a total jbell on PROD1PC69 with REPORTS 84 SCAP Results, supra note 24, at 3. This $600 billion is in addition to losses recorded on the banks’ balance sheets in the six quarters ending December 31, 2008. 85 SCAP Results, supra note 24, at 6. 86 SCAP Results, supra note 24, at 9. 87 SCAP Results, supra note 24, at 10. The BHCs expected losses were actually calculated more granularly. The supervisors estimated BHC loan losses for 12 categories of loans and multiple categories of securities. The eight buckets that were disclosed were netted figures for some of these smaller categories. 88 SCAP Results, supra note 24, at 9. 89 SCAP Results, supra note 24, at 10. 90 SCAP Results, supra note 24, at 10. VerDate Nov 24 2008 04:20 Jun 18, 2009 Jkt 050104 PO 00000 Frm 00027 Fmt 6602 Sfmt 6602 E:\HR\OC\A104.XXX A104 22 of $185 billion in capital. As a result of capital actions and the results of Q1 2009 results, this figure decreased by $110.4 billion, to a total of $74.6 billion.91 By far the largest portion of this decrease is attributable to Citigroup, whose required capital buffer was reduced from $92.6 billion to $5.5 billion.92 The most important factor in the abrupt change in Citigroup’s adjustment was a $58.1 billion preferred stock exchange offer announced on February 27, 2009. This exchange offer involves conversion of up to $27.5 billion in Citigroup preferred stock held by Treasury into Citigroup common stock 93 (increasing Treasury’s ownership in Citigroup to 36 percent).94 It also includes two pending sales of operating subsidiaries of Citigroup. In addition, Citigroup has sold a Japanese subsidiary 95 and announced a brokerage venture for Salomon Smith Barney, for which Citigroup will book a gain.96 This unprecedented exercise reported that nine of the top 19 BHCs were adequately capitalized to withstand a serious downturn in the economy over the next two years. It further reported to the remaining banks a quantifiable amount of capital that they needed to raise to remain well capitalized during this potential downturn. C. IMMEDIATE IMPACT OF THE STRESS TESTS The stress tests appeared to have an immediate impact on financial markets and public confidence.97 As soon as the results of the stress tests were announced, the BHCs began raising capital to meet shortfalls. The 19 BHCs have raised or publicly announced plans for raising $48.2 billion in new debt and equity. Treasury has claimed that, in total, $56 billion in capital-raising was planned as of May 20.98 Debt and equity 91 SCAP Results, supra note 24, at 9. Results, supra note 24, at 9. Results, supra note 24, at 9; Citigroup Inc., Form 8–K (Feb. 27, 2009) (online at www.sec.gov/Archives/edgar/data/831001/000095010309000421/dp12698l8k.htm). 94 Citigroup Inc., Citi To Exchange Preferred Securities for Common, Increasing Tangible Common Equity to as Much as $81 Billion (Feb. 27, 2009) (online at www.sec.gov/Archives/edgar/ data/831001/000095010309000421/dp12698lex9901.htm). Citigroup did not receive any additional government funds as the result of the conversion. 951A Citigroup Inc., Form 8–K (May 1, 2009) (online at www.sec.gov/Archives/edgar/data/ 831001/000095014209000583/form8kl050109.htm). 96 Citigroup Inc., Morgan Stanley and Citi To Form Industry-Leading Wealth Management Business Through Joint Venture (Jan. 13, 2009) (online at www.sec.gov/Archives/edgar/data/ 831001/000095010309000089/dp12289lex9901.htm). 97 Various measures show the impact of the tests on the markets. CDS prices show that the price of protecting against default in the large banks fell after the results of the tests were released. Alistair Barr and Ronald D. Orol, B. of A., Citi are Stress-Test Winners, CDS Prices Suggest, MarketWatch (May 8, 2009) (online at www.marketwatch.com/story/b-of-a-citi-are-stresstest-winners-group-says?dist=TQPlModlmktwN) (‘‘The cost of protecting against a default by Citigroup and Bank of America dropped by more than a third this week, as news of the stresstest results leaked out, according to Credit Derivatives Research. The cost of default protection on other banks and investment banks, including Morgan Stanley and Goldman Sachs has also fallen a lot this week, the research firm said.’’). Short interest in the 19 banks fell by 20 percent from May 7, 2009 through May 29, 2009. DataExplorers, Update: Stress Test for US Financials (May 29, 2009) (online at dataexplorers.com/sites/default/files/ Sector%20Focus%20Bank%20Stress%20Test%20-%20Update%20May%2029%202009.pdf). Media reports reflect that many felt a general sense of relief on seeing the results. See e.g., After the Financial Stress Tests: Relief But Still Some Uncertainty, CNBC (May 8, 2009) (online at www.cnbc.com/id/30640189); Jim Puzzanghera and E. Scott Reckard, Bank ‘Stress Test’ Results Hint at Economic Recovery, Los Angeles Times (May 8, 2009) (online at www.latimes.com/ business/la-fi-stress-tests8–2009may08,0,6880257.story). 98 Senate Committee on Banking, Housing, and Urban Affairs, Testimony of Secretary Geithner, Oversight of the Troubled Asset Relief Program, 111th Cong. (May 20, 2009) (online at banking.senate.gov/public/index.cfm?FuseAction=Hearings.Testimony&HearinglID =64feeb1d-f2c3-4f11-a298–800be9bd360d&WitnesslID=ae7c9f56-f16f-4b3c-b4e7-b5919e3ccd7c) 92 SCAP jbell on PROD1PC69 with REPORTS 93 SCAP VerDate Nov 24 2008 04:20 Jun 18, 2009 Jkt 050104 PO 00000 Frm 00028 Fmt 6602 Sfmt 6602 E:\HR\OC\A104.XXX A104 23 issuances reported for each BHC so far are set out in part K of Section One of this report. Though the official results were released on Thursday, May 7, 2009, the results for many of the BHCs were reported in the press prior to that date. By early that week, the public knew that ten of the 19 BHCs would be required to raise additional capital.99 It also knew the amount of capital required to be raised for some of the BHCs. However, there appears to have been some confusion surrounding the reported numbers. Federal Reserve Board officials have told the Panel that some of the reports revealed only the preliminary required capital, before it was adjusted for the effect of capital actions and 2009 first quarter results. The officials further suggested that, as a result of changes in the figures when the official results were released, many commentators mistakenly believed that the delay in the release was the result of negotiations with the BHCs.100 To gain a better understanding of the stress tests, on March 30, the Panel requested that Treasury provide the Panel with documents related to Treasury’s work on the stress tests. On May 11, the Panel made a similar request of the Federal Reserve Board. The Panel followed up with Treasury to reiterate its need for access to the documents on May 26. On June 5, Treasury made available to Panel staff a number of documents related to the stress tests. On June 8, the Federal Reserve made additional documents available. Panel staff is reviewing the documents and expects to see more documents; the meaning of the documents reviewed to date remains unclear. The Panel expects to include information resulting from that review in a future report or update where appropriate. Although the SCAP involved only the nation’s 19 largest BHCs, it spurred the private evaluation of smaller institutions. An analysis performed for the Financial Times showed that 7,900 U.S. small and medium sized banks would need to raise $24 billion in capital to achieve the capital buffer levels required of large BHCs in the SCAP.101 The firm that conducted this analysis stated that it expects that the stress test’s methodology and capital adequacy focus will migrate to the broader U.S. banking system.102 D. A COMMENT ON THE SUPERVISORY PROCESS The stress tests involved the submission of material by the 19 BHCs estimating their loss, income, and resource figures for the test period. The banking supervisors evaluated the quality of the BHCs’ submissions and made their own estimates of losses and resources to absorb those losses. As part of that process, supervisors jbell on PROD1PC69 with REPORTS (hereinafter ‘‘Geithner Testimony’’). The $8 billion difference is the result of Treasury using a more lenient standard to decide whether a fund has been ‘‘planned’’ yet. 99 Damian Paletta and Deborah Solomon, More Banks Will Need Capital, Wall Street Journal (May 5, 2009) (online at online.wsj.com/article/SB124148189109785317.html). 100 Arianna Huffington, The Stress Tests Fail the Smell Test, Huffington Post (May 5, 2009) (online at www.huffingtonpost.com/arianna-huffington/the-stress-tests-fail-thelbl196350.html). 101 Saskia Scholtes, et al., Smaller US Banks Need Additional $24bn, Financial Times (May 17, 2009) (online at www.ft.com/cms/s/0/79c47ffa-4306-11de-b7930014feabdc0,dwpluuid=ffa475a0-f3ff-11dc-aaad-0000779fd2ac.html) (hereinafter ‘‘Financial Times Study’’) (The Financial Times-commissioned study used metrics that differed from the SCAP in two ways: (1) it did not adjust for first quarter performance; and (2) it was not able to estimate loss rates with the same degree of individualized precision as the regulators). 102 Stress Test Consequences, supra note 35. VerDate Nov 24 2008 04:20 Jun 18, 2009 Jkt 050104 PO 00000 Frm 00029 Fmt 6602 Sfmt 6602 E:\HR\OC\A104.XXX A104 24 used supporting information provided by the BHCs, as well as the supervisors’ own knowledge and supervisory information. Supervisors also included their own independent benchmarks, such as the indicative loan loss rates discussed above. The supervisory teams performing the tests involved more than 150 examiners from the Federal Reserve Board, the Federal Reserve Banks, the Office of the Comptroller of the Currency (OCC), and the FDIC. Additionally, specialist teams were assigned to examine loss projections for specific asset classes across all the BHCs. This ensured that the same or similar assets would be valued the same way in the projections for each institution, and that counterparty risk, revenue projections, and loan loss would be treated consistently across institutions. The BHCs had several thousand people working to produce the raw data that informed the stress tests. Additional advisory groups provided assistance with accounting, regulatory capital, and financial and macroeconomic modeling. The supervisory process, by its nature, always involves constant interaction between the supervisor and the regulated entity, and the SCAP process was no exception. The supervisors presented the BHCs with indicative guidelines for loan loss rates, but the BHCs were able to use alternative measures if they could prove to the supervisors (with adequate documentation) that the alternative was more appropriate. The supervisors alone, however, decided whether the loan loss rates used were appropriate. (The supervisors found some BHCs’ submissions to be of a higher quality than others, and, after the supervisors had presented the BHCs with their initial estimates, some BHCs presented the supervisors with more detailed information in order to correct errors and double-counting that had been reflected in their results.) While SCAP in some ways represents a new and tougher approach by federal regulators, it does not constitute a genuine break from past supervision methods and tactics, and was not intended to be. The fact that regulators did not identify emerging systemic risks prior to the crisis underscores the importance of scrutiny toward the supervisory role generally and the recent round of stress testing. E. SPECIFIC LIMITATIONS OF THE STRESS TESTS jbell on PROD1PC69 with REPORTS Any evaluation of the stress tests must start with both what the tests are and what they are not. Supervisors have always regarded regulatory capital as a baseline measure and have required additional capital (or changes in capital composition) for particular institutions when the situation warranted. The stress tests operate under this premise but they are also a unique, cross-institution exercise. They are not a regulatory examination of the 19 BHCs, focused on capital adequacy, and do not test the BHCs’ overall safety and soundness, as would a regular examination. In this and in more granular ways, the SCAP builds from a starting point of existing bank supervision and conclusions about the health of the institutions at issue. It is logical, in view of such a starting point, that the supervisors relied on raw data that were produced by the BHCs themselves. For example, the stress tests estimated the losses that might occur VerDate Nov 24 2008 04:20 Jun 18, 2009 Jkt 050104 PO 00000 Frm 00030 Fmt 6602 Sfmt 6602 E:\HR\OC\A104.XXX A104 25 on first lien mortgages held by each BHC but did not test whether the BHC held the total amount of mortgages that it said it did, or whether it actually had enforceable liens on them.103 The tests were not re-audits or re-examinations; they relied on BHC-generated figures whose assumptions were tests only. Thus, to a significant extent, the stress tests rely on the accuracy of the audit and examination process, and the integrity and soundness of the judgments and internal processes of the participating BHCs.104 The stress test results are presented as the estimates of the supervisors, not those of the institutions tested. The Federal Reserve Board emphasizes that those institutions or other outside analysts might have produced very different estimates, even using a similar set of economic assumptions.105 F. INDEPENDENT ANALYSIS OF STRESS TESTS The Panel asked Professors Eric Talley and Johan Walden to review the stress test methodology. Professor Talley is a Professor of Law and the U.C. Berkeley School of Law (Boalt Hall), and Co-Director, the Berkeley Center for Law, Business, and the Economy; he has been a Visiting Professor of Law at the Harvard Law School during the 2008–2009 academic year. Professor Walden is a Professor in the Haas Finance Group of the U.C. Berkeley Haas School of Business. Both are recognized experts in finance, asset pricing, economic analysis of risk, and economic analysis of law. Their report, ‘‘The Supervisory Capital Assessment Program: An Appraisal’’ (the Appraisal), dated June 2009, is attached as Annex to Section One. The Appraisal contains an overview of the dominant approaches in the finance literature for measuring risk using statistical models, attempting to understand and situate the approach used by the Federal Reserve Board. It examines the relative strengths and weaknesses of each model, as well as the systemic issue of model uncertainty, resulting from the fact that there is no single consensus approach to measuring financial risk from multiple sources. In this process, the Appraisal also highlights a number of statistical measures for quantifying risk from single sources, noting their usefulness in developing models. These models include: the Capital Adequacy Ratio (which measures the ratio of a bank’s equity capital to the risk-weighted value of its assets), Value at Risk (VaR) (which captures the probability of losses exceeding some specified threshold), and the Expected Shortfall (which measures the expected amount of losses in the 103 Such jbell on PROD1PC69 with REPORTS matters would be covered by the regular audit and examination processes. 104 In its April report, the Panel noted that the success of the Reconstruction Finance Corporation in stabilizing the U.S. banking system during the Great Depression has since been attributed in large part to the forced write-downs of bank assets to realistic values as determined by the RFC. Panel April Oversight Report, supra note 63, at 40. Similarly, the Panel noted that Japan did not emerge from its ‘‘Lost Decade’’ until it began to rigorously examine the valuation of bank assets in 2002, as part of a broader plan of uncovering the true health of the financial system. Panel April Oversight Report, supra note 63, at 57–58. 105 For example, Bank of America argues that its internal projections show that the supervisors underestimated its future income over the next two years while, in many cases, overestimating its loan losses. Bank of America Corp., Stress Test: Bank of America Would Need $33.9 Billion More in Tier 1 Common (May 7, 2009) (online at investor.bankofamerica.com/phoenix.zhtml?c=71595&p=irol-newsArticle&ID=1286200&highlight=). VerDate Nov 24 2008 04:20 Jun 18, 2009 Jkt 050104 PO 00000 Frm 00031 Fmt 6602 Sfmt 6602 E:\HR\OC\A104.XXX A104 26 event that losses exceed the VaR threshold).106 While acknowledging the merits of such summary statistical measures, the Appraisal points out that these measurements classify risk quite roughly and may neglect co-movement among assets, two factors that greatly reduce the amount of information contained in the final number. After discussing the methods of evaluating single-source risk, the Appraisal treats the problem of calculating a portfolio of risks, highlighting three dominant approaches within the finance literature: Merton models (in which companies default at the maturity of a debt when their total asset value is less than the face value of the debt), First Passage models (in which a company defaults if its asset value drops below a specified default trigger at any time before maturity), and Reduced Form models (which rely completely on empirical data to model default dependencies between firms in discrete periods of time). On the basis of the conceptual and mathematical analyses that it reflects, the Appraisal makes a number of points about the stress tests. At the outset, it states that: Based largely on information collected through public document review and conference calls with representatives from the Federal Reserve and the Treasury Department, and taking into account the enormity of the task within a short time horizon, we conclude that the Fed’s risk modeling approach has, on the whole, been a reasonable and conservative one . . . For example, the macro-economic scenarios they hypothesized under the adverse case appear relatively extreme by historical standards, and the (purportedly one-time) sizing of the capital buffer was made relatively stringent. Moreover, the general approach undertaken here appears to have avoided some of the more dangerous simplifications manifest in certain types of risk modeling . . . On the whole, then, our assessment is that the SCAP stress tests have provided valuable information to the public.107 The authors note that: We warn the Panel that our knowledge of the Fed’s program is based largely on the same information possessed by the panel, consisting of two reports, the first (describing methodology) was issued on April 24, and the second (describing results) was issued on May 7. Beyond these reports, we were privy to a number of conference calls involving the Federal Reserve (twice) and the Treasury department (once).108 The Appraisal begins by explaining that in evaluating any model of risk assessment . . . it is more constructive to use four criteria: 1. Intuitiveness: From a practical perspective, given the complexity of the problem and the limited time frame with which to ac- jbell on PROD1PC69 with REPORTS 106 Also included are Standard Deviation and Mean Absolute Deviation (statistics commonly used to measure risk). 107 See Annex to Section One of this report, at 2, 5. 108 Id. at 17. VerDate Nov 24 2008 04:20 Jun 18, 2009 Jkt 050104 PO 00000 Frm 00032 Fmt 6602 Sfmt 6602 E:\HR\OC\A104.XXX A104 27 complish it, does the risk model employed appear to make intuitive sense? 2. Robustness: Do the results continue to hold across alternative model and/or parametric specifications? 3. Transparency: Are both the structure of the risk model and the data inputs clear and transparent to outsiders? If the model is a hybrid of multiple risk models, how clear is the hybridization process? 4. Replicability: Is it possible for a third party to gain access to the same data, and to replicate the results within conventional standards of error? The authors note that the first two of these criteria relate to internal design considerations,109 while the third and fourth criteria, in contrast, bear on how well the Federal Reserve Board’s approach might be evaluated by outsiders.110 The Appraisal notes a number of sound elements in the SCAP’s design. It states that: • ‘‘The choice of a two year time horizon does not, ipso facto, give us cause for concern (though it may necessarily require updating on a going-forward basis)’’; 111 • ‘‘Using econometric models that relate loss rates to differing macroeconomic scenarios (baseline and more adverse) is a sensible way to characterize loss exposure’’; 112 • ‘‘Assembl[ing] projections from multiple methodological approaches . . . helped to avoid some of the most extreme problems associated with model risk’’; 113 • ‘‘It [was] clearly sensible for the Fed to allow for tailoring of individual BHC’s loss rates’’; 114 • ‘‘The Fed’s approach in specifying and sizing the required SCAP capital buffer seems sensible, transparent, and replicable [and] . . . within the time and information constraints [in which] they operated, the 6%/4% sizing was, at the very least, a defensible first approximation.’’ 115 However, the Appraisal also states that ‘‘the SCAP’s design and implementation do leave some open questions in our minds.’’ 116 The Appraisal’s overriding concern is that, although the stress tests involve a mix of quantitative (modeling) and qualitative (judgments in application of modeling) elements, a lack of transparency in the way the models were applied (even illustratively) makes it impossible to replicate—and hence to evaluate—the stress tests in jbell on PROD1PC69 with REPORTS 109 Id. at 18. ‘‘The multiple approaches to financial risk modeling, along with the special circumstances under which the SCAP was implemented make the first [criterion] extremely important. Due to the current high uncertainty in capital markets, and the attendant hazards of model risk, the second [criterion] is also relatively crucial.’’ 