President Bush Signs the Emergency Economic Stabilization Act of 2008
By: KAREN L. GRANDSTRAND & KARLA L. REYERSON
October 3, 2008
On October 3, 2008, President Bush signed into law the Emergency Economic Stabilization Act of 2008 (“EESA”), a measure principally designed to allow the U.S. Treasury and other government agencies to take action to restore liquidity and stability to the U.S. financial system.
The passage of EESA was initially prompted by a proposal that U.S. Treasury Secretary Hank Paulson submitted to Congress seeking permission to create a program under which the Treasury would purchase up to $700 billion of troubled assets that are currently weighing down the balance sheets of U.S. financial institutions.
These troubled assets largely consist of mortgages that are in danger of foreclosure and complex securities that are backed by pools of more troubled mortgages. Current accounting laws require that financial institutions reflect the current market value of these assets on their balance sheets. But since the assets are not performing, the market for these securities has basically dried up. Financial institutions are no longer sure what they are worth and in many instances have been forced to mark them down to virtual fire-sale prices. The markdowns force institutions to recognize huge losses up-front instead of over time.
To cover their losses, financial institutions have had to dip into their capital, which has left very little money to lend to businesses, most of which rely on credit in order to function; and the credit that is available is becoming more and more expensive. The concern is that soon, if not already, the credit crunch will affect the ability of companies to meet payroll and the availability of consumer credit for homes, vehicles, and education.
Secretary Paulson’s strategy is to create a market for the troubled assets by offering to purchase them from financial institutions. The idea is that the current fire-sale price of these assets is lower than the value that the government could realize on them by holding on to them until the real estate market improves. By purchasing these troubled mortgages and mortgage-backed securities, the Treasury hopes to free up financial institutions to begin lending again. And by holding these assets until the real estate market improves, the Treasury hopes to recoup the costs of purchasing them and perhaps even make a profit.
The difficulties of the plan lie in determining the best mechanisms by which to price the assets, execute the sales, efficiently manage the complex securities, and resell them in the future.
Secretary Paulson’s proposal contained few details on the logistics of the program in order to provide maximum flexibility for the Treasury to create efficient purchase mechanisms that are able to react to changing market conditions. The proposal also did not contain oversight provisions.
Many in Congress felt that any plan would need to include mechanisms to assess the effectiveness of the program and to rein in any abuse of power. Also, some members of Congress had additional theories on how best to respond to the credit crisis and felt the confidence crisis needed more attention.
After a short but intense period of redrafting and debate, Congress passed EESA, which continues to include Secretary Paulson’s purchase plan but also includes other features designed to attack the nation’s financial problems from several directions, while closely monitoring the success of these mechanisms and attempting to provide some protection to taxpayers and consumers.
Purchasing Troubled Assets
The name given to the Treasury’s asset purchase plan is the Troubled Assets Relief Program (“TARP”). As with Secretary Paulson’s original proposal, the TARP provisions provide little detail regarding the specific manner in which the Treasury should execute the program. It generally authorizes the Treasury, via a newly established Office of Financial Stability, to purchase “residential or commercial mortgages and any securities, obligations, or other instruments that are based on or related to such mortgages” and that were originated on or before March 14, 2008. TARP allows the Secretary to purchase, hold and sell the assets and to issue obligations for future purchases.
The Treasury can purchase such assets from any financial institution by whatever means, and on whatever terms, the Secretary deems appropriate. The Secretary is also given discretion to appoint financial institutions as financial agents of the federal government to assist in the management of the assets and to perform other reasonable duties.
The Secretary is required to issue guidelines related to determining which assets to purchase, pricing the assets, executing the purchases, and selecting financial agents to assist in the process. The Secretary may not allow any financial institution to sell an asset at a profit.
Taxpayers and lawmakers initially questioned whether Secretary Paulson needed all of the funds requested in his proposal. The final version of EESA does allow the Secretary to procure up to $700 billion to fund the program, but not all at once, and not without some strings attached.
Upon enactment of EESA, the Secretary has immediate access to up to $250 billion. In order to receive the next $100 billion, the President must submit to Congress a written certification that the extra money is needed. Finally, the last $350 billion is only available after the President sends a report to Congress detailing the Secretary’s plan for the additional funds. Upon receipt of the report, Congress has fifteen days to pass a joint resolution blocking disbursement of the final installment, if it so chooses. If such a resolution is not passed within this fifteen-day period, the Secretary will receive the additional funds.
Lawmakers also focused on the need to ensure, to the extent possible, that taxpayers will receive a return on their investment. EESA responds to this concern first by directing the Secretary to use his authority under EESA “in a manner that will minimize any potential long-term negative impact on the taxpayer.”
The Secretary is required to hold the assets the Treasury acquires to maturity and until the market is optimal for sale of the asset at the best price possible. He is also ordered to encourage the private sector to participate in purchases of troubled assets and to invest in financial institutions.
The Treasury is to purchase troubled assets at the lowest price consistent with the