110 Id. (‘‘The third [criterion] encapsulates what is, in a sense, a minimal condition on observability that need be met; that is, so long as one presumes the competence and good faith of Fed researchers, satisfying the transparency [criterion] is tantamount to understanding the material steps undertaken in the enterprise. The fourth criterion—replicability—is a more stringent condition than transparency, effectively requiring that an outsider be able to directly verify the Fed’s conclusions. It should be noted, however, that this criterion may be more difficult to satisfy for a program such as SCAP, due to confidentiality issues within the BHCs being studied. We believe, nevertheless, that the third and fourth [criteria] are material considerations, particularly given the high level of market uncertainty, the magnitude of resources at issue, and the failure of state-of-the-art models to capture the market’s risk in 2008.’’) 111 Id. at 19. 112 Id. at 26. 113 Id. at 34. 114 Id.. at 29. 115 Id. at 31. 116 Id. at 5. VerDate Nov 24 2008 04:20 Jun 18, 2009 Jkt 050104 PO 00000 Frm 00033 Fmt 6602 Sfmt 6602 E:\HR\OC\A104.XXX A104 28 any detail. For example, say the authors, the Appraisal could only take a ‘‘broad-brush approach’’ to the SCAP, because: • ‘‘The Fed evidently attempted to synthesize numerous alternative macro-economic models . . . with subjective judgments of experts across different domains’’; 117 • ‘‘The process by which the initial [loss models] became tailored to each BHC appeared analogously opaque.’’ 118 • The ‘‘Fed’s stress test formulation (and particularly the derivation of the adverse case) is potentially subject to criticism as to transparency, its replicability, and its robustness’’ (for example, in its omission of interest rate, wage and price inflation, and exchange risk that ‘‘play a significant role in assessing not only prospective default risks within asset classes but potentially also asset valuations today’’).119 • ‘‘[T]here is effectively no way for a third party to replicate (or even, evidently, selectively audit) the [loss projections]’’ used to conduct the stress tests.120 The Appraisal continues: ‘‘On the basis of our interactions with them, we believe the Fed staff to be both professionally competent and acting in good faith. It may therefore be acceptable to take them at their word. Nevertheless, given the fact that the [loss ranges] constituted an important focal point for the SCAP stress tests, the description of the process did not permit us to pierce through their derivations at anything more than a general level.’’ 121 • ‘‘[T]he significant interaction required between supervisors and the BHCs has the potential of undermining the objectivity of the stress tests . . . It may well be that the Fed’s efforts [to bolster the objectivity of the tests despite the necessary supervisor-BHC interaction] were wholly successful . . . but we are not in a position to either confirm or reject this hypothesis. Indeed, when queried as to whether it would be possible to walk us through one or two examples of the tailoring process for specific (but anonymous) BHCs, Fed researchers reported that such an exercise was not practically feasible.’’ 122 • ‘‘To the extent we have a concern [with the Fed’s approach in specifying and sizing the required SCAP capital buffer] it likely is rooted in a more general concern with . . . the appropriateness of a 2-year time horizon for projecting required capital buffers.’’ 123 This issue might have been dealt with by: • Conducting a longer-term stress test (at least for longmaturing illiquid assets) • Quantifying the faction of illiquid and highly risky assets with distant maturities the BHCs as a group, and each BHC separate, have; or 117 Id. at 3. at 6. at 23. Federal Reserve Board staff has told a Panel staff member that interest rate assumptions were ‘‘built into’’ the macro-economic assumptions for the stress tests as well to the data banks provided to the supervisors, that currency exchange risk was also built into that data, and that inflation risk was now so low as to be difficult to factor in. 120 Id. at 25. 121 Id. at 25–26. 122 Id. at 27–28. 123 Id. at 29. See also, Lucian Bebchuk, Near-Sighted Stress Tests (May 20, 2009) (online at www.forbes.com/2009/05/20/stress-tests-banking-opinions-contributors-maturity.html) (hereinafter ‘‘Near-Sighted Stress Tests’’). 118 Id. jbell on PROD1PC69 with REPORTS 119 Id. VerDate Nov 24 2008 04:20 Jun 18, 2009 Jkt 050104 PO 00000 Frm 00034 Fmt 6602 Sfmt 6602 E:\HR\OC\A104.XXX A104 29 • Revisiting the SCAP approach periodically to reassess risk profiles of these assets as they become more current. • The SCAP does not explore the possibility that BHCs ‘‘may be able to use their own segmented corporate structure to compartmentalize (and thus externalize) risk, even if they have an adequate capital buffer in the aggregate.’’ 124 G. NEXT STEPS 1. CAPITAL-RAISING The ten BHCs estimated to require a capital buffer were required to give the supervisors a Capital Plan by June 8, 2009, explaining how they will raise equity capital. Their options include: (1) selling stock to the markets or under the CAP; 125 (2) converting existing preferred stock (whether privately held or issued under the CPP); or (3) selling assets. Some of these options are preferable to others and result in higher quality capital. Conversions of preferred to common stock are the weakest option (as no new capital is added) and new equity offerings for cash are the strongest. Asset sales fall in between these options as they raise cash but diminish earnings capacity. The plan must include dates by which the BHC plans to take these actions, which must be completed by November 9, 2009. The plans are not specifically required to address plans to repay TARP funds. However, no bank can repay its TARP capital if this would cause its capital levels to be inconsistent with ‘‘supervisory expectations.’’ 126 It is unclear if these expectations will be the same as the capital levels demanded by SCAP. The most direct way for a BHC to increase its capital base is to earn net income from its normal banking business and add that income to its capital accounts. Estimated PPNR for 2009 and 2010 (as adjusted by reference to performance in the first quarter of 2009) is already reflected in the SCAP calculation and therefore BHCs cannot ‘‘earn their way out’’ of the capital buffer requirements.127 Next, a BHC can raise capital by selling assets, usually businesses or branches. For example, Citigroup recently announced that it expects to gain $2.5 billion in tangible common equity through the sale of its Japanese securities business.128 For its part, Bank of America sold nearly a third of its stake in China’s second largest bank.129 However, as discussed below, any sale risks a transaction at a ‘‘fire sale’’ price because the buyer knows that the 124 Id. jbell on PROD1PC69 with REPORTS at 30. 125 If there are future CAP transactions, the Panel will need to consider a valuation exercise similar to that in the February report. 126 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/2009bcreg.htm). 127 To the extent that the BHCs’ revenues are strong, however, their ability to sell securities will of course be enhanced. 128 Citigroup Inc., Citi to Sell Nikko Cordial Securities to Sumitomo Mitsui Banking Corporation and to Forge Alliance with Sumitomo Mitsui Financial Group (May 1, 2009) (online at www.citigroup.com/citi/press/2009/090501a.htm). 129 Amy Or, BofA Raises US$7.3 Bln from CCB Share Sale to 4 Investors, Wall Street Journal (May 13, 2009) (online at online.wsj.com/article/BT-CO-20090513-708215.html?mod=crnews). VerDate Nov 24 2008 04:20 Jun 18, 2009 Jkt 050104 PO 00000 Frm 00035 Fmt 6602 Sfmt 6602 E:\HR\OC\A104.XXX A104 30 selling BHC must raise capital and is counting on the sale to do so. A BHC can also raise funds through the sale of additional common stock, the approach most in line with the requirements of the supervisors following the stress tests. But the sale of common stock is not without its own issues. First, existing shareholders’ interests will be diluted by the new sale—that is, part of their investment will in effect be shared with the new shareholders, diluting their proportional ownership of the BHC and the value of their shares. Of course, that may be a completely justified result, since, without an infusion of billions of taxpayer dollars, the common stock of at least some of these institutions would likely have become worthless.130 In addition, sale of a large block of shares to a single investor may shift control, or at least reconfigure the control, of the BHC in question. Such sales of common stock may be made to investors in the open market or in a private offering, or the BHC may rely on the CAP and issue mandatory convertible preferred stock (which will be treated as tier 1 common) to Treasury. The BHCs may also convert preferred stock into common stock, as Citibank is in the process of doing. This conversion may include existing preferred stock issued to private parties or the preferred stock issued to Treasury under the CPP. Since this involves moving Treasury’s assets to a more risky class of securities, Treasury has stated that it expects such a conversion to be accompanied by new capital raises or exchanges of private capital securities into common equity.131 2. TARP REPAYMENT Many banks, including the BHCs involved in the stress tests, have indicated their desire to repay funds received under TARP programs, and several smaller banks have already done so.132 The Panel’s next report will discuss certain issues arising from the TARP repayment process in detail, but it is worth discussing the interplay of the SCAP with TARP repayment. BHCs that do not need to raise additional equity capital may be permitted to repay TARP funds. The Federal Reserve Board has designed criteria that it will use to determine whether to allow a BHC to repay TARP funds.133 BHC applications for repayment must be first approved by the primary federal supervisor before being sent to Treasury. A BHC that wishes to repay funds must jbell on PROD1PC69 with REPORTS 130 Since warrant holders, including the holders of stock options, are generally protected against dilution by the terms of the warrants, a paradoxical result might be that the executives who were in charge of the troubled institutions would incur far less loss (if stock values recovered) than ordinary common shareholders. Thus, where bank executives are compensated to any extent by the issuance of stock or stock options, they may have a conflict of interest when deciding whether common stock, rather than a sale of assets, should be part of their BHC’s capital plan. 131 U.S. Department of the Treasury, FAQs on Capital Purchase Program Repayment and Capital Assistance Program, at 3 (online at www.financialstability.gov/docs/FAQl CPPCAP.pdf) (accessed June 8, 2009) (hereinafter ‘‘CPP FAQs’’). 132 As of May 27, 20 banks have repaid the TARP funds they received. Goldman Sachs, Morgan Stanley, BB&T, and JPMorgan, among others, have announced their intentions to repay TARP funds as soon as possible. Brian Wingfield, Banks Ready To Throw in the TARP, Forbes (June 1, 2009) (online at www.forbes.com/2009/06/01/banking-tarp-fed-business-beltwaytarp.html). 133 Board of Governors of the Federal Reserve System, Press Release (June 1, 2009) (online at www.federalreserve.gov/newsevents/press/bcreg/20090601b.htm). VerDate Nov 24 2008 04:20 Jun 18, 2009 Jkt 050104 PO 00000 Frm 00036 Fmt 6602 Sfmt 6602 E:\HR\OC\A104.XXX A104 31 show that it can issue debt without relying on TLGP. It must also show that it has access to the public equity markets. Additional criteria that the Federal Reserve Board will consider include the bank’s ability to continue to act as an intermediary for lending to families and businesses, its ability to maintain appropriate capital levels, its ability to ‘‘continue to serve as a source of financial and managerial strength and support to its subsidiary bank(s) after the redemption,’’ and its ability to meet ‘‘funding requirements and obligations to counterparties’’ while again lessening its reliance on government funds and guarantees.134 Since the announcement that BHCs will need to use new, nonguaranteed capital to repay TARP funds, several BHCs have issued non-guaranteed debt. However, these BHCs had to pay relatively high interest rates on this debt.135 In addition to repaying the preferred stock issued under the CPP, BHCs will have to repurchase the warrants that were issued at the same time.136 The price at which those warrants will be repaid has already become a source of controversy with respect to non-stress test banks.137 This issue is one which the Panel will be paying close attention to in the near future.138 H. ISSUES 1. THE CONTEXT AND PURPOSE OF THE STRESS TESTS To date, $245 billion has been injected into the banking system and an additional $69.8 billion into the American International Group (AIG). After raising $75 billion more in public or private funds, the nations’ largest banking institutions will be well capitalized enough to withstand further economic difficulties, at least during 2009 and 2010. It has to be noted that the $75 billion dollar figure rests on existing taxpayer support of the banking system, and the SCAP must be understood in this context. The stress tests’ stated purpose was to ensure that the BHCs were well capitalized enough to withstand continued economic bad news and to continue lending to qualified borrowers, but the subtext of the tests was to calm the markets. The markets have been calmed, but it must be 134 Id. jbell on PROD1PC69 with REPORTS 135 Since SCAP, the BHCs have raised $35 billion in stock and $13 billion in debt. The BHCs’ notes ranged from 271 basis points over U.S. Treasuries to 562 basis points over U.S. Treasuries. Compare the spread on Citigroup’s recent non-guaranteed debt offering, 8.765 percent tenyear notes (562.5 basis points over U.S. Treasuries) with a Citigroup debt offering prior to the financial crisis, 5.773 percent ten-year notes (130 basis points over U.S. Treasuries). Citigroup Inc., Form FWP (May 15, 2009) (online at www.sec.gov/Archives/edgar/data/831001/ 000095012309008985/y77311fwfwp.htm); Citigroup Inc., Form FWP (Sept. 6, 2007) (online at www.sec.gov/Archives/edgar/data/831001/000095012307012318/y39368afwp.htm). See Figure 5 for other recent BHC debt issuances. 136 See, e.g., U.S. Department of the Treasury, Securities Purchase Agreement Standard Terms, at 42 (Oct. 26, 2008) (online at www.financialstability.gov/docs/agreements/BOAl 10262008.pdf) (The agreement contains terms setting up a direct repurchase by Treasury of all bank securities based on a negotiated fair market value. These terms cover the repurchase of warrants and do not specifically provide for auctions to third parties as a method of pricing the repurchase.). 137 See, e.g., Old National Bancorp, Form 8–K (May 11, 2009) (online at www1.snl.com/Cache/ c7780441.htm) (first publicly-traded company to finalize repurchase of its warrants from Treasury); Linus Wilson, Valuing the First Negotiated Repurchase of the TARP Warrants, Social Science Research Network (May 23, 2009) (online at papers.ssrn.com/sol3/papers.cfm?abstractl id=1404069) (arguing that, based on economic models, that Treasury did not receive fair market value for the Old National Bank warrants). 138 The effect on the projected capital buffers of potential repayment of CPP infusions was apparently not taken into account in computing whether an institution would require a capital buffer or the size of that buffer. VerDate Nov 24 2008 04:20 Jun 18, 2009 Jkt 050104 PO 00000 Frm 00037 Fmt 6602 Sfmt 6602 E:\HR\OC\A104.XXX A104 32 understood that the underlying regulatory and legal systems that permitted the financial crisis to occur have not changed, and the current financial position of the BHCs relies on massive amounts of government assistance, the impact of which has not been clearly identified in the supervisors’ assessment of the BHCs’ current and future financial viability. The supervisors’ releases indicate that infusions of funds under the CAP may be necessary to make up any failure by the ten institutions to raise the necessary capital in the private market. But there are other forms of government assistance whose impact on the tests was not made clear. The loan guarantees provided by Treasury and the FDIC and the availability of funds through the various liquidity programs established by the Federal Reserve Board during the early days of the crisis would appear to lower substantially the cost of funds for the 19 BHCs, presumably increasing their net income during the testing period. This raises the question of how solid those earnings would be if the government programs were removed or if external economic conditions caused the Federal Reserve Board to tighten the money supply even modestly. 2. ISSUES RELATING TO THE DESIGN OF THE STRESS TESTS The stress tests are conducted within the bounds of the current supervisory context and do not represent a new measure or test of risk. They start with the amounts and values projected by the tested institutions themselves. The extent to which the supervisors delved deeply into the BHC-provided data to verify its accuracy is unclear. This is not to question the good faith of either the supervisors or the tested institutions. But the experience of the last two years cannot but cause some to question the adequacy of both the risk management practices of many of the nation’s largest financial institutions and of the scope of the supervisory regime to which those institutions were subjected. As one serious example, the stress test reports assert that the 19 BHCs tested are all well capitalized, but they do not discuss or rebut claims by a number of respected economists that at least some of the same banks are in fact insolvent.139 Reliance on the present system may well be understandable in view of the short time frame within which the tests had to be done, but the time pressures could have been mitigated by a rolling set of tests adjusted for operating results and changes in economic assumptions. Failure to do so may be seen as limiting the usefulness of the tests. A number of issues with the modeling techniques used in the stress tests were noted by Professors Talley and Walden in their report. These include a lack of sensitivity to the ownership structure of BHCs, the exclusion of a number of micro- and macroeconomic factors (such as interest rates and inflation), and the use jbell on PROD1PC69 with REPORTS 139 Nouriel Roubini, According to Press Reports the IMF May Allegedly Be Increasing Its Estimate of Global Bank Losses to $4 Trillion, a Figure Consistent With Estimates by a Variety of Independent Bank Analysts, RGE Monitor (Apr 10, 2009) (online at www.rgemonitor.com/ roubini-monitor/256364/according ltolpresslreportslthe limflmaylallegedlylbe lincreasinglitslestimatelof lgloballbankllossesllto l4ltrillionlalfigurel lconsistentlwithlestimateslby lallvarietyloflindependent lbanklanalysts). VerDate Nov 24 2008 04:20 Jun 18, 2009 Jkt 050104 PO 00000 Frm 00038 Fmt 6602 Sfmt 6602 E:\HR\OC\A104.XXX A104 33 of the relatively short time horizon of two years. In their opinion, these factors might have affected the results of the stress tests.140 When the two alternative economic scenarios were announced, commentators immediately criticized the scenarios for insufficient ‘‘harshness.’’ 141 They stated that the baseline scenario especially was too optimistic in light of an economy that at that time was deteriorating rapidly and beginning to follow the path of the more adverse scenario.142 Nouriel Roubini, for example, has suggested that policymakers ‘‘used assumptions for the macro variables in 2009 and 2010 [for] both the baseline and more adverse scenarios that are so optimistic that actual data for 2009 are already worse than the adverse scenario.’’ 143 He has challenged the GDP, unemployment, and home prices assumptions in both the baseline and adverse scenarios.144 The OECD released baseline real GDP and unemployment projections that were equal to the SCAP’s more adverse scenario assumptions.145 On the other hand, some comparisons suggest that the assumptions are appropriate. In their review of the stress test methodology, Professors Talley and Walden state that, ‘‘[t]he criteria used for assessing risk, and the assumptions [the Federal Reserve Board] made in calibrating the more adverse case have typically erred on the side of caution.’’ 146 In the end, it is not clear that we know whether the economic assumptions were harsh enough or what the BHCs’ capital needs would be if the economy continued along the path it appeared to be following in February. The ability to extrapolate the data by those wishing to modify the model to use their own macroeconomic assumptions is somewhat limited. Treasury officials informed the staff of the Panel that sufficient data would be available such that private analysts would be able to build on the results disclosed, substituting their own assumptions with respect to the direction of the economy, and working out for themselves what the capital needs of the BHCs would be under even more adverse conditions. The publicly announced results of the SCAP focused only on the more adverse scenario. The model may be replicated,147 but it is not clear that private analysts could use these data to build their own models or to test the 140 See Annex to Section One of this report, at 23, 33, 34. generally Douglas J. Elliott, Bank Stress Test Results, Brookings (May 18, 2009) (online at www.brookings.edu/opinions/2009/0512l stressl testl results elliott.aspx); Paul Krugman, Stressing the Positive, New York Times (May 7, 2008) (online at www.nytimes.com/2009/05/08/ opinion/08krugman.html) (‘‘The regulators didn’t have the resources to make a really careful assessment of the banks’ assets, and in any case they allowed the banks to bargain over what the results would say. A rigorous audit it wasn’t.’’); Nouriel Roubini, Ten Reasons Why the Stress Tests Are ‘‘Schmess’’ Tests and Why the Current Muddle-Through Approach to the Banking Crisis May Not Succeed, RGE Monitor (May 8, 2009) (online at www.rgemonitor.com/roubini-monitor/256694/tenl reasonsl whyl thel stressl testsl arel schmessl testslandl whyl thel currentl muddle-throughl approach l tol thel bankingl crisisl mayl notl succeed) (hereinafter ‘‘Roubini Article’’); Edmund L. Andrews and Eric Dash, Government Offers Details of Bank Stress Test, New York Times (Feb. 25, 2009) (online at www.nytimes.com/2009/ 02/26/business/economy/26banks.html) (hereinafter ‘‘Andrews and Dash Article’’). 142 Unemployment rose to 9.4 percent in April 2009. Employment Situation, supra note 60. GDP fell 5.9 percent in the first quarter of 2009 from the previous quarter. Gross Domestic Product, supra note 59. 143 Roubini Article, supra note 141; Andrews and Dash Article, supra note 141. 144 Id. 145 Organization for Economic Cooperation and Development, OECD Economic Outlook Interim Report, at 68 (Mar. 2009) (online at www.oecd.org/dataoecd/18/1/42443150.pdf). 146 See Annex to Section One of this report. 147 Stress Test Consequences, supra note 35. jbell on PROD1PC69 with REPORTS 141 See VerDate Nov 24 2008 04:20 Jun 18, 2009 Jkt 050104 PO 00000 Frm 00039 Fmt 6602 Sfmt 6602 E:\HR\OC\A104.XXX A104 34 strength of the supervisors’ modeling. Without the ability to replicate and re-test, the robustness of the model remains in question. Professor Lucian Bebchuk, among others, has argued that the failure to take into account mark-to-market values for ‘‘toxic assets,’’ necessarily undervalues bank liabilities to the extent that those liabilities result in losses after 2010.148 This point is also echoed in the report from Professors Talley and Walden.149 Professor Bebchuk notes that the total estimate of potential bank losses published by the supervisors is as much as $600 billion and that no attempt has been made ‘‘to come up with a precise estimate of the extent to which, at the end of 2010, the economic value of the troubled assets will fall below [their] face value.’’ 150 Bebchuk acknowledges the Federal Reserve Board’s recognition of this problem, but he responds that: To get a full picture of the banks’ situation, bank supervisors should estimate also the decline in the economic value of banks’ positions with longer maturities. Only then will the stress tests be able to deliver reliable figures for the additional capital necessary to make the banking sector healthy and vigorous.151 This approach suggests a useful insight about what the stress tests do and do not do. Their purpose is to compute the amounts necessary, within the framework of existing supervisory and risk management techniques, to keep BHCs well capitalized for two years if a specified set of economic assumptions is borne out. What they do not do is to compute the point at which BHCs will be stressed beyond the breaking point—even under the supervisors’ view that BHCs are now well capitalized—based on their current balance sheets. For example, banks hold $1.068 trillion in core commercial real estate (CRE) loans.152 A recent study commissioned by Deutsche Bank suggests that the majority of losses on CRE loans will not affect bank balance sheets for several more years when poorly underwritten CRE loans made in the easy credit years (e.g., 2005–2007) will reach maturity and will in many instances fail to qualify for refinancing: FIGURE 3: ESTIMATE OF CORE CRE LOANS NOT QUALIFYING FOR REFINANCE, 2009–18 153 Maturing loans Maturing year 2009 2010 2011 2012 2013 2014 2015 2016 2017 ..................................... ..................................... ..................................... ..................................... ..................................... ..................................... ..................................... ..................................... ..................................... # 2,556 3,053 4,443 4,340 5,051 4,898 8,807 10,331 9,598 Loans not qualifying for refinance Balance (dollars in billions) # 18.1 33.0 42.6 56.3 39.1 47.8 89.0 123.9 127.4 Balance (dollars in billions) 923 1,375 2,510 2,675 2,635 2,986 5,587 6,295 5,827 %(#) 8.0 21.1 29.0 43.7 25.2 33.2 60.9 88.8 94.7 36.1 45.0 56.5 61.6 52.2 61.0 63.4 60.9 60.7 148 Near-Sighted Stress Tests, supra note 123. Annex to Section One of this report. Stress Tests, supra note 123. 151 Near-Sighted Stress Tests, supra note 123. 152 Core CRE does not include construction, multi-family, or farm loans. 149 See jbell on PROD1PC69 with REPORTS 150 Near-Sighted VerDate Nov 24 2008 04:20 Jun 18, 2009 Jkt 050104 PO 00000 Frm 00040 Fmt 6602 Sfmt 6602 E:\HR\OC\A104.XXX A104 %($) 44.0 63.9 68.2 77.6 64.5 69.6 68.5 71.7 74.3 35 FIGURE 3: ESTIMATE OF CORE CRE LOANS NOT QUALIFYING FOR REFINANCE, 2009–18 153— Continued Maturing loans Maturing year Loans not qualifying for refinance Balance (dollars in billions) # Balance (dollars in billions) # %(#) %($) 2018 ..................................... 895 4.2 108 1.4 12.1 33.7 Total ............................. 53,972 581,542,418,727 30,921 406,163,154,040 57.3 69.8 153 This data is used with permission of Deutsche Bank and was originally compiled in a different form for a Deutsche Bank special report. See 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). This report was also submitted as written testimony for the Panel’s May 28, 2009 hearing on Impact of Financial Recovery Efforts on Corporate and Commercial Real Estate Lending in New York. As the report explains, the high percentage of loans not qualifying for refinancing, and hence in danger of default without significant injections of new equity, is attributable to the combined effects of stricter underwriting standards, steep declines in property values, and reduced income streams to finance the loans because of lower rents and increased vacancies.154 The findings are based on quantitative data for commercial mortgage-backed securities (CMBS), which constitute 25 percent of the core CRE market. While the authors of the report state that there was insufficient data to perform a detailed study in the larger non-CMBS sector, the authors say they expect a similar if not higher level of maturity defaults on non-securitized CRE bank portfolio loans because portfolio loans typically have shorter maturities (which would not allow sufficient time for property values to recover from their present depressed levels) and higher risk profiles than CMBS.155 As another hearing witness explained, however, it is possible that a higher proportion of maturity defaults can be avoided in the non-CMBS sector because banks face fewer legal and practical obstacles in attempting workouts with their borrowers.156 The extent to which the stress tests, which were never intended to look more than two or three years in the future, fully grapple with the prospect of massive future CRE loan defaults is uncertain.157 Several of the institutions tested were not traditional banking enterprises, and yet, by choosing to become BHCs, have become subject to the higher capital requirements of banks and the assumptions and analysis of risk that underlie those requirements. Is this appropriate, or should certain BHCs be subjected to alternative measures of regulatory capital or be assessed for risk using 154 Id. jbell on PROD1PC69 with REPORTS at 11. 155 See Congressional Oversight Panel, Oral Testimony of Richard Parkus, Hearing on Corporate and Commercial Real Estate Lending (May 28, 2009) (hereinafter ‘‘Oral Testimony of Richard Parkus’’). 156 See Congressional Oversight Panel, Oral Testimony of Kevin Pearson, Hearing on Corporate and Commercial Real Estate Lending (May 28, 2009). 157 At the Panel’s hearing in New York on May 28, 2009, there was disagreement among Panel witnesses as to whether the stress tests’ use of a three-year analysis was sufficient to account for the future strains on bank balance sheets attributable to a balloon in expected maturity defaults for CRE loans. See Oral Testimony of Richard Parkus, supra note 155 (‘‘I do, however, understand the timeframe for the stress test was, I believe, three years. And that, if that is the case, that would, in my view, be fairly short, as many of the mortgages we are looking at do not mature for quite a while.’’); Congressional Oversight Panel, Oral Testimony of Federal Reserve Bank of New York Vice President of Bank Supervision Til Schuermann, Hearing on Corporate and Commercial Real Estate Lending (May 28, 2009) (‘‘For sure, there are going to be some of the losses that will occur after this horizon, but I think I feel comfortable that a sizable portion of the commercial real estate exposure was, in fact, taken into account in the stress test.’’). VerDate Nov 24 2008 04:20 Jun 18, 2009 Jkt 050104 PO 00000 Frm 00041 Fmt 6602 Sfmt 6602 E:\HR\OC\A104.XXX A104 36 different tests? One issue (discussed above in ‘‘Specific Limitations of the Stress Tests’’) is that the accuracy of the input (the data on which the tests were performed) depended on prior supervisory examinations; in the present climate the nature of those examinations has itself been questioned, and the stress testing may ultimately improve the examinations themselves. The supervisors noted that, in some cases, data initially presented were inaccurate or resulted in double counting and that data was corrected and resubmitted. As noted above, no full re-examination of the tested BHCs was possible in the time period in which the test occurred, but that fact necessarily places some limitation on the tests’ results. 3. ISSUES RELATING TO THE PROCESS AND IMPLEMENTATION The primary issue identified by Professors Talley and Walden with the stress test process is the program’s lack of ‘‘transparency to outsiders and replicability of its results.’’ They state that it would be ‘‘virtually impossible for the third parties to replicate the SCAP’s conclusions, or even major sub-components of it.’’ As a result, while they express the utmost trust in the Federal Reserve Board’s assessment, they are ultimately unable to confirm any of its conclusions.158 The supervisors informed the staff of the Panel that there was no ‘‘negotiation’’ of the results of the SCAP and that the BHCs were merely informed of the supervisors’ estimates, with adjustments arising only from the specified first quarter adjustments and clear errors and omissions. The range of the adjustments permitted, however, and the lack of a full explanation of those adjustments necessarily raise questions in this regard. For example, it is unclear how large an effect accounting changes had on the BHCs’ first quarter earnings,159 and how much of the resulting earnings improvements flowed through to the adjustments that were made with respect to the capital buffer by reason of earnings improvements. This leads to questions regarding whether the process could have been better handled and whether there should have been more transparency and clearer communication as to what exactly was communicated to the BHCs, which BHCs were affected, and which numbers were being adjusted. Securities trading portfolios were specifically ‘‘stressed’’ only for the five BHCs that were the largest traders (this is, for those with trading accounts of $100 billion or more). That process showed very large estimated losses in the securities trading portfolios of the five BHCs for which the exercise was conducted. Given the size of those losses, the way the stress tests take into account estimated securities trading losses of the BHCs with trading accounts of less than $100 billion is unclear, and it is thus difficult to tell how or if those losses have been appropriately accounted for. 4. THE IMPACT OF Q1 ADJUSTMENTS Adjustments were presented on a net basis, and thus it is not possible to see how much of the $110 billion reduction in capital 158 See jbell on PROD1PC69 with REPORTS 159 For VerDate Nov 24 2008 04:20 Jun 18, 2009 Annex to Section One of this report, at 34. further discussion of the impact of the recent accounting changes, see supra note 80. Jkt 050104 PO 00000 Frm 00042 Fmt 6602 Sfmt 6602 E:\HR\OC\A104.XXX A104 37 buffer produced by the first quarter adjustments was due to sales of assets and conversions of preferred securities and other capital actions and how much was due to ‘‘strong PPNR.’’ 160 This approach undercuts the transparency of the process. It is also important because many commentators do not believe that the strong earnings of the first quarter are likely to be repeated. Knowing how much of the first quarter adjustments were due to earnings would assist independent analysts in running their own versions of the stress tests. 5. PRESENTATION OF DATA While 12 categories of assets were measured, only eight categories of assets were reported out in the SCAP results, and some assets were grouped together. For example, estimated losses on ‘‘First Lien Mortgages’’ are reported in aggregate, while first lien mortgages were divided into prime, Alt-A, and sub-prime for the purposes of estimation. Estimated losses in the various categories of securities are also aggregated together. It is possible that significant information is obscured by the aggregation of data, and since the public knew that 12 categories of assets were being measured, some expectation of obtaining this information had been raised. This aggregation prevented the public from fully replicating the tests or from comparing the results of the testing on the 19 banks, or other banks, with different variables.161 Neither Treasury nor the supervisors have explained why this information was not made available. Because results are presented on the ‘‘more adverse’’ scenario alone, the ability to extrapolate results from a single set of data is impaired. Even though the ‘‘baseline’’ scenario was likely too optimistic, publishing the results from that scenario would have improved transparency and enabled private analysts, who can play an important role in the way information is used, to present their own predictions and analyses. 6. SHOULD STRESS TESTING BE REPEATED? As discussed above, Treasury conducted a one-time stress test on the 19 largest U.S. BHCs under the CAP. While Treasury intended the CAP to ensure that BHCs have adequate capital cushions to weather worse-than-anticipated economic conditions in the shortterm, it is uncertain whether Treasury will conduct any future stress testing during or after the current crisis. It is uncertain whether this expanded form of stress testing will or should become a permanent fixture of the financial regulatory system. While Treasury has created capital cushion requirements through yearend 2010 under the CAP, it has not required fundamental or permanent changes in capital adequacy requirements or general regulatory processes. 160 SCAP jbell on PROD1PC69 with REPORTS Results, supra note 24. 161 The Wall Street Journal and the Financial Times both applied the SCAP methodology to small- and mid-size banks. However, they could not exactly replicate the testing. Financial Times Study, supra note 101; Maurice Tamman and David Enrich, Local Banks Face Big Losses, Wall Street Journal (May 19, 2009) (online at online.wsj.com/article/ SB124269114847832587.html). VerDate Nov 24 2008 04:20 Jun 18, 2009 Jkt 050104 PO 00000 Frm 00043 Fmt 6602 Sfmt 6602 E:\HR\OC\A104.XXX A104 38 There are advantages and disadvantages of more permanent use of stress testing. On one hand, regular stress testing of large banks may enable regulators to: (1) limit the sorts of risk-taking that contributed to the current crisis; and (2) counterbalance the heightened moral hazard that the government, through TARP, has created for too-large-to-fail institutions.162 Moreover, the one-time nature of the stress tests is difficult to understand in light of how rapidly, and sometimes radically, the fortunes of banking institutions have changed over the past two years. These rapid changes led to some institutions requiring multiple capital infusions. For example, both Citigroup and Bank of America, after participating in the initial round of CPP investments, received emergency capital infusions and asset guarantees which were eventually allocated to the TIP program.163 Given the questions raised about the economic assumptions incorporated into the baseline and adverse scenarios of the stress tests and about the continuing uncertainty around the value and terms for write-down of many bank assets, a strong case can be made for six-month repetitions of the stress tests for the next few years. While comprehensive internal stress testing existed at banks here and abroad even before the onset of the current crisis,164 there is a justified skepticism about the sufficiency of bank risk management programs. In particular, internal testing lacks public transparency and accountability, which are especially important in the case of too-big-to-fail institutions because of the government’s recent interventions. Additionally, bank executives can continue to take excessive risks in the future—as they did prior to the current crisis—regardless of whether or how they engage in internal stress testing. Transparency, which the Federal Reserve Board has stated is justified to restore confidence in the banking system, would also be missing if stress testing were conducted within the context of the normal supervisory process where results are not made public, but stress tests as part of regular examinations still have merit in and of themselves. Regular government stress testing may lose support as time passes because of debates over: (1) methodologies; (2) government capacity and resources; and (3) the perception of negotiation between banks and their regulators.165 7. SHOULD STRESS TESTING BE EXPANDED TO A WIDER RANGE OF BANKS? Since the passage of EESA in October 2008, Treasury has devoted a great deal of attention and resources to so-called too-large- jbell on PROD1PC69 with REPORTS 162 See Sebastian Mallaby, Stress Tests Forever, Washington Post (May 9, 2009) (online at www.washingtonpost.com/wp-dyn/content/article/2009/05/07/AR2009050703538.html). 163 For more information, see Panel’s January and February reports. Congressional Oversight Panel, Accountability for the Troubled Asset Relief Program (Jan. 9, 2009) (online at cop.senate.gov/reports/library/report-010909-cop.cfm); Congressional Oversight Panel, Valuing Treasury’s Acquisitions (Feb. 6, 2009) (online at cop.senate.gov/reports/library/report-020609cop.cfm). 164 See Bank for International Settlements (BIS), Stress Testing at Major Financial Institutions: Survey Results and Practice, at 2 (Jan. 2005) (online at www.bis.org/publ/cgfs24.pdf) (noting that stress testing is ‘‘becoming an integral part of the risk management frameworks of banks and securities firms’’ and that it ‘‘benefits from its flexibility, comprehensibility and the onus that it puts on management to discuss the risks that a firm is currently running.’’). 165 Stress testing under the CAP raised considerable concerns among observers. See, e.g., discussion earlier in this report, supra note 141. VerDate Nov 24 2008 04:20 Jun 18, 2009 Jkt 050104 PO 00000 Frm 00044 Fmt 6602 Sfmt 6602 E:\HR\OC\A104.XXX A104 39 to-fail institutions. The health of these institutions has considerable bearing on the financial system because of the enormous value of their combined assets and the breadth of their transactions involving other institutions and private citizens. Moreover, while these institutions have complex structures and, in some cases, branches and business ventures across the globe, efforts to stabilize too-big-to-fail institutions may require fewer human resources overall than efforts to conduct a similar exercise for a far larger number of institutions ranging in size from just under $100 billion in assets to the comparatively very small capitalization of some community banks. Moreover, the events of the financial crisis necessarily caused Treasury and the Federal Reserve Board to devote particularly heavy focus to large institutions. Nonetheless, Treasury has provided capital infusions under the TARP to a wider range of institutions over the time since the passage of EESA. By focusing on small institutions in addition to large ones, Treasury has sought to: (1) minimize line-drawing problems inherent in providing capital infusions to only the largest institutions; (2) expand the geographic reach of its efforts; (3) increase the overall breadth of its stabilizing influences; and (4) respond to concerns among taxpayers that TARP targeted only Wall Street, not Main Street. Despite Treasury’s overall strategy to include banks of all sizes in its stabilization programs, Treasury and the Federal Reserve Board chose not to include even a sample of smaller banks in stress testing (even though those banks are eligible for infusions under the CAP).166 BHCs not included in the stress tests are responsible for one-third of the assets and close to half of the loans in the US banking system.167 While the federal government’s capacity may be strained by conducting stress tests on as many institutions as it has given capital infusions, such an approach could: (1) have the same general benefits as other efforts toward smaller banks, as discussed in the preceding paragraph; and (2) expand the reach and potential benefits of the stress tests generally. With the first round of stress testing complete, Treasury should explain whether it intends to conduct stress tests on additional institutions in the future. If it does not intend to do so, Treasury should explain more fully why it chose to make capital infusions available to smaller institutions under the CPP, CAP, and other programs but not to include those institutions in stress testing, and therefore not require the same additional capital buffer of medium and smaller institutions. 8. ISSUES REGARDING CAPITAL-RAISING AND RELATED ISSUES The BHCs needing to establish an additional regulatory capital buffer must present a plan to their supervisors by June 8 and complete the elements of that plan by November 9. This may have the impact of limiting their bargaining power with respect to asset dispositions as potential counterparties know that the seller has to raise funds in a ‘‘fire sale.’’ For example, Bank of America’s sale of part of its holding in China Construction Bank was effected at a 166 Financial jbell on PROD1PC69 with REPORTS 167 SCAP VerDate Nov 24 2008 04:20 Jun 18, 2009 Stability Plan Fact Sheet, supra note 26. Design Report, supra note 32, at 1. Jkt 050104 PO 00000 Frm 00045 Fmt 6602 Sfmt 6602 E:\HR\OC\A104.XXX A104 40 high 14 percent discount to CCB’s market price. The supervisors may need to exercise flexibility in oversight of the BHCs’ capital plans in order to make sure they are permitted to get the best price possible in the sales of assets and their own securities. It is unclear what the impact of the stress tests will be on the PPIP program.168 To the extent the stress test may have been built on unrealistic values for toxic assets, they will have created a disincentive to sell those assets at market prices, decreasing the likelihood of PPIP achieving its stated goals.169 On the other hand, to the extent the stress tests have accurately revealed that some banks are healthy, they may be more likely to sell toxic assets to the PPIP program at realistic prices. If PPIP ends up setting inflated prices for toxic assets, it is harder to assess what effect the stress tests will have on PPIP. The SCAP did not take into account the possibility of repayment of TARP funds. Only banks that do not need CAP funds will be permitted to repay CPP funds,170 and they will only be permitted to do so once they have proved they can issue debt securities without a government guarantee and with the approval of their supervisors. However, repayment will necessarily have an impact on the capital of BHCs that repay TARP funds, and it might be argued that more attention should be paid to the danger of driving down capital after so much effort has been expended in shoring it up. 9. ISSUES RELATING TO THE BANKS NOT TESTED The selection of the 19 largest BHCs, and not others, for the stress tests may distort the BHC marketplace in a few ways. First, by verifying that these 19 BHCs are healthy, the stress tests may provide them with a competitive advantage against smaller banks whose viability has not been confirmed. Second, the market might interpret the selection of these 19 largest BHCs as an indication that the supervisors consider them ‘‘too big to fail.’’ Both effects could lead to market participants favoring the tested BHCs against smaller competitors, distorting the marketplace. I. RECOMMENDATIONS • If economic conditions continue to worsen, raising the possibility that the ‘‘more adverse’’ scenario may be met or exceeded, the stress tests of the 19 BHCs should be repeated under the more difficult economic assumptions, looking forward at least two years.171 It should be noted that as of June 5, 2009, the unemployment rate for May had climbed to 9.4 percent 172 and the average for the first five months of 2009 had reached 8.5 percent, compared with the assumed 2009 average of 8.9 percent under the more adverse sce- jbell on PROD1PC69 with REPORTS 168 U.S. Department of Treasury, White Paper: Public Private Investment Program (Mar. 23, 2009) (online at www.treas.gov/press/releases/reports/ppipl whitepaperl 032309.pdf). PPIP targets so-called ‘‘toxic assets’’—the troubled loans and securities on banks’’ balance sheets. The immediate goal is to use a combination of private and public capital to buy ‘‘toxic assets.’’ The intended result is to improve liquidity and promote bank lending. 169 U.S Banks Have $168 Billion Reason to Avoid PPIP, Bloomberg (May 29, 2009) (online at www.bloomberg.com/apps/news?pid=20601208&sid=aa5Joz86l K6w&refer=finance). 170 CPP FAQs, supra note 131. 171 Additional stress tests that consider more alternatives—longer periods of time, more adverse conditions—would permit experts to evaluate the robustness of the tests and, if the results remain strong, to develop more confidence in the strength of the financial institutions tested. 172 Employment Situation, supra note 60. VerDate Nov 24 2008 04:20 Jun 18, 2009 Jkt 050104 PO 00000 Frm 00046 Fmt 6602 Sfmt 6602 E:\HR\OC\A104.XXX A104 41 nario. We recommend that Treasury publicly track the status of its stress test macro-economic assumptions (unemployment, GDP, and housing prices) and repeat the stress test if the adverse scenario assumptions have been exceeded. • Stress testing should be a regular feature of the 19 BHC’s examination cycle so long as an appreciable amount of toxic assets remain on their books, economic conditions do not substantially improve, or both. Public disclosure of the main results of such tests should continue to be a part of this process. Between supervisory stress tests, the BHCs should be required to run the stress tests themselves, according to supervisory guidance, and to submit the results as part of their ongoing supervisory examinations. Additionally, regulators should use stress tests on an ad hoc basis for all banks or BHCs where circumstances, including the bank’s business mix, dictate. • More information should be released with respect to the results of the stress tests. More granular information on estimated losses by sub-categories (e.g., the 12 loan categories that were administered versus the eight that were released) should be disclosed. The components of the first quarter adjustments should be disclosed, showing more clearly the impact of capital actions and revenue. Additional information will improve transparency of the process and increase confidence in the robustness of the tests. • The results of the stress tests under the ‘‘baseline’’ economic scenario should be released or Treasury should explain why they were not released. • The CPP repayment process should be more transparent, and information should be available to the public with respect to eligibility for repayment, the approval process, and the process for valuation and repurchase of warrants. Treasury should also make clear how it proposes to use repaid TARP funds. The relationship of the SCAP results to CPP repurchase must be completely transparent. • Capital weaknesses must be addressed. At the same time, supervisors should be aware of the business needs of the BHCs. The supervisors should be encouraged to exercise discretion and flexibility in oversight of the capital plans of the BHCs required to raise a SCAP buffer. In particular, supervisors should be sensitive to the need of BHCs to be able to time capital-raising and asset dispositions in response to market conditions and not to be forced into uneconomic transactions in order to meet inflexible timetables. This discretion, however, should not be used as an excuse to avoid the pressing need to address capital weaknesses. J. CONCLUSIONS jbell on PROD1PC69 with REPORTS The three-month stress testing of the nation’s largest BHCs was an unprecedented cross-supervisor effort, conducted in the midst of a financial crisis and deteriorating national and international economic condition; the effort involved on the part of the more than 150 experts involved is highly commendable. It is also extremely encouraging that the Federal Reserve Board has been willing to make public information involving the tests on an almost unprecedented (although unfortunately incomplete) scale. The tests must be placed in context. They were conducted solely within the present supervisory context and are based on the prin- VerDate Nov 24 2008 04:20 Jun 18, 2009 Jkt 050104 PO 00000 Frm 00047 Fmt 6602 Sfmt 6602 E:\HR\OC\A104.XXX A104 42 jbell on PROD1PC69 with REPORTS ciple that the supervisors can require capital in excess of the regulatory baseline when either bank or economic conditions dictate. They are not a thorough re-examination of the banks involved (although they are based on the results of prior examinations), and they rely on a combination of bank data, modeling based on particular economic assumptions, and qualitative judgments of the experienced examiners involved, many of whose conclusions have not been made public. Independent experts asked by the Panel to review the stress tests found the economic modeling used to conduct them to be generally soundly conceived and conservative, based on the limited information available to those experts. And the addition of capital to ten of the tested BHCs is certainly a good step forward. Moreover, 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. All the same, the stress tests should not be taken for more than they are. As indicated above, they were conducted within the present supervisory context only, and they are a temporary twoyear projection of a one-time capital buffer that need not be rebuilt. They do not model BHC performance under ‘‘worst case’’ scenarios, and as a result they do not project the capital necessary to prevent banks from being stressed to near the breaking point. Most important, for some observers, they do not address the question whether the values shown on bank balance sheets for certain classes of assets are too high; by restricting themselves to a two-year time frame, their conclusions thus do not take into account the possibility that the asset values assumed (particularly for so-called toxic assets) may undervalue bank liabilities to the extent that those liabilities result in losses after 2010. The short-term effect of the stress tests was positive, and the financial markets have calmed to some extent. The Panel concludes that it 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. The 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 crisisladen conditions many found themselves experiencing during 2008 and early 2009. While no one should gainsay the potentially positive results of the tests, it would be equally unwise to think that those results reflect a diagnosis of all of the potential weaknesses or create a necessarily sufficient buffer against future reverses for the banking system. VerDate Nov 24 2008 04:20 Jun 18, 2009 Jkt 050104 PO 00000 Frm 00048 Fmt 6602 Sfmt 6602 E:\HR\OC\A104.XXX A104 43 K. TABLES FIGURE 4: BHCS SUBJECT TO THE STRESS TEST Total BHC assets 173 (as of 3/31/2009) (dollars in billions) TARP capital injections to BHC 174 (to date) (dollars in billions) Other significant entities in BHC / major recent acquisitions Name of BHC Primary location Bank of American Corporation. JPMorgan Chase & Co ......... Charlotte, NC ...................... 2,323.0 45.0 Merrill Lynch Countrywide New York, NY ...................... 2,079.0 25.0 Bear Stearns Washington Mutual New York, NY ...................... San Francisco, CA .............. New York, NY ...................... 1,823.0 1,286.0 926.0 45.0 25.0 10.0 New York, NY ...................... New York, NY ...................... Pittsburgh, PA .................... 626.0 491.0 286.0 10.0 0.0 7.6 Minneapolis, MN ................. New York, NY ...................... 264.0 204.0 6.6 3.0 Detroit, MI .......................... Atlanta, GA ......................... McLean, VA ......................... 180.0 179.0 177.0 13.4 4.9 3.6 Boston, MA ......................... Winston-Salem, NC ............ Birmingham, AL ................. 145.0 143.0 142.0 2.0 3.1 3.5 New York, NY ...................... Cincinnati, OH .................... Cleveland, OH ..................... 120.0 119.0 98.0 3.4 3.4 2.5 Citigroup, Inc ....................... Wells Fargo & Company ...... The Goldman Sachs Group, Inc. Morgan Stanley .................... MetLife, Inc .......................... PNC Financial Services Group, Inc. U.S. Bancorp ........................ The Bank of New York Mellon. GMAC LLC ............................ SunTrust Banks, Inc ............ Capital One Financial Corporation. State Street Corporation ...... BB&T Corporation ................ Regions Financial Corporation. American Express Company Fifth Third Bancorp .............. KeyCorp ................................ Wachovia National City jbell on PROD1PC69 with REPORTS 173 National Information Center, Top 50 Bank Holding Companies Summary Page (online at www.ffiec.gov/nicpubweb/nicweb/Top50Form.aspx) (accessed June 5, 2009). This web site compiles data on total BHC assets based on BHCs’ quarterly Consolidated Financial Statements (FR Y–9C) and ranks BHCs by total assets on a quarterly basis. The data used in this chart comes from the most recent financial statements, which include information through March 31, 2009. One bank that qualified for the stress tests because it held over $100 billion in total assets as of December 31, 2009—KeyCorp—no longer holds assets exceeding $100 billion. GMAC received an exemption from filing a FR Y–9C form for the first quarter of 2009. See Board of Governors of the Federal Reserve System, Letter to David J. DeBrunner (Apr. 13, 2009) (online at www.federalreserve.gov/boarddocs/legalint/BHCl ChangeInControl/2009/20090413a.pdf). Data on GMAC’s total assets was taken from the company’s quarterly 10–Q filed with the SEC. See GMAC LLC, Form 10–Q (online at www.sec.gov/Archives/edgar/data/40729/ 000119312509105735/d10q.htm) (accessed May 19, 2009). 174 June 5 TARP Transactions Report, supra note 13. VerDate Nov 24 2008 04:20 Jun 18, 2009 Jkt 050104 PO 00000 Frm 00049 Fmt 6602 Sfmt 6602 E:\HR\OC\A104.XXX A104 44 FIGURE 5: CAPITAL-RAISING TO DATE Company Equity American Express Co ................... $500 million in stock 175 ............ Debt Bank of America Corp ................. BB&T Corp ................................... The Bank of New York Mellon Corp. Capital One Financial Corp ......... $20.8 billion in stock 177 ............ $1.5 billion in stock 178. $1.2 billion in stock 179. $1.6 billion in stock 180 .............. Citigroup, Inc ............................... Fifth Third Bancorp ..................... GMAC LLC .................................... Goldman Sachs Group Inc. JPMorgan Chase & Co ................. KeyCorp ........................................ MetLife Inc. Morgan Stanley ............................ SCAP requirements $3.0 billion of non-guaranteed five- and ten-year notes 176. $33.9 billion $1 billion of non-guaranteed five-year notes 181. $2 billion of non-guaranteed ten-year notes 182. $5.5 billion $1.1 billion $11.5 billion $5.0 billion in stock 183 .............. $750 million in stock 185 ............ $2.5 billion of five-year notes 184. $6.2 billion in stock 186 .............. $4 billion of five and ten-year notes 187. PNC Financial Services Group Inc Regions Financial Corp ............... State Street Corp ......................... $600 million in stock 188 ............ $1.9 billion in stock 189 .............. $2.0 billion in stock 190 .............. SunTrust Banks, Inc .................... U.S. Bancorp ................................ Wells Fargo & Co ......................... $1.8 billion $1.8 billion $1.4 billion in stock 192 .............. $2.4 billion 193. $8.6 billion in stock 194 .............. $54.5 billion ................................ 175 American $600 million $2.5 billion $500 million of five-year, senior notes 191. $2.2 billion $13.7 billion $13 billion ................................... $ 67.5 billion Express Co., Form 8–K (June 1, 2009) (online at www.sec.gov/Archives/edgar/data/4962/000093041309003114/c57844l jbell on PROD1PC69 with REPORTS ex1.htm). 176 $1.25 billion of 7.25 percent five-year notes (527 basis points over U.S. Treasuries) and $1.75 billion of 8.125 percent ten year notes (502 basis points over U.S. Treasuries). American Express Co., Form 8–K (May 20, 2009) (online at www.sec.gov/Archives/edgar/data/4962/ 000093041309002795/c57673l 8k.htm) 177 Bank of America, Form 8–K (May 27, 2009) (online at www.sec.gov/Archives/edgar/data/4962/000093041309003114/c57844l ex1.htm). 178 BB&T Corp, Form 8–K (May 12, 2009) (online at www.sec.gov/Archives/edgar/data/92230/000119312509114095/d8k.htm). 179 Bank of New York Mellon Corp., Form 8–K (May 12, 2009) (online at www.sec.gov/Archives/edgar/data/1390777/000095012309008628/ y77159e8vk.htm). 180 Capital One Financial Corp., Form 8–K (May 11, 2009) (online at www.sec.gov/Archives/edgar/data/927628/000119312509107460/ d8k.htm). 181 7.494 percent five-year notes (540 basis points over U.S. Treasuries). One Financial Corp., Form FWP (May 20, 2009) (online at www.sec.gov/Archives/edgar/data/927628/000119312509115052/dfwp.htm). 182 8.765 percent ten-year notes (562.5 basis points over U.S. Treasuries). Citigroup Inc.q, Form FWP (May 15, 2009) (online at www.sec.gov/Archives/edgar/data/831001/000095012309008985/y77311fwfwp.htm). 183 JPMorgan Chase & Co., Form 8–K (June 1, 2009) (online at www.sec.gov/Archives/edgar/data/19617/000119312509122723/d8k.htm). 184 4.696 percent five-year notes (271 basis points over U.S. Treasuries). JPMorgan Chase & Co., Form FWP (May 13, 2009) (online at www.sec.gov/Archives/edgar/data/19617/000001961709000793/fwp51309.htm). 185 Key Corp., Form 8–K (June 1, 2009) (online at www.sec.gov/Archives/edgar/data/19617/000119312509122723/d8k.htm). 186 Initial offering of $4 billion. Morgan Stanley, Form 8–K (May 8, 2009) (online at www.sec.gov/Archives/edgar/data/895421/ 000095010309001058/dp13415l 8k.htm). Second offering of $2.2 billion. Morgan Stanley, Form 8–K (June 1, 2009) (online at www.sec.gov/ Archives/edgar/data/895421/000095010309001280/dp13673l 8k.htm). 187 $2 billion of 6.0 percent five-year notes (385 basis points over U.S. Treasuries) and $2 billion of 7.3 percent ten-year notes (399 basis points over U.S. Treasuries). Morgan Stanley, Form FWP (May 8, 2009) (online at www.sec.gov/Archives/edgar/data/895421/ 000090514809001909/efc9–0580l formfwp.htm). 188 PNC Financial Service Group, Inc., Form 8–K (May 20, 2009) (online at www.sec.gov/Archives/edgar/data/713676/000119312509119280/ d8k.htm). 189 Regions Financial Corp., Form 8–K (May 20, 2009) (online at www.sec.gov/Archives/edgar/data/1281761/000119312509115380/d8k.htm). 190 State Street Corp., Form 8–K (May 21, 2009) (online at www.sec.gov/Archives/edgar/data/93751/000119312509116176/d8k.htm). 191 4.3 percent five-year notes (196 basis points over U.S. Treasuries). State Street Corp., Form 8–K (May 22, 2009) (online at www.sec.gov/ Archives/edgar/data/93751/000119312509117661/d8k.htm). 192 SunTrust Banks, Inc., Form 8–K (June 1, 2009) (online at www.sec.gov/Archives/edgar/data/750556/000119312509121956/d8k.htm). 193 U.S. Bancorp., Form 8–K (May 11, 2009) (online at www.sec.gov/Archives/edgar/data/36104/000129993309002107/html 32711.htm). 194 Wells Fargo & Co., Form 8–K (May 8, 2009) (online at www.sec.gov/Archives/edgar/data/72971/000089882209000287/wfc8k.htm). VerDate Nov 24 2008 04:20 Jun 18, 2009 Jkt 050104 PO 00000 Frm 00050 Fmt 6602 Sfmt 6602 E:\HR\OC\A104.XXX A104 45 FIGURE 6: BANKS THAT HAVE REPAID THEIR TARP FUNDS UNDER THE CPP AS OF MAY 29, 2009 CPP Repayment date Bank Washington Federal Inc ... TCF Financial Corp .......... First Niagara Financial Group. Iberiabank Corp ............... Bank of Marin Bancorp ... Old National Bancorp ...... Signature Bank ................ Sterling Bancshares, Inc Berkshire Hills Bancorp, Inc. Alliance Financial Corporation. FirstMerit Corporation ...... Sun Bancorp, Inc ............. Independent Bank Corp ... Shore Bancshares, Inc .... Somerset Hills Bancorp ... SCBT Financial Corp ....... Texas Capital Bancshares, Inc. Centra Financial Holdings, Inc/Centra Bank, Inc. First Mantowoc Bancorp, Inc. First ULB Corp ................. Valley National Bancorp .. HF Financial Corp ............ CPP Repayment amount (dollars in millions) Amount remaining to repay (dollars in millions) Warrant repurchase amount (dollars in millions) Does Treasury still hold warrants? 05/27/2009 04/22/2009 05/27/2009 200.0 361.2 184.0 0 0 0 Y Y Y 03/31/2009 03/31/2009 03/31/2009 03/31/2009 05/05/2009 05/27/2009 90.0 28.0 100.0 120.0 125.2 40.0 0 0 0 0 0 0 N Y N Y Y Y 05/13/2009 26.9 0 Y 04/22/2009 04/08/2008 04/22/2009 04/15/2009 05/20/2009 05/20/2009 05/13/2009 125.0 89.3 78.2 25.0 7.4 64.8 75.0 0 0 0 0 0 0 0 N N N Y Y Y Y 5.0 (05/27/2009) 2.1 (05/27/2009) 2.2 (05/27/2009) 03/31/2009 15.0 0 N 195 .8 05/27/09 12.0 0 N .6 (05/27/2009) 04/22/09 06/03/09 06/03/09 4.9 75.0 25.0 0 225.0 0 N Y Y .2 (04/22/2009) 1.2 (05/20/2009) 1.2 (05/08/2009) (04/15/2009) jbell on PROD1PC69 with REPORTS 195 For certain privately held institutions such as this one, Treasury immediately exercised a warrant for additional preferred shares. Upon exiting TARP, the institution repurchased those additional shares for the total repurchase amount indicated. VerDate Nov 24 2008 04:20 Jun 18, 2009 Jkt 050104 PO 00000 Frm 00051 Fmt 6602 Sfmt 6602 E:\HR\OC\A104.XXX A104 46 VerDate Nov 24 2008 04:20 Jun 18, 2009 Jkt 050104 PO 00000 Frm 00052 Fmt 6602 Sfmt 6602 E:\HR\OC\A104.XXX A104 Insert offset folio 61 here 50104A.001 jbell on PROD1PC69 with REPORTS Annex to Section One: The Supervisory Capital Assessment Program: An Appraisal VerDate Nov 24 2008 04:20 Jun 18, 2009 Jkt 050104 PO 00000 Frm 00053 Fmt 6602 Sfmt 6602 E:\HR\OC\A104.XXX A104 Insert offset folio 62 here 50104A.002 jbell on PROD1PC69 with REPORTS 47 VerDate Nov 24 2008 04:20 Jun 18, 2009 Jkt 050104 PO 00000 Frm 00054 Fmt 6602 Sfmt 6602 E:\HR\OC\A104.XXX A104 Insert offset folio 63 here 50104A.003 jbell on PROD1PC69 with REPORTS 48 VerDate Nov 24 2008 04:20 Jun 18, 2009 Jkt 050104 PO 00000 Frm 00055 Fmt 6602 Sfmt 6602 E:\HR\OC\A104.XXX A104 Insert offset folio 64 here 50104A.004 jbell on PROD1PC69 with REPORTS 49 VerDate Nov 24 2008 04:20 Jun 18, 2009 Jkt 050104 PO 00000 Frm 00056 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2009 Jkt 050104 PO 00000 Frm 00110 Fmt 6602 Sfmt 6602 E:\HR\OC\A104.XXX A104 Insert offset folio 119 here 50104A.059 jbell on PROD1PC69 with REPORTS 104 105 SECTION TWO: ADDITIONAL VIEWS A. REP. JEB HENSARLING 1. GENERAL PROGRAM OVERVIEW As a member of the Congressional Oversight Panel (COP or the panel) for the Troubled Asset Relief Program (TARP), it has become evident to me that, unfortunately, the program is no longer being utilized for its intended purposes of financial stability and taxpayer protection. It is being used instead to promote the economic, social and political agendas of the current administration. As evidenced by TARP’s financing of two bankrupt auto makers, multiple capital infusions into ‘‘healthy’’ institutions, increased complexity for institutions wishing to repay TARP, I have come to the conclusion that Congress’ original intent for financial stability and taxpayer protection is no longer being respected and the program should be unwound. 2. BACKGROUND AND THE CONGRESSIONAL OVERSIGHT PANEL’S STATUTORY RESPONSIBILITIES On October 3, 2008, Congress voted to enact and the president signed into law the Emergency Economic Stabilization Act of 2008 (EESA). The act provided the United States Treasury with the authority to spend $700 billion to stabilize the U.S. economy and prevent a systemic meltdown. The act also established two bodies with broad oversight responsibilities: the COP and the Financial Stability Oversight Board (FSOB). The act placed audit responsibilities in the GAO and a Special Inspector General for the Troubled Asset Relief Program (SIGTARP). While the oversight and audit organizations have some overlapping responsibilities, only the COP is specifically empowered to hold hearings, take testimony, receive evidence, administer oaths to witnesses, and review official data, and is required to write reports on the extent to which the information on transactions has contributed to market transparency.196 The EESA statute requires COP to accomplish the following, through regular reports: • Oversee Treasury’s TARP-related actions and use of authority; • Assess the impact to stabilization of financial markets and institutions of TARP spending; • Evaluate the extent to which TARP information released adds to transparency; and • Ensure effective foreclosure mitigation efforts in light of minimizing long-term taxpayer costs and maximizing taxpayer benefits. All are tremendous responsibilities. However, the American people, through Congress, determined that each were necessary and expressed confidence that the COP, as an organization and an arm of Congress, was the right body to carry out the assigned tasks. jbell on PROD1PC69 with REPORTS 196 Congressional Research Service, Emergency Economic Stabilization Act: Preliminary Analysis of Oversight Provisions (Nov. 20, 2008). VerDate Nov 24 2008 04:20 Jun 18, 2009 Jkt 050104 PO 00000 Frm 00111 Fmt 6602 Sfmt 6602 E:\HR\OC\A104.XXX A104 106 It is no secret that I voted against EESA. However, as the only sitting member of Congress on the COP, I have consistently expressed my commitment to ensure that the TARP program works, that decisions made are based on merit and not political considerations, and most importantly, that the taxpayers are protected. I respect the panel and each of its members and staff; however, I fear that by choosing to focus much of its work on issues not central to our mandate the panel has missed critical opportunities to provide effective oversight. The American people have long understood that when it comes to government actions, sunshine is the best disinfectant. The COP is supposed to ensure that the sun is always shining when it comes to Treasury’s actions and the use of TARP funds. However, due to the panel’s pursuit of interesting topics for legislative and policy debates, taxpayers have not received answers as to whether the TARP program works, how decisions are being made or what the banks are doing with the taxpayers’ money. A number of anecdotes exist, but the panel has the ability to establish the facts. As I have said in the past, effective oversight begins with a vigorous examination of those who administer the TARP. Unfortunately, the panel has conducted only one hearing with a Treasury official during its six-month existence. As a starting point, I echo my call that the panel hold a hearing each month with the Secretary of the Treasury or a senior designee with TARP management responsibilities. If the Treasury refuses to participate, the panel should hold its officials to account for not participating. If the panel refuses to call regular hearings with Treasury officials, the American public and Congress should hold the panel to account for negligence. Additionally, effective taxpayer accountability requires that the panel question TARP recipients. To date, the panel has questioned 3 institutions, representing 0.11 percent of total TARP authorization, out of over 600 197 TARP recipients. None of the major TARP recipients have been questioned in a public hearing. If presented with the opportunity, I believe the taxpayers would pose the following types of questions to the TARP recipients in a matter-of-fact, plainspoken American manner: • Did the financial stability of the economy require that you accept TARP funds in the first place? Did your business model, risk management techniques, compliance protocols and underwriting standards threaten macroeconomic stability? • If so, have you addressed those issues to ensure that taxpayers won’t be called upon once again to infuse capital into your company? Please tell us what remedial actions you took and why you think they will be effective. • If the financial stability of our economy did not require a TARP infusion into your company, did Treasury ‘‘force’’ you to accept any TARP funds? If so, please tell us what happened. • When can taxpayers expect you to repay the TARP funds? jbell on PROD1PC69 with REPORTS 197 Total number of financial institutions participating in Treasury’s Capital Purchase Plan. See U.S. Department of the Treasury, Seventh Tranche Report to Congress (June 3, 2009) (online at www.financialstability.gov/docs/TrancheReports/7thl Tranche-Report-Appendix.pdf). VerDate Nov 24 2008 04:20 Jun 18, 2009 Jkt 050104 PO 00000 Frm 00112 Fmt 6602 Sfmt 6602 E:\HR\OC\A104.XXX A104 107 • To achieve the goal of financial stability, do you anticipate the need for additional TARP funds? If so, how much and when will you need the additional TARP funds? • Has Treasury refused to permit you to repay all or any part of your TARP funds in the name of financial stability? If so, please tell us about your disagreement with Treasury. • We realize that money is fungible, but please tell us what you did with your TARP funds. • Has Treasury or anyone from the government ‘‘encouraged’’ (or directed) you to (i) extend credit to any person or entity or (ii) forgive or restructure any loan that may run counter to the goal of your company’s financial stability? • Using the TARP funds your company has received as leverage, has Treasury or anyone from the government ‘‘assisted’’ (or directed) you in managing the affairs of your institution? • Did your receipt of TARP funds result in new lending activity or increased lending activity? While the COP has reviewed a number of historical precedents and commented on various policies, including how Iceland handled its banking crisis, the panel cannot tell the American people what safeguards Treasury has in place to ensure that TARP money is not being wasted or if TARP money is being used in their best interest. The panel knows the answers to ancillary questions regarding how Spain, Germany, and Italy handled their banking crises, but the panel cannot answer fundamental questions on how Treasury is handling the current crisis. For example, the COP should ascertain how Treasury measures success, how it will know when TARP funds are no longer required, and what is Treasury’s exit strategy. The taxpayers deserve to know answers to these fundamental questions, and it is the COP’s duty to help provide them. As SIGTARP discussed at length in its last report, TARP has expanded a ‘‘tremendous’’ amount in scope, scale and complexity.198 I am including analysis of and questions about additional, key TARP-related issues upon which the panel has so far failed to shed light. I have also provided a few observations on the panel’s June report. a. Investigation of Chrysler’s and GM’s Bankruptcy and Restructuring Under the terms of the proposed Chrysler restructuring plan, the Chrysler senior secured creditors will receive 29 cents on the dollar and the pension funds of the United Auto Workers (UAW), each an unsecured creditor, will receive 43 cents on the dollar and a 55 percent equity ownership interest in the ‘‘new’’ Chrysler, even though the claims of the senior secured creditors are of a higher bankruptcy priority than the claims of the UAW.199 The State of Indiana’s pension funds, one group of Chrysler’s secured creditors, filed an appeal to the Chrysler sale, causing the bankruptcy judge to freeze the proceedings. In their filing, the funds stated, ‘‘This at- jbell on PROD1PC69 with REPORTS 198 Office of the Special Inspector General for the Troubled Asset Relief Program, Quarterly Report to Congress (Apr. 21, 2009) (online at www.sigtarp.gov/reports/congress/2009/April2009l Quarterlyl Reportl tol Congress.pdf) (hereinafter ‘‘SIGTARP April Report’’). 199 Chad Bray and Alex P. Kellog, Court Affirms Chrysler Sale but Puts Deal on Hold Until Monday, Wall Street Journal (June 3, 2009) (online at online.wsj.com/article/ SB124423529553090069.html#mod=testMod). VerDate Nov 24 2008 04:20 Jun 18, 2009 Jkt 050104 PO 00000 Frm 00113 Fmt 6602 Sfmt 6602 E:\HR\OC\A104.XXX A104 108 tack on the most fundamental of creditor rights has been funded, orchestrated and controlled by Treasury, despite its complete lack of statutory and constitutional authority to do so.’’ 200 Under the terms of the proposed GM restructuring plan, the United States and Canadian governments, the UAW pension funds and the GM bondholders will receive an initial common equity interest in GM of 72.5 percent, 17.5 percent and 10 percent, respectively. The equity interest of the UAW pension funds and the GM bondholders may increase (with an offsetting reduction in each government’s equity share) to up to 20 percent and 25 percent, respectively, upon the satisfaction of specific conditions. The GM bondholders have been asked to swap $27 billion in debt for a 10–25 percent common equity interest in GM, while the UAW has agreed to swap $20 billion in debt for a 17.5–20 percent common equity interest and $9 billion in preferred stock and notes in GM.201 Apparently, even though the bankruptcy claims of the UAW pension funds and the GM bondholders are of the same priority, the UAW will receive a disproportionately greater distribution than the GM bondholders in the reorganization. Given the unorthodox reordering of the rights of the Chrysler and GM creditors, a fundamental question arises as to whether the Administration directed that TARP funds be used to advance its policy and legislative objectives rather than to stabilize the American economy as required by EESA. In other words, did the Administration use any TARP funds as a carrot or stick? The Administration should also inform the American taxpayers regarding its proposed exit strategy from the Chrysler, GM and other TARP investments and whether it plans to reinvest such proceeds in other entities. The panel has agreed to hold a public hearing on the Chrysler and GM reorganizations. I commend the panel for this oversight effort. An effective hearing will take place as soon as possible in the nation’s capitol and include senior Treasury officials, auto company executives, union executives, TARP recipient bondholders, and nonTARP recipient bondholders, to name a few. In order to discharge its specific duties and responsibilities under EESA in a professional and timely manner, the panel should seek answers to the following additional questions (among others): • Why would certain Chrysler and GM creditors agree to accept less than what they were contractually owed and entitled to receive under bankruptcy law? 202 jbell on PROD1PC69 with REPORTS 200 Tiffany Kary, et al., Chrysler Says Indiana Pension Funds Can’t Win Appeal, Bloomberg (June 4, 2009) (online at www.bloomberg.com/apps/news?pid=20601103&sid=aDSQ2KKXfDPI). 201 Peter Whoriskey, U.S. Gets Majority Stake in New GM, Washington Post (June 1, 2009) (online at www.washingtonpost.com/wpdyn/content/article/2009/05/31/ AR2009053101959.html?sid=ST2009060100034). 202 Thomas Lauria, a senior bankruptcy and reorganization attorney with the international law firm White & Case LLP, who represents a group of Chrysler creditors, recently stated on CNBC that the Administration flagrantly violated constitutional principles by trampling on the contractual rights of the Chrysler bondholders. This is a serious charge by a seasoned and well respected attorney at a top-tier law firm and should be investigated by the panel. See Thomas Lauria, Interview: GM, Bonds & Beyond, CNBC (May 13, 2009) (online at www.cnbc.com/id/ 15840232?video=1122734987&play=1); Thomas Lauria, Interview: A Case of Gangster Government, CNBC (May 8, 2009) (online at www.cnbc.com/id/15840232?video=1118369112&play=1); Thomas Lauria, Interview: White House Bullying Bondholders?, CNBC (May 6, 2009) (online at www.cnbc.com/id/15840232?video=1116040367&play=1). VerDate Nov 24 2008 04:20 Jun 18, 2009 Jkt 050104 PO 00000 Frm 00114 Fmt 6602 Sfmt 6602 E:\HR\OC\A104.XXX A104 109 jbell on PROD1PC69 with REPORTS • Specifically, what is the legal and business justification for preferring the claims of the UAW pension funds over the claims of (i) the Chrysler senior secured creditors since the claims of such creditors are of a higher bankruptcy priority and should receive preferential treatment under bankruptcy law, and (ii) the GM bondholders since the claims of the UAW and the GM bondholders are of the same bankruptcy priority (both unsecured) and should receive identical (or at least substantially similar) treatment under bankruptcy law? • Does it matter that some of the creditors were also TARP recipients? TARP beneficiaries who were also secured bondholders of Chrysler—including Citigroup, JP Morgan Chase, Morgan Stanley, and Goldman Sachs—agreed to the swap of $6.9 billion in debt for just $2 billion in cash. Did these institutions acquiesce with the knowledge that losses from their Chrysler holdings may be replenished with TARP funds? Were they pressured into doing so? How would the taxpayer know whether or not Treasury channeled TARP funds through these institutions as a backdoor way of financing the auto industry and, indirectly, UAW claims? Were any of the GM bondholders TARP recipients? • Why would TARP recipients (that by definition owe substantial sums to the United States government) agree to settle bankruptcy claims for less than the maximum amount allowable under bankruptcy law? • Who authorized those decisions—the management of each TARP recipient or Treasury acting as the de facto manager of the TARP recipients—and what, if any, fiduciary duties were violated? • If management of each such TARP recipient voluntarily agreed to forgive part of its claim against Chrysler and GM, as applicable, what was their legal basis for making such a gift? • Why would TARP recipients agree to transfer part of their bankruptcy claims to another creditor—the UAW—and not use such amounts to repay their TARP loans? • Did the Administration ‘‘reimburse’’ Chrysler and GM for any TARP funds transferred to the UAW? • Did the Administration choose to prefer one group of employees—UAW members and their retiree benefits fund—over other non-UAW employees whose pension funds invested in GM bonds? Under such an approach the retirement plans of the UAW employees would be enriched while the retirement plans of the non-UAW employees would be diminished. • What message does this send to the financial markets—should investors expect their contractual rights to be ignored when dealing with the United States government? How will the cases of GM and Chrysler affect future financings and reorganizations? • What message does this send to non-UAW employees whose pension funds invested in Chrysler and GM indebtedness—you lose part of your retirement savings because your pension fund does not have the special relationships of the UAW? • Is the Administration setting corporate policy and/or running the day-to-day affairs of Chrysler and GM, including the two reorganizations? If so, under what authority? • Did the Administration ‘‘force’’ Chrysler to accept a deal with Fiat? VerDate Nov 24 2008 04:20 Jun 18, 2009 Jkt 050104 PO 00000 Frm 00115 Fmt 6602 Sfmt 6602 E:\HR\OC\A104.XXX A104 110 jbell on PROD1PC69 with REPORTS • Have the Chrysler and GM boards of directors and officers abandoned their fiduciary duties and acquiesced in the management decisions made by the Administration? • Has the Administration appropriately discharged its fiduciary duties in its role as the de facto manager of an insolvent Chrysler and GM? • Will the United States government be open to suit by private parties based upon the breach of its fiduciary duties owed to Chrysler and GM and their shareholders and creditors? • Should the panel recommend that SIGTARP, which performs audits and investigations on abuse and fraud, investigate any such inappropriate use of TARP funds? • What is the Administration’s exit strategy regarding the investment of TARP funds in Chrysler and GM? On top of a bankruptcy that will give the UAW a sweeter deal than comparable GM creditors, there is also the wider concern that GM is becoming another black hole for taxpayer dollars. The government will presumably receive a 72.5 percent initial ownership stake in exchange for $50 billion of TARP funds committed so far. Although the President has called the government a ‘‘reluctant’’ shareholder that will ‘‘take a hands-off approach, and get out quickly,’’ the Administration has presented no exit strategy for its ownership, nor any plan for recouping equity investments. In its latest baseline, the Congressional Budget Office (CBO) estimated that the TARP auto program carried about a 74 percent subsidy rate for the taxpayer—a rate calculated before GM announced bankruptcy and before loans were converted to what will amount to common stock. Congress and the public still have little knowledge of how the Administration will manage the automaker, how it assesses risks of taxpayer losses, and a strategy to unwind its investment. These issues will require rigorous and ongoing investigation by the COP. Regrettably, the consequences of these actions may not be limited to Chrysler and GM but may resonate through and have a chilling effect on the broader bond and capital markets. Once investors realize that their contracts may not be respected by the Administration, if they even agree to participate, they will demand interest rate and other premiums to compensate for the enhanced risk. Such expenses will be passed on to consumers and will render American businesses at a competitive disadvantage to their foreign counterparts. Following the well-stumbled path of unintended consequences, two misguided attempts perhaps to favor the UAW may cause other hard working Americans to lose their jobs to business enterprises organized in foreign countries that continue to respect the sanctity of a contract. How can the Administration believe that its actions in the Chrysler and GM reorganizations will go unnoticed by the investment community? These ‘‘technicalities’’ may have not garnered the attention of most Americans but they are front-and-center issues with financial institutions and their counsel and investors. How can an Administration that is beating the drum with one hand to encourage financial institutions to extend credit poke the same financial institutions in the eye with the other hand? I suspect this lesson has not been lost on the financial com- VerDate Nov 24 2008 04:20 Jun 18, 2009 Jkt 050104 PO 00000 Frm 00116 Fmt 6602 Sfmt 6602 E:\HR\OC\A104.XXX A104 111 munity and may serve as one of the reasons for the community’s tepid embrace of the TALF and PPIP programs. b. Transparency of Bank of America’s Acquisition of Merrill Lynch Recently, reports have appeared to the effect that Treasury ‘‘coerced’’ Bank of America into purchasing Merrill Lynch even though Bank of America’s management concluded that the transaction was not in the best interest of the bank and its shareholder. In May the chair of the panel, Professor Elizabeth Warren, sent a letter to Treasury Secretary Geithner requesting his ‘‘thoughts on the issue.’’ In order to determine what actually occurred, the panel should investigate whether Treasury threatened to withhold TARP funds if Bank of America withdrew from the acquisition, when any such threats were made and if such actions impacted Bank of America’s decision to acquire Merrill Lynch. c. TALF and PPIP The COP’s April report indicates a lack of participation by potential investors in other government programs like the Term AssetBacked Securities Loan Facility (TALF) and the Public-Private Investment Program (PPIP), due to the uncertainty regarding changing terms and conditions of the programs.203 Although the Federal Reserve announced that requests for participation in TALF increased $11.5 billion from last month, the program had a rocky start and may pose a greater risk as it brings on commercial and residential mortgage-backed securities (MBS).204 The PPIP, which has not yet gone live, continues to be a program in limbo, and the FDIC now says it will delay the sale of legacy loans.205 As we await further details and in order to discharge its specific duties and responsibilities under EESA in a professional and timely manner, the panel should address the following inquiries: • How have these uncertainties—specifically including the complex executive compensation rules, the threatened ‘‘outing’’ of certain AIG employees and their families, the alleged inequitable treatment of certain creditors of Chrysler and GM, and the pending SIGTARP investigations—affected the TALF and PPIP programs? • Why haven’t hedge funds, private equity funds and other investors embraced the TALF and PPIP programs as anticipated by Treasury? • Has Treasury marketed these programs to passive foreign investors and tax exempt organizations (as well as the typical domestic investors) and what regulatory and other burdens prohibit or limit the participation by such investors? • Are the tax laws written so as to encourage passive foreign investors to invest in performing loans and securities but discourage such investors from investing in distressed loans and securities? jbell on PROD1PC69 with REPORTS 203 Jody Shenn, Dudley’s TALF Comments Add Signs of a PPIP Stall, Bloomberg (June 5, 2009) (online at www.bloomberg.com/apps/news?pid=newsarchive&sid=a2Wl7tAD6rEA). 204 Scott Lanman and Sarah Mulholland, Fed Says TALF Loan Requests Increase to $11.5 Billion, Bloomberg (June 2, 2009) (online at www.bloomberg.com/apps/ news?pid=20601087&sid=aUonjouK30hU). 205 Margaret Chadbourn, FDIC Said to Delay PPIP Test Sale of Distressed Loans, Bloomberg (June 2, 2009) (online at www.bloomberg.com/apps/ news?pid=20601103&sid=aVLm8N96tvV0&refer=us). VerDate Nov 24 2008 04:20 Jun 18, 2009 Jkt 050104 PO 00000 Frm 00117 Fmt 6602 Sfmt 6602 E:\HR\OC\A104.XXX A104 112 • Why hasn’t the panel called leaders in the financial and investment communities to testify as to why they consider the TALF and PPIP programs unattractive? • What do potential investors like and what do they dislike, and why? • Is it possible to address the ‘‘dislikes’’ in a reasonable and mutually beneficial manner? • Why have some investors abandoned their participation in the programs after expressing initial interest? • What legal and financial impediments exist? • What other impediments exist? • If Treasury is struggling to introduce market-ready investment programs, why hasn’t the panel offered its assistance? I am certainly not suggesting that hedge fund managers be permitted to structure the programs de novo, but since Treasury desperately needs private capital to arrest the financial crisis it seems entirely appropriate for the panel to solicit and consider the views of the targeted investor classes. Treasury and the panel must remember that private sector investors have limited capital to deploy and numerous attractive opportunities to consider and will not chose to invest in any Treasury program unless they expect to earn an appropriate risk adjusted rate of return without excessive administrative and regulatory burdens. These private sector institutions owe a fiduciary duty to their investors (which often include pension funds and university endowments) and simply cannot allocate capital to off-market investments. With the full knowledge that private dollars will not participate unless they anticipate upside potential, the panel should also ask Treasury to provide more detail on how it assesses downside risk to the taxpayers of the TALF and PPIP programs. SIGTARP, for example, has already made several recommendations to Treasury on ways to reduce risk and the potential for fraud in TALF and PPIP. It is extremely concerned with the inclusion of legacy residential MBS in TALF, stating the Treasury should screen individual securities, have more stringent requirements for loans used as collateral, and require higher haircuts for all MBS. In addition, SIGTARP believes that PPIP is ‘‘inherently vulnerable to fraud, waste and abuse,’’ including various conflicts of interests between participants.206 d. June COP Report The report is fairly straightforward in that it focuses on the mechanics of the recently completed stress tests. Although I voted ‘‘yes’’ to the report, I offer the following questions and observations. i. Underlying Legal and Regulatory System. Increased government involvement in our housing markets created significant distortions and disruptions. This increased involvement is contrary to the oft-repeated, now disproven claims of proponents of expanded government control of our economy that a ‘‘wave’’ of market deregulation over the last 20 years caused the current crisis. To the contrary, facts indicate that there were at least five key factors which contributed to financial crisis, at least four of which were a direct jbell on PROD1PC69 with REPORTS 206 SIGTARP VerDate Nov 24 2008 04:20 Jun 18, 2009 Jkt 050104 April Report, supra note 198. PO 00000 Frm 00118 Fmt 6602 Sfmt 6602 E:\HR\OC\A104.XXX A104 113 result of government involvement. Those four factors—highly accommodative monetary policy by the Federal Reserve, continual federal policies designed to expand home ownership, the congressionally-granted duopoly status of housing GSEs Fannie Mae and Freddie Mac, and an anti-competitive government-sanctioned credit rating oligopoly—are thoroughly discussed in the Joint Dissenting Views to the COP’s ‘‘Special Report On Regulatory Reform’’ that I offered along with Senator John Sununu along with a fifth factor (failures throughout the mortgage securitization process that resulted in the abandonment of sound underwriting practices).207 As such, a thorough recitation of those points here would be redundant. ii. Further Information on Counterparty Risk. The current COP report gives a broad overview of how bank holding companies (BHCs) provided estimates of counterparty losses, potentially occurring from deterioration in the credit markets, under the two stress test scenarios. But the fact remains that there is still a considerable amount of uncertainty about the inputs used to stress test counterparty agreements like credit default swaps and similarlystructured products. The panel neglects to provide much detail beyond what the Federal Reserve’s SCAP ‘‘Design and Implementation’’ presents in its white paper. What was the interaction like between the BHCs, who ran the tests, and the Federal Reserve, who supervised them? Was the Fed able to validate counterparty data? There is also little discussion of disparate data among BHCs, and how the Federal Reserve rationalized what is a complicated framework with interdependent assumptions on the risks of default. If the financial institutions already have counterparty data available to reasonably assess losses, were another set of market shocks to occur, why is there still so much uncertainty about systemic risk? Is there any way for the Federal Reserve to separate the potential losses from agreements like credit default swaps from other potential trading losses? Information that addresses these questions would enable COP to fulfill its responsibility of assessing how effective TARP funds have been in stabilizing financial markets. iii. Application of the Mark-to-Market Rules. Was the methodology applied to the ‘‘more adverse’’ scenario too conservative? That is, if the newly relaxed mark-to-market rules were applied to the ‘‘more adverse’’ scenario by how much would the additional capital requirements have dropped? A lesser capital requirement would decrease the likelihood that the BHCs would have to raise equity capital by (i) selling stock in the market or under CAP, (ii) converting preferred stock (whether privately held or issued under the CPP) into common stock, or (iii) selling assets. No such alternative is in the best interests of the taxpayers or the BHCs and, as such, should be avoided unless necessary and appropriate. Perhaps prudent underwriting necessitates the use of the old mark-to-market rules under the theory ABS securities will continue to be worth far less than their face values. The panel should continue to investigate by how much the additional capital requirements would have jbell on PROD1PC69 with REPORTS 207 Congressional Oversight Panel, Special Report on Regulatory Reform: Modernizing the American Financial Regulatory System: Recommendations for Improving Oversight, Protecting Consumers, and Ensuring Stability, at 54–89 (Jan. 29, 2009) (online at cop.senate.gov/documents/cop-012909-report-regulatoryreform.pdf). VerDate Nov 24 2008 04:20 Jun 18, 2009 Jkt 050104 PO 00000 Frm 00119 Fmt 6602 Sfmt 6602 E:\HR\OC\A104.XXX A104 114 jbell on PROD1PC69 with REPORTS dropped if the recently modified mark-to-market rules were applied to the ‘‘more adverse’’ scenario. iv. ‘‘Negotiation’’ of Stress Tests. The report raises the question as to whether the stress test results were ‘‘negotiated’’ between the BHCs and their supervisors. The report notes that the supervisors informed the staff of the panel that there was no ‘‘negotiation’’ of the results except with respect to specific first quarter adjustments and clear errors and omissions. The report also asks if the process could have been better handled in a more transparent manner. Although such inquiry is no doubt appropriate, absent evidence to the contrary, I think it might be counterproductive to dig aggressively into the discussions between the BHCs and their supervisors because such discussions were no doubt candid and may have indeed resulted in lower capital requirements for specific institutions. It’s naive to think otherwise. It does not follow, however, that the regulators were persuaded to recommend inappropriately low additional capital requirements for any institution. Regulated entities and their supervisors typically discuss (and argue) at length the results of an examination or audit. Through this back-and-forth process each side presents its case and advocates the merits of its position. The regulated entity works to assist the regulator in better understanding how the applicable regulations should apply to its business, financial position and operating results, and the regulator argues in support of its application of the regulations to the regulated entity. This process is critical for the regulators because they are generally significantly outnumbered by the employees of the regulated entities. Regulated entities and their supervisors must have an open line of communication that permits each to speak frankly. Such interaction and exchange of ideas between a regulated entity and its supervisor by no means implies that the regulated entity acted in an inappropriate manner or that the regulator conceded an issue that is not in the best interest of the taxpayers. If credible evidence develops to the contrary the panel should promptly investigate, otherwise any investigation will most likely yield only the obvious: the supervisors presented their results to the BHCs; the BHCs commented on any inconsistencies, errors and omission; the supervisors made any modifications to their reports that they considered appropriate in their sole and absolute discretion; and the results were released. v. CMBS. I continue to receive less than enthusiastic reports regarding the commercial real estate market. If all commercial real estate loans and CMBSs were marked-to-market the additional capital requirement could jump dramatically. The supervisors should diligently monitor these loans and securities. vi. Government Intervention, Exit Strategy and Related Issues. The following sentences were included in a draft version of the June report, but were not included in the final report. They are important issues to consider in the context of TARP’s effectiveness, and I have included them below: ‘‘To the extent that BHCs rely on CAP funds in meeting their capital buffer needs, all the issues involved in government ownership of companies’ common stock are raised. Promised Treasury guidance as to the corporate governance principles that will be fol- VerDate Nov 24 2008 04:20 Jun 18, 2009 Jkt 050104 PO 00000 Frm 00120 Fmt 6602 Sfmt 6602 E:\HR\OC\A104.XXX A104 115 jbell on PROD1PC69 with REPORTS lowed does not yet seem to have been published, and will be crucial.’’ ‘‘Since government intervention in the markets causes uncertainty, and may make investors less likely to participate in capital raising by the BHCs, the Administration should be as transparent as possible with respect to policy issues regarding intervention.’’ ‘‘Treasury should publish the corporate governance policies or guidelines which it will follow as a shareholder in institutions requiring CAP funding.’’ In addition, and in order to discharge its specific duties and responsibilities under EESA in a professional and timely manner, the panel should investigate the following related issues (among others): • What is Treasury’s exit strategy with respect to each TARP investment? Treasury should specify its exit strategy on an entity-byentity basis with a time line and in sufficient detail. • What TARP investments does Treasury expect to hold at the end of 2009 and each of the next five years? Treasury should specify on an entity-by-entity basis and in sufficient detail. • Does Treasury anticipate that it will need to make additional investments in any of the current TARP recipients or any other entity? If so, in what amount, in what form, for what entity and for what purpose? • Does Treasury anticipate that it will reinvest any repaid TARP funds, that is, is TARP a revolving credit/investment facility? • Will Treasury remain a passive investor or will it undertake to designate the directors and officers of the TARP recipients and in substance exercise day-to-day control over the management and affairs of such entities? • Will Treasury timely announce its decision to act in a passive or active manner with respect to the TARP recipients so as to lessen the uncertainty regarding the large block of shares held by the public sector? • Will Treasury follow and respect applicable state corporate and federal and state securities law? • If the government acts as the de facto management of any TARP recipient will it be liable to suit as a controlling person and subject to all applicable federal and state corporate, securities and other rules and regulations? • What are the consequences of the United States government serving as the de facto manager of Chrysler, GM and the largest financial institutions? • Will the government mandate which cars will be built and which borrowers will qualify for loans? • How will ‘‘non-subsidized’’ businesses compete with TARP recipients whose government shareholder may literally print money? • Will TARP recipients receive favorable government contracts or other direct or indirect subsidies the award of which is not based upon objective and transparent criteria? • Will TARP recipients promptly disclose all contractual arrangements (oral or written) between each TARP recipient and the government, together with a detailed description of the contract, its purpose, the transparent and open competitive bidding process un- VerDate Nov 24 2008 04:20 Jun 18, 2009 Jkt 050104 PO 00000 Frm 00121 Fmt 6602 Sfmt 6602 E:\HR\OC\A104.XXX A104 116 jbell on PROD1PC69 with REPORTS dertaken and the arm’s length and market directed nature of the contract? • Will TARP recipients be able to obtain private or public credit or enter into other contractual arrangements at favorable rates because of the implicit governmental guarantee of such indebtedness and contracts? • Will any such subsidies violate U.S. law or the laws of any foreign jurisdiction? • How may all aspects of the relationship between each TARP recipient and the government be made more transparent, accountable and beyond reproach? • What are the best practices the government should adopt with respect to its role as the sole TARP investor? • Will employees (and members of their immediate families) of the government that work with or supervise any TARP recipients be barred from seeking employment or serving as a director with TARP recipients or from working with any public policy shop, law firm or other organization that represents any TARP recipients for a period of, say, at least five-years following the departure from government service of such employee? • Will governmental employees (and members of their immediate families) be barred from serving as directors, managers or employees of any TARP recipient during their government service? • What corporate governance, compliance, risk management and internal control protocols and procedures will the government adopt with respect to its role as a creditor and shareholder of the TARP recipients? • Will the government in its capacity as a shareholder of each TARP recipient undertake to abide by all insider trading, controlling shareholder and other applicable rules and regulations? • Will the government exert disproportionate influence over management relative to its actual ownership interests in the TARP recipients? • How will Treasury resolve any conflict of interest between its role as a creditor or equity holder in any TARP recipient and as a supervising governmental authority for any such TARP recipient? • Will the IRS, SEC, Federal Reserve, FDIC and other governmental agencies be able to discharge their regulatory and enforcement responsibilities with respect to each TARP recipient without political influence? • Will management of the TARP recipients support the government’s slate of proposed directors and thus disenfranchise the remaining shareholders under the proxy rules? • If Treasury plans to sell its common stock to the public what are the appropriate benchmarks that will trigger such sales? • Should Treasury sell its shares in the market (whereby the TARP recipients will not share in the proceeds, but the TARP advances will be repaid) or should Treasury agree to retain its stock and permit the TARP recipients to sell newly issued shares to third-parties (whereby the TARP recipients will retain the proceeds from the offering, but the TARP advances will remain outstanding)? VerDate Nov 24 2008 04:20 Jun 18, 2009 Jkt 050104 PO 00000 Frm 00122 Fmt 6602 Sfmt 6602 E:\HR\OC\A104.XXX A104 117 SECTION THREE: CORRESPONDENCE WITH TREASURY UPDATE On behalf of the Panel, Chair Elizabeth Warren sent a letter on May 11, 2009 to Federal Reserve Board Chairman Bernanke to request certain documents and information related to the SCAP and to arrange a series of meetings to discuss SCAP.208 Negotiations regarding the production of the requested materials are ongoing. On behalf of the Panel, Chair Elizabeth Warren sent a letter to Secretary Geithner on May 12, 2009, inviting him to testify before the Panel on Wednesday, June 17, 2009.209 The Panel seeks to continue its public dialogue with Secretary Geithner, which began with his first appearance before the Panel on April 21, 2009. The letter specifically requests that the Secretary appear before the Panel to discuss the results of the stress tests and the questions the results raise concerning methodology, repayment of TARP funds, and the next steps for the use of TARP money. On behalf of the Panel, Chair Elizabeth Warren sent a letter on May 19, 2009 to Secretary Geithner and Chairman Bernanke referencing public concern that Treasury and the Board had applied strong pressure on Bank of America to complete its acquisition of Merrill Lynch, despite Bank of America’s concerns about Merrill Lynch’s deteriorating financial state.210 The letter cites this episode as an example of the conflicts of interest that can arise when the government acts simultaneously as regulator, lender of last resort, and shareholder. The letter concludes by soliciting Secretary Geithner’s and Chairman Bernanke’s thoughts on how to manage these inherent conflicts to ensure that similar episodes do not undermine government efforts to stabilize the financial system in the future. On behalf of the Panel, Chair Elizabeth Warren sent a letter on May 26, 2009, to Secretary Geithner requesting information about Treasury’s Temporary Guarantee Program for Money Market Funds, which is funded by TARP.211 The Temporary Guarantee Program uses assets of the Exchange Stabilization Fund to guarantee the net asset value of shares of participating money market mutual funds. The letter requests a description of the program mechanics and an accounting of its obligations and funding mechanisms. 208 See Appendix Appendix Appendix 211 See Appendix 209 See jbell on PROD1PC69 with REPORTS 210 See VerDate Nov 24 2008 04:20 Jun 18, 2009 Jkt 050104 I of this report, infra. II of this report, infra. III of this report, infra. IV of this report, infra. PO 00000 Frm 00123 Fmt 6602 Sfmt 6602 E:\HR\OC\A104.XXX A104 118 SECTION FOUR: TARP UPDATES SINCE LAST REPORT In addition to the release of the stress test results on May 7, 2009 (see Section One of this report), Treasury and the Federal Reserve Board released data and made program adjustments to a number of initiatives under the Financial Stability Plan since the release of the Panel’s last oversight report. A. AUTOMOTIVE INDUSTRY FINANCING PROGRAM (AIFP) On June 1, 2009, a federal bankruptcy judge approved the sale of the majority of Chrysler’s assets to the Italian automaker Fiat, clearing the way for the company to exit the bankruptcy process. On the same day, General Motors (GM) filed for chapter 11 bankruptcy following the approval of its revised viability plan by the President’s Auto Industry Task Force. The Administration pledged to support GM through an expedited chapter 11 proceeding with an additional public investment of $30.1 billion under AIFP. The additional cash infusion will raise the total U.S. investment in GM to $49.8 billion. In return, the government will receive $8.8 billion in debt and preferred stock, giving it a 60 percent ownership stake in the new GM. B. ADDITIONAL CPP INVESTMENT IN GMAC On May 21, 2009, Treasury announced a $7.5 billion preferred equity investment in GMAC. GMAC was one of ten banks subjected to ‘‘stress tests’’ under the SCAP determined to be in need of additional capital. Treasury mandated that the auto lender raise $9.1 billion in new tier 1 capital within six months. $3.5 billion of this investment will go toward addressing the capital shortage. The remaining $4 billion will be used to support new financing for Chrysler dealers and customers, a condition of federal assistance. GMAC must submit a plan for meeting the remainder of its capital needs to Treasury by June 8. Treasury also announced its intention to exercise the right to exchange an earlier $884 million loan to GM for common equity interests in GMAC, giving the government a 35.4 percent equity interest in GMAC. C. TERM ASSET-BACKED SECURITIES LOAN FACILITY (TALF) jbell on PROD1PC69 with REPORTS The Federal Reserve Board approved the addition of legacy commercial mortgage-backed securities (Legacy CMBS) to the classes of assets eligible for TALF loans. Legacy CMBS are those issued before January 1, 2009. Previously, the Board had announced it would expand the range of acceptable TALF collateral to include new CMBS (those issued after January 1, 2009) starting with the June 16 subscription date. Legacy CMBS are expected to join TALF beginning with the subscription in late July. The terms of TALF coverage of Legacy CMBS will differ from those for other assets. The haircut (adjusted for length of maturity) will be a standard 15 percent of par—the face amount—of the Legacy CMBS financed. Because the haircut is based on par value, it will increase with every dollar that the Legacy CMBS are valued below par. Thus, the government compensation for risk increases as its collateral loses value. The interest rate carry (the amount that can be earned in excess of the interest paid to the New York Fed) will be capped at VerDate Nov 24 2008 04:20 Jun 18, 2009 Jkt 050104 PO 00000 Frm 00124 Fmt 6602 Sfmt 6602 E:\HR\OC\A104.XXX A104 119 90 percent; this is the first explicit ceiling on TALF returns. The cap amounts to a second haircut of six to eight percent. On June 2, 2009, the Federal Reserve Bank of New York offered its June TALF subscription on non-mortgage asset-backed securities (ABS). In the two hours the facility was open, $11.5 billion in loans were requested. More than three quarters of the funds were secured by assets backed by credit card debt ($6.2 billion) or auto loans ($3.3 billion). As a point of comparison, there was a total of $10.6 billion in loans at the May facility, $1.7 billion at the April facility and $4.7 billion at the March facility. D. MAKING HOME AFFORDABLE PROGRAM (MHA) On May 14, 2009, Secretary Geithner and Housing and Urban Development (HUD) Secretary Shaun Donovan announced two new program components intended to help homeowners obtain modifications and stabilize property values in areas suffering from home price declines. 1. Foreclosure Alternatives Program provides incentives for servicers and borrowers to pursue short sales and deeds-in-lieu (DIL) of foreclosure in cases where the borrower is generally eligible for a MHA modification but is unable to complete the process. The program aims to simplify and streamline the short sale and deed-in-lieu process by providing a standard process flow, minimum performance timeframes, and standard documentation. 2. Home Price Decline Protection Incentives will provide lenders additional incentives for modifications in areas where home price declines have been most severe and there is concern that the market has yet to bottom out. The program will provide cash payments to lenders based on the rate of recent home price declines in a local housing market, as well as the average cost of a home in that market. The incentive payments on all modified homes will help cover the incremental collateral loss on those modifications that do not succeed. Treasury also released a progress report on MHA. According to the report, since MHA was announced in early March, 14 servicers, including the nation’s five largest, had signed contracts and begun modifications under MHA. The servicers had extended offers on over 55,000 trial modifications and mailed over 300,000 letters with information about trial modifications to troubled borrowers. E. PUBLIC-PRIVATE INVESTMENT PROGRAM (PPIP) jbell on PROD1PC69 with REPORTS On June 3, 2009, the FDIC announced that the June pilot auction of illiquid bank assets under the Legacy Loans Program (LLP), one component of the Administration’s two-part Public-Private Investment Program (PPIP), would be postponed. According to the FDIC, the auction was postponed because many banks have been able to raise new capital without having to contemplate selling bad assets through the LLP. The FDIC did not state when the postponed auction would take place. A pilot auction for receivership assets, those assets retained by the FDIC from failed banks, is scheduled to take place in July. VerDate Nov 24 2008 04:20 Jun 18, 2009 Jkt 050104 PO 00000 Frm 00125 Fmt 6602 Sfmt 6602 E:\HR\OC\A104.XXX A104 120 F. CPP MONTHLY LENDING REPORT Treasury released its first CPP Monthly Lending Report, a survey of all CPP participants designed to provide insight into their lending activities. The report captures three data points on a monthly basis: average outstanding balances of consumer loans, commercial loans, and total loans from all CPP participants. This first report includes data from 500 banks from February 2009 and March 2009. The report shows that the total average outstanding loans for all CPP participants were $5,279 billion in February 2009 and $5,237 billion in March 2009. The CPP Monthly Lending Report joins the Monthly Lending and Intermediation Snapshot of the top 21 CPP participants (launched in January) as Treasury’s primary sources of public data on lending trends and loans outstanding from CPP institutions. G. REPAYMENT OF TARP FUNDS On June 1, 2009, the Federal Reserve Board released an outline of the criteria it will use to evaluate applications to redeem Treasury capital from the 19 BHCs that participated in SCAP. The Board’s primary requirements for approval are a demonstration on the part of the BHC that it can access the long-term debt markets without reliance on a guarantee from the FDIC and the ability to successfully access public equity markets. Among other things, a BHC must also demonstrate the ability to maintain certain minimum capital levels and to serve as a source of financial and managerial strength and support to its subsidiary banks. Redemption approvals for an initial set of BHCs are expected to be announced the week of June 8. Applications will be evaluated periodically thereafter. H. ADMINISTRATION PROPOSAL ON REGULATING OVER-THE-COUNTER (OTC) DERIVATIVES jbell on PROD1PC69 with REPORTS On May 13, 2009, the Obama Administration announced its proposal for a comprehensive regulatory framework to cover all OTC derivatives. In a letter to Congress, Secretary Geithner identified the four broad objectives of the proposal: (1) preventing activities in derivatives markets from posing risk to the financial system; (2) promoting the efficiency and transparency of those markets; (3) preventing market manipulation, fraud, and other market abuses; and (4) ensuring that OTC derivatives are not marketed inappropriately to unsophisticated investors. The proposal requires legislative action to amend the Commodity Exchange Act and enhance the regulatory authority of the Commodity Futures Trading Commission (CFTC) and the Securities and Exchange Commission (SEC). Under the proposal, a new regulatory regime of OTC derivatives would require the clearing of all standardized OTC derivatives through regulated central counterparties, enhanced supervision and regulation of firms who deal in OTC derivatives by the CFTC and the SEC, and stricter recordkeeping and recording requirements, including the movement of all standardized trades onto regulated exchanges and regulated electronic execution systems. VerDate Nov 24 2008 04:20 Jun 18, 2009 Jkt 050104 PO 00000 Frm 00126 Fmt 6602 Sfmt 6602 E:\HR\OC\A104.XXX A104 121 I. METRICS The Panel’s April oversight report 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. The Panel’s May oversight report described some significant movement that had occurred in a few of the indicators in the time between the Panel’s April and May reports. This report highlights changes that have occurred in several indicators since the release of the Panel’s May report. • Interest Rate Spreads. Several key interest rate spreads have dropped significantly in recent weeks, most notably the 3-month and 1-month LIBOR–OIS spreads and the TED spread. The Fed attributes the moderation of many of these spreads to its lending programs as well as to the somewhat improved general economic outlook.212 FIGURE 7: INTEREST RATE SPREADS Current spread (as of 6/8/09) Indicator 3-Month LIBOR–OIS Spread 213 ......................................................................................... 1-Month LIBOR–OIS Spread 214 ......................................................................................... TED Spread 215 (in basis points) ...................................................................................... Conventional Mortgage Rate Spread 216 ........................................................................... Corporate AAA Bond Spread 217 ........................................................................................ Corporate BAA Bond Spread 218 ........................................................................................ Overnight AA Asset-backed Commercial Paper Interest Rate Spread 219 ........................ Overnight A2/P2 Nonfinancial Commercial Paper Interest Rate Spread 220 .................... Percent change since last report (5/7/09) ¥45.06 ¥45.02 ¥38.67 ¥6.55 ¥15.25 ¥21.51 ¥35.71 ¥23.81 0.41 ¥0.10 47.76 1.57 2.00 4.05 0.18 0.32 213 3-Mo LIBOR–OIS Spread, Bloomberg (online at www.bloomberg.com/apps/quote?ticker=.LOIS3:IND) (accessed June 8, 2009). LIBOR–OIS Spread, Bloomberg (online at www.bloomberg.com/apps/quote?ticker=.LOIS1:IND) (accessed June 8, 2009). Spread, Bloomberg (online at www.bloomberg.com/apps/quote?ticker=.TEDSP:IND) (accessed June 8, 2009). 216 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/Weeklyl Thursdayl /H15l MORTGl NA.txt) (accessed June 8, 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/Weeklyl Fridayl /H15l TCMNOMl Y10.txt) (accessed June 8, 2009) (hereinafter ‘‘Fed H.15 10-Year Treasuries’’). 217 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/Weeklyl Fridayl /H15l AAAl NA.txt) (accessed June 8, 2009); Fed H.15 10-Year Treasuries, supra note 216. 218 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/Weeklyl Fridayl /H15l BAAl NA.txt) (accessed June 8, 2009); Fed H.15 10-Year Treasuries, supra note 216. 219 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 June 8, 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 June 8, 2009) (hereinafter ‘‘Fed CP AA Nonfinancial Rate’’). 220 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 June 8, 2009); Fed CP AA Nonfinancial Rate, supra note 219. 214 1-Mo 215 TED • Commercial Paper Outstanding. Commercial paper outstanding, a rough measure of short-term business debt, is an indicator of the availability of credit for enterprises. Levels of financial, nonfinancial, and asset-backed commercial paper continued to de- jbell on PROD1PC69 with REPORTS 212 House Committee on the Budget, Testimony of Board of Governors of the Federal Reserve System Chairman Ben S. Bernanke, Challenges Facing the Economy: The View of the Federal Reserve, 111th Cong. (June 3, 2009) (online at budget.house.gov/hearings/2009/06.03.2009l Bernankel Testimony.pdf). VerDate Nov 24 2008 04:20 Jun 18, 2009 Jkt 050104 PO 00000 Frm 00127 Fmt 6602 Sfmt 6602 E:\HR\OC\A104.XXX A104 122 cline in May, indicating a sustained tightening of credit for businesses. FIGURE 8: COMMERCIAL PAPER OUTSTANDING Current level (as of 6/8/09) (dollars billions) Indicator Asset-Backed Commercial Paper Outstanding (seasonally adjusted) 221 .................. Financial Commercial Paper Outstanding (seasonally adjusted) 222 ......................... Nonfinancial Commercial Paper Outstanding (seasonally adjusted) 223 .................... Percent change since last report (5/7/09) ¥10.55 ¥10.80 ¥2.85 557.4 530.5 156.7 221 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 June 8, 2009). 222 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 June 8, 2009). 223 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 June 8, 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 increased across all categories of bank lending in March when compared to February; 224 however, Treasury notes that this could be due to the three additional business days in March or to a seasonal increase in loan activity in the closing days of a quarter. 225 A continued spike in refinancing activity is particularly noteworthy. Changes in average loan balances were relatively minor from February to March, with mortgage and other consumer loan balances up modestly and home equity, credit card, consumer and industrial loan, and commercial real estate loan balances down over the period.226 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. FIGURE 9: LENDING BY THE LARGEST TARP-RECIPIENT BANKS Most recent data (March 2009) (dollars in billions) Indicator Total Loan Originations ............................................................ Mortgage Refinancing ............................................................... Total Average Loan Balances ................................................... 220.2 53.1 3,390.2 Percent change since february 2009 Percent change since october 2008 30.80 11.04 ¥0.96 0.91 183.04 ¥0.95 • 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 jbell on PROD1PC69 with REPORTS 224 U.S. Department of the Treasury, Treasury Department Monthly Lending and Intermediation Snapshot Data for October 2008–March 2009 (May 15, 2009) (online at www.financialstability. gov/docs/surveys/Snapshotl Datal March%202009.xls) (hereinafter ‘‘Treasury Snapshot March Summary Data’’). 225 U.S. Department of the Treasury, Treasury Department Monthly Lending and Intermediation Snapshot: March Summary Analysis (May 15, 2009) (online at www.financialstability.gov/ docs/surveys/SnapshotAnalysisMarch2009.pdf) (hereinafter ‘‘Treasury March Snapshot’’). 226 Id. VerDate Nov 24 2008 04:20 Jun 18, 2009 Jkt 050104 PO 00000 Frm 00128 Fmt 6602 Sfmt 6602 E:\HR\OC\A104.XXX A104 123 outstanding for large and small domestic banks have remained largely flat over the past month, with both falling slightly.227 However, while total loans and leases outstanding at large domestic banks have dropped by over three percent since EESA was enacted, total loans and leases outstanding at small domestic banks have increased by 1.37 percent over that time period.228 FIGURE 10: LOANS AND LEASES OUTSTANDING Current level (as of 6/8/09) (dollars in billions) Indicator Large Domestic Banks—Total Loans and Leases ......... Small Domestic Banks—Total Loans and Leases ......... Percent change since last report (5/7/09) Percent change since ESSA signed into law (10/3/08) ¥0.13 ¥0.14 3984.8 2480.3 ¥3.32 1.37 • Housing Indicators. Foreclosure filings stayed relatively level from March to April, increasing by a modest 0.25 percent, while remaining markedly above the level of last October. Housing prices, as illustrated by the S&P/Case-Shiller Composite 20 Index, continued to dip in March. The index is down over ten percent since October 2008. FIGURE 11: HOUSING INDICATORS Percent change from data available at time of last report (5/7/09) Most recent monthly data Indicator Monthly Foreclosure Filings 229 ................................................. Housing Prices—S&P/Case-Shiller Composite 20 Index 230 .... 342,038 141.35 Percent change since October 2008 0.25 ¥2.17 22.35 ¥10.02 229 RealtyTrac, Foreclosure Activity Press Releases (online at www.realtytrac.com//ContentManagement/PressRelease.aspx) (accessed June 8, 2009). 230 Standard & Poor’s, S&P/Case-Shiller Home Price Indices (Instrument: Seasonally Adjusted Composite 20 Index) (online at www2.standardandpoors.com/spf/pdf/index/SAl CSHomePricel Historyl 052619.xls) (accessed June 8, 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 June 3, 2009; and (2) an update of the full federal resource commitment as of June 3, 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 Board loans for facilities jbell on PROD1PC69 with REPORTS 227 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 June 8, 2009). 228 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 June 8, 2009). VerDate Nov 24 2008 04:20 Jun 18, 2009 Jkt 050104 PO 00000 Frm 00129 Fmt 6602 Sfmt 6602 E:\HR\OC\A104.XXX A104 124 designed to restart secondary securitization markets, Treasury has committed to spend $645.8 billion, leaving $54.2 billion available for new programs or other needs.231 Of the $645.8 billion that Treasury has committed to spend, $434.7 billion has already been allocated and counted against the statutory $700 billion limit.232 This includes purchases of preferred stock, warrants and/or debt obligations under the CPP, TIP, SSFI Program, and AIFP initiatives, a $20 billion loan to TALF LLC, the special purpose vehicle used to guarantee Federal Reserve Board TALF loans, and the $5 billion Citigroup asset guarantee already exchanged for a guarantee fee composed of additional preferred stock and warrants.233 Additionally, Treasury has allocated $15.2 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 TARP reach $450 billion. b. Income: Dividends and Repayments Secretary Geithner’s testimony to the Senate Banking Committee on May 20 included Treasury’s estimate of TARP funds remaining for allocation as of May 18. Treasury provided two figures, $98.7 billion and $123.7 billion,234 the later including an estimated $25 billion in CPP investments that Treasury expects recipients to repay or liquidate.235 Although describing this estimate as ‘‘conservative,’’ neither Secretary Geithner nor Treasury has identified the institutions that will supply these anticipated repayments, when they will supply these repayments, or any methodological basis underpinning this figure. The total amount of CPP repayments currently stands at $1.772 billion.236 In addition, Treasury’s investment in preferred stock 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.237 Treasury has not yet begun to officially report dividend payments on its transaction reports. c. TARP Accounting as of June 3, 2009 FIGURE 12: TARP ACCOUNTING (AS OF JUNE 3, 2009) [Dollars in billions] Announced funding TARP Initiative Total ............................................................................... CPP ........................................................................ 645.8 218.0 Purchase price Repayments Dividend income 238 434.7 239 1.8 240 6.2 199.4 1.8 4.8 jbell on PROD1PC69 with REPORTS 231 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 1, at 115(a)–(b). 232 U.S Department of the Treasury, Seventh Tranche Report to Congress (June 3, 2009) (online at www.financialstability.gov/docs/TrancheReports/7thl Tranche-Report-Appendix.pdf). 233 June 5 TARP Transactions Report, supra note 13. 234 After these figures were provided to the Senate Committee on Banking, Housing, and Urban Affairs, Treasury allocated an additional $44.5 billion of TARP funds in loans to GM, GMAC, and Chrysler. Including these allocations would bring Treasury’s estimates to $54.2 billion and $79.2 billion, respectively. 235 Geithner Testimony, supra note 98. 236 June 5 TARP Transactions Report, supra note 13. 237 See, e.g., U.S. Department of the Treasury, Bank of New York Mellon, Securities Purchase Agreement: Standard Terms, at A–1 (Oct. 28, 2008) (Annex A). VerDate Nov 24 2008 04:20 Jun 18, 2009 Jkt 050104 PO 00000 Frm 00130 Fmt 6602 Sfmt 6602 E:\HR\OC\A104.XXX A104 125 FIGURE 12: TARP ACCOUNTING (AS OF JUNE 3, 2009)—Continued [Dollars in billions] Announced funding TARP Initiative TIP ......................................................................... SSFI Program ......................................................... AIFP ....................................................................... AGP ........................................................................ CAP ........................................................................ TALF ....................................................................... PPIP ....................................................................... Supplier Support Program ..................................... Unlocking SBA Lending ......................................... HAMP ..................................................................... 238 See June 5 239 See June 5 240 As of June Purchase price 40.0 70.0 80.3 12.5 TBD 80.0 75.0 5.0 15.0 50.0 Dividend income Repayments 40.0 69.8 80.3 5.0 0.0 20.0 0.0 5.0 0.0 15.2 0 0 0 0 0 0 0 0 0 0 1.1 0 0.2 0.1 0 0 0 0 0 0 TARP Transactions Report, supra note 13. TARP Transactions Report, supra note 13. 3, 2009. This information was passed on by Treasury officials to Panel staff. 2. OTHER FINANCIAL STABILITY EFFORTS a. Federal Reserve Board, FDIC, and Other Programs In addition to the more direct expenditures Treasury has undertaken through 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 PPIF Legacy Loans or asset guarantees for Citigroup and Bank of America, or operate in tandem with Treasury programs, such as the interaction between PPIP and TALF. Other programs, like the Federal Reserve Board’s extension of credit through its § 13(3) facilities and special purpose vehicles or the FDIC’s Temporary Liquidity Guarantee Program, stand independent of TARP and seek to accomplish different goals. b. Total Financial Stability Resources as of June 3, 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 13: FEDERAL GOVERNMENT FINANCIAL STABILITY EFFORT (AS OF JUNE 3, 2009) Federal Reserve Board Treasury (TARP) Program FDIC Total VerDate Nov 24 2008 700 466.4 86.9 92.5 54.2 2,440.7 0 2123.7 317 0 1,427.4 29.5 0 1,397.9 0 243 4,568.1 AIG .................................................................................................. Outlays .................................................................................. jbell on PROD1PC69 with REPORTS Total ............................................................................................... Outlays 241 ............................................................................. Loans ..................................................................................... Guarantees 242 ....................................................................... Uncommitted TARP Funds .................................................... 70 70 245 112.5 0 0 182.5 70 04:20 Jun 18, 2009 Jkt 050104 PO 00000 Frm 00131 Fmt 6602 Sfmt 6602 0 E:\HR\OC\A104.XXX A104 495.9 2,210.6 1,807.4 54.2 126 FIGURE 13: FEDERAL GOVERNMENT FINANCIAL STABILITY EFFORT (AS OF JUNE 3, 2009)— Continued Federal Reserve Board Treasury (TARP) Program FDIC Total 0 0 246 112.5 0 0 0 112.5 0 52.5 87.2 0 0 249 87.2 2.5 0 0 250 2.5 142.2 45 0 97.2 229.8 0 0 253 229.8 10 0 0 254 10 289.8 45 0 244.8 0 0 0 0 0 0 0 0 0 0 168 168 0 0 Capital Assistance Program .......................................................... TBD TBD TBD 256 TBD TALF ................................................................................................ Outlays .................................................................................. Loans ..................................................................................... Guarantees ............................................................................ 80 0 0 257 80 720 0 0 0 0 0 0 800 0 720 80 50 50 0 0 0 0 0 0 600 0 0 260 600 650 50 0 600 25 0 0 0 0 0 0 0 0 25 10 15 0 0 0 0 0 0 0 0 0 264 50 0 0 0 0 0 0 0 0 80.3 13.4 66.9 0 0 0 0 0 0 0 0 0 5 5 0 0 0 0 0 0 0 0 0 0 0 0 15 15 0 0 Temporary Liquidity Guarantee Program ....................................... Outlays .................................................................................. Loans ..................................................................................... Guarantees ............................................................................ 0 0 0 0 0 0 0 0 785.4 0 0 269 785.4 785.4 0 0 785.4 Deposit Insurance Fund ................................................................. Outlays .................................................................................. 0 0 0 0 29.5 270 29.5 29.5 29.5 Loans ..................................................................................... Guarantees ............................................................................ Bank of America ............................................................................ Outlays .................................................................................. Loans ..................................................................................... Guarantees ............................................................................ Citigroup ........................................................................................ Outlays .................................................................................. Loans ..................................................................................... Guarantees ............................................................................ Capital Purchase Program (Other) ................................................ Outlays .................................................................................. Loans ..................................................................................... Guarantees ............................................................................ PPIF 247 45 0 248 7.5 50 251 45 0 252 5 168 255 168 (Loans) 259 .............................................................................. Outlays .................................................................................. Loans ..................................................................................... Guarantees ............................................................................ PPIF (Securities) 261 ....................................................................... Outlays .................................................................................. Loans ..................................................................................... Guarantees ............................................................................ Home Affordable Modification Program ......................................... Outlays .................................................................................. Loans ..................................................................................... Guarantees ............................................................................ Automotive Industry Financing Plan .............................................. Outlays .................................................................................. Loans ..................................................................................... Guarantees ............................................................................ 262 10 15 0 50 263 50 0 0 80.3 265 13.4 266 66.9 0 Auto Supplier Support Program ..................................................... Outlays .................................................................................. Loans ..................................................................................... Guarantees ............................................................................ jbell on PROD1PC69 with REPORTS Unlocking SBA Lending .................................................................. Outlays .................................................................................. Loans ..................................................................................... Guarantees ............................................................................ VerDate Nov 24 2008 04:20 Jun 18, 2009 Jkt 050104 PO 00000 Frm 00132 Fmt 6602 5 267 5 0 0 15 268 15 Sfmt 6602 258 720 E:\HR\OC\A104.XXX A104 50 0 0 127 FIGURE 13: FEDERAL GOVERNMENT FINANCIAL STABILITY EFFORT (AS OF JUNE 3, 2009)— Continued Federal Reserve Board Treasury (TARP) Program Loans ..................................................................................... Guarantees ............................................................................ 0 0 Other Federal Reserve Board Credit Expansion ............................ Outlays .................................................................................. Loans ..................................................................................... Guarantees ............................................................................ 0 0 0 0 Uncommitted TARP Funds ............................................................. 272 54.2 FDIC Total 0 0 0 0 0 0 1,291.2 0 0 0 0 0 0 1,291.2 0 1,291.2 0 0 0 54.2 271 1,291.2 241 The jbell on PROD1PC69 with REPORTS 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 EESA § 123 are recorded on a ‘‘credit reform’’ basis. 242 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. 243 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) (online at finance.senate.gov/hearings/testimony/2009test/033109nbtest.pdf). 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 Board credit extensions outside of the TALF or FDIC guarantees under the Temporary Liquidity Guarantee Program and sets the maximum Federal Reserve Board guarantees under the TALF at $1 trillion. 244 This number includes both investments in AIG under the SSFI program: a $40 billion investment made on November 25, 2008, and a $30 billion investment made on April 17, 2009 (less a reduction of $165 million representing bonuses paid to AIG Financial Products employees). June 5 TARP Transactions Report, supra note 13. 245 The value of loans extended by the Federal Reserve Board to AIG has been calculated according to a different methodology from that used in previous Panel reports. Previously, this figure reflected the current balance sheet value of credit extended to AIG and the Maiden Lane II and III SPVs. The Panel has replaced this measurement of government exposure with the maximum amounts the Federal Reserve Board is authorized to loan, as described below. This number represents the total credit line the Federal Reserve Board is authorized to extend to AIG ($60 billion) and the maximum amount that the FRBNY is authorized to lend to the Maiden Lane II LLC ($22.5 billion) and Maiden Lane III LLC ($30 billion) special purpose vehicles. See Board of Governors of the Federal Reserve System, Federal Reserve Board and Treasury Department Announce Restructuring of Financial Support to AIG (Nov. 10, 2008) (online at www.federalreserve.gov/newsevents/press/other/20081110a.htm). 246 As of June 5, the value of loans outstanding to AIG stands at $84 billion. This includes $43 billion in loans directly provided to AIG as well as $41 billion in the outstanding principal amount of loans extended to special purpose vehicles (approximately $18 billion to Maiden Lane II and $23 billion to Maiden Lane III). See Board of Governors of the Federal Reserve System, Federal Reserve Statistical Release H.4.1: Factors Affecting Reserve Balances (June 4, 2009) (online at www.federalreserve.gov/releases/h41/Current/) (hereinafter ‘‘Fed Balance Sheet June 4’’). 247 June 5 TARP Transactions Report, supra note 13. 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. 248 Bank of America Asset Guarantee, supra note 41 (granting a $118 billion pool of Bank of America assets a 90 percent federal guarantee of all losses over $10 billion, the first $10 billion in federal liability to be split 75/25 between Treasury and the FDIC and the remaining federal liability to be borne by the Federal Reserve Board). 249 Bank of America Asset Guarantee, supra note 41. 250 Bank of America Asset Guarantee, supra note 41. 251 June 5 TARP Transactions Report, supra note 13. 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. 252 Citigroup Asset Guarantee, supra note 41 (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 Final Citi Guarantee Terms, supra note 41 (reducing the size of the asset pool from $306 billion to $301 billion). 253 Citigroup Asset Guarantee, supra note 41. 254 Citigroup Asset Guarantee, supra note 41. 255 This figure represents the $218 billion Treasury has anticipated spending under the CPP, minus the $50 billion investments 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. 256 Funding levels for the CAP have not yet been announced but will likely constitute a significant portion of the remaining $54.2 billion of TARP funds. 257 Geithner Testimony, supra note 98, at 1; June 5 TARP Transactions Report, supra note 13. 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. 258 This number derives from the unofficial 1:10 ratio of the value of Treasury loan guarantees to the value of Federal Reserve Board loans under the TALF. See Financial Stability Plan Fact Sheet, supra note 26 (describing the initial $20 billion Treasury contribution tied to $200 billion in Federal Reserve Board loans and announcing potential expansion to a $100 billion Treasury contribution tied to $1 trillion in Federal Reserve Board 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. 259 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. However, the FDIC recently announced that it was postponing the implementation of the Legacy Loans program. See FDIC Loans Program Statement, supra note 25. It is not yet clear whether this postponement will affect the allocation of TARP funds for the LLP. 260 U.S. Department of the Treasury, Fact Sheet: Public-Private Investment Program, at 2 (Mar. 23, 2009) (online at www.treas.gov/press/releases/reports/ppipl factl sheet.pdf) (hereinafter ‘‘Treasury PPIP Fact Sheet’’) (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 $50 billion), the amount of FDIC loan guarantees will be reduced proportionally. VerDate Nov 24 2008 04:20 Jun 18, 2009 Jkt 050104 PO 00000 Frm 00133 Fmt 6602 Sfmt 6602 E:\HR\OC\A104.XXX A104 128 jbell on PROD1PC69 with REPORTS 261 In previous reports, the Panel projected that Treasury would split the $100 billion allocated to PPIP evenly between legacy loans and legacy securities. However, it now appears that Treasury will allocate $25 billion to the TALF for legacy securities, implying that only $25 billion of TARP funds will be directly allocated to PPIF Legacy Securities. 262 Treasury PPIP Fact Sheet, supra note 260, 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. 263 Government Accountability Office, Troubled Asset Relief Program: March 2009 Status of Efforts to Address Transparency and Accountability Issues, at 55 (Mar. 31, 2009) (GAO09/504) (online at www.gao.gov/new.items/d09504.pdf); Geithner Testimony, supra note 98. Of the $50 billion in announced TARP funding for this program, only $15.2 billion has been allocated as of June 3, and no funds have yet been disbursed. See June 5 TARP Transactions Report, supra note 13. 264 Fannie Mae and Freddie Mac, government-sponsored entities (GSEs) that were placed in conservatorship of the Federal Housing Finance 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/housingl factl sheet.pdf). 265 June 5 TARP Transactions Report, supra note 13. This figure represents Treasury’s equity stake in GMAC. 266 June 5 TARP Transactions Report, supra note 13. Treasury’s initial allocation to GM was effectively a loan. Under the terms of the company’s pending bankruptcy proceedings the $49.9 billion in debt obligations to Treasury will be converted to a 60 percent stake in the restructured company and $8.8 billion in debt and preferred stock. See U.S. Department of the Treasury, Fact Sheet: Obama Administration Auto Restructing Initiatives, General Motors Restructing (May 31, 2009) (online at www.financialstability.gov/latest/05312009l gm-factsheet.html). It is less clear how Treasury’s $17 billion in loans to Chrysler will be affected by its bankruptcy proceedings. It appears that approximately $9 billion lent before the Chrysler bankruptcy will be converted to an eight percent equity stake, while $8 billion will be retained as first-lien debt. See U.S. Department of the Treasury, Obama Administration Auto Restructuring Initiative, Chrysler-Fiat Alliance (Apr. 30, 2009) (online at www.financialstability.gov/latest/tgl043009.html). 267 June 5 TARP Transactions Report, supra note 13. 268 Geithner Testimony, supra note 98, at 15. 269 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. $334.6 billion of debt subject to the guarantee has been issued to date, which represents about 43 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 20, 2009) (online at www.fdic.gov/ regulations/resources/TLGP/totall issuance4–09.html). 270 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. 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/cfol reportl 4qtrl 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/cfol reportl 3rdqtrl 08/income.html). As of June 5, 2009, the FDIC had not yet released first quarter 2009 data. 271 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), the value of 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 June 4, supra note 246. The level of Federal Reserve Board lending under these facilities will fluctuate in response to market conditions and independent of any federal policy decisions. This calculation is slightly changed from previous reports. The Panel previously looked at the balance sheet value of Federal Reserve Board holdings in Maiden Lane I LLC and the Commercial Paper Funding Facility; in this report, the Panel calculates this figure as the outstanding principal amount of the loans extended to these SPVs. 272 One potential use of uncommitted funds is Treasury’s obligation to reimburse the Exchange Stabilization Fund (ESF), currently valued at $50.5 billion. See U.S. Department of Treasury, Exchange Stabilization Fund, Statement of Financial Position, as of April 30, 2009 (online at www.ustreas.gov/offices/international-affairs/esf/esf-monthly-statement.pdf) (accessed June 5, 2009). Treasury must reimburse any use of the fund to guarantee money market mutual funds from TARP money. See EESA, supra note 1, at § 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. EESA § 131 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). VerDate Nov 24 2008 04:20 Jun 18, 2009 Jkt 050104 PO 00000 Frm 00134 Fmt 6602 Sfmt 6602 E:\HR\OC\A104.XXX A104 129 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 six 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 May oversight report, the following developments pertaining to the Panel’s oversight of TARP took place: • The Panel held a hearing in New York City on May 28 entitled, ‘‘The Impact of Economic Recovery Efforts on Corporate and Commercial Real Estate Lending.’’ Witnesses representing banks, businesses, and the Federal Reserve Bank of New York discussed the impact of the financial crisis on credit availability for mid-market businesses that rely on commercial and industrial loans and commercial real estate loans to operate. Written testimony and video from the hearing can be found on the Panel’s website at http://cop.senate.gov/hearings/library/hearing-052809-newyork.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 the methodology and results of the stress tests, lending data from CPP participants, and home ownership programs. • The Panel and Treasury have reached agreement on a protocol for Treasury’s production of documents to the Panel. Treasury has stated that it will begin production of requested documents shortly, but no documents have been produced pursuant to this protocol as of the date of this report. The Panel is in the process of negotiating a similar protocol with the Federal Reserve Board. Upcoming Reports and Hearings jbell on PROD1PC69 with REPORTS • The Panel will release its next oversight report in July. 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 terms of repayment of TARP money, including the repurchasing of warrants. • The Panel is currently working with Treasury to find a date for Secretary Geithner to make his second appearance at a Panel oversight hearing in June. • The Panel is planning a field hearing in Detroit in early July to hear testimony on Treasury’s administration of the Automotive Industry Financing Program. • On May 20, 2009, the President signed into law the Helping Families Save Their Homes Act of 2009 (P.L. 111–22). Section 501 of the law requires the Panel to submit a special report to Congress that 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 by recipients of TARP assistance. To inform its composition of this report, the Panel is planning a field hearing on farm credit in the coming weeks. VerDate Nov 24 2008 04:20 Jun 18, 2009 Jkt 050104 PO 00000 Frm 00135 Fmt 6602 Sfmt 6602 E:\HR\OC\A104.XXX A104 130 SECTION SIX: ABOUT THE CONGRESSIONAL OVERSIGHT PANEL jbell on PROD1PC69 with REPORTS 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. VerDate Nov 24 2008 04:20 Jun 18, 2009 Jkt 050104 PO 00000 Frm 00136 Fmt 6602 Sfmt 6602 E:\HR\OC\A104.XXX A104 131 VerDate Nov 24 2008 04:20 Jun 18, 2009 Jkt 050104 PO 00000 Frm 00137 Fmt 6602 Sfmt 6602 E:\HR\OC\A104.XXX A104 Insert offset folio 156 here 50104A.060 jbell on PROD1PC69 with REPORTS APPENDIX I: LETTER FROM CHAIR ELIZABETH WARREN TO FEDERAL RESERVE CHAIRMAN BEN BERNANKE REGARDING THE CAPITAL ASSISTANCE PROGRAM, DATED MAY 11, 2009 VerDate Nov 24 2008 04:20 Jun 18, 2009 Jkt 050104 PO 00000 Frm 00138 Fmt 6602 Sfmt 6602 E:\HR\OC\A104.XXX A104 Insert offset folio 157 here 50104A.061 jbell on PROD1PC69 with REPORTS 132 VerDate Nov 24 2008 04:20 Jun 18, 2009 Jkt 050104 PO 00000 Frm 00139 Fmt 6602 Sfmt 6602 E:\HR\OC\A104.XXX A104 Insert offset folio 158 here 50104A.062 jbell on PROD1PC69 with REPORTS 133 VerDate Nov 24 2008 04:20 Jun 18, 2009 Jkt 050104 PO 00000 Frm 00140 Fmt 6602 Sfmt 6602 E:\HR\OC\A104.XXX A104 Insert offset folio 159 here 50104A.063 jbell on PROD1PC69 with REPORTS 134 VerDate Nov 24 2008 04:20 Jun 18, 2009 Jkt 050104 PO 00000 Frm 00141 Fmt 6602 Sfmt 6602 E:\HR\OC\A104.XXX A104 Insert offset folio 160 here 50104A.064 jbell on PROD1PC69 with REPORTS 135 VerDate Nov 24 2008 04:20 Jun 18, 2009 Jkt 050104 PO 00000 Frm 00142 Fmt 6602 Sfmt 6602 E:\HR\OC\A104.XXX A104 Insert offset folio 161 here 50104A.065 jbell on PROD1PC69 with REPORTS 136 137 VerDate Nov 24 2008 04:20 Jun 18, 2009 Jkt 050104 PO 00000 Frm 00143 Fmt 6602 Sfmt 6602 E:\HR\OC\A104.XXX A104 Insert offset folio 163 here 50104A.066 jbell on PROD1PC69 with REPORTS APPENDIX II: LETTER FROM CHAIR ELIZABETH WARREN TO SECRETARY TIMOTHY GEITHNER REGARDING THE POSSIBILITY OF THE SECRETARY APPEARING BEFORE A PANEL HEARING IN JUNE, DATED MAY 12, 2009 138 VerDate Nov 24 2008 04:20 Jun 18, 2009 Jkt 050104 PO 00000 Frm 00144 Fmt 6602 Sfmt 6602 E:\HR\OC\A104.XXX A104 Insert offset folio 165 here 50104A.067 jbell on PROD1PC69 with REPORTS APPENDIX III: LETTER FROM CHAIR ELIZABETH WARREN TO SECRETARY TIMOTHY GEITHNER AND FEDERAL RESERVE CHAIRMAN BEN BERNANKE REGARDING THE ACQUISITION OF MERRILL LYNCH BY BANK OF AMERICA, DATED MAY 19, 2009 VerDate Nov 24 2008 04:20 Jun 18, 2009 Jkt 050104 PO 00000 Frm 00145 Fmt 6602 Sfmt 6602 E:\HR\OC\A104.XXX A104 Insert offset folio 166 here 50104A.068 jbell on PROD1PC69 with REPORTS 139 140 VerDate Nov 24 2008 04:20 Jun 18, 2009 Jkt 050104 PO 00000 Frm 00146 Fmt 6602 Sfmt 6602 E:\HR\OC\A104.XXX A104 Insert offset folio 168 here 50104A.069 jbell on PROD1PC69 with REPORTS APPENDIX IV: LETTER FROM CHAIR ELIZABETH WARREN TO SECRETARY TIMOTHY GIETHNER REGARDING THE TEMPORARY GUARANTEE PROGRAM, DATED MAY 26, 2009 VerDate Nov 24 2008 04:20 Jun 18, 2009 Jkt 050104 PO 00000 Frm 00147 Fmt 6602 Sfmt 6602 E:\HR\OC\A104.XXX A104 Insert offset folio 169 here 50104A.070 jbell on PROD1PC69 with REPORTS 141 VerDate Nov 24 2008 04:20 Jun 18, 2009 Jkt 050104 PO 00000 Frm 00148 Fmt 6602 Sfmt 6602 E:\HR\OC\A104.XXX A104 Insert offset folio 170/200 here 50104A.071 jbell on PROD1PC69 with REPORTS 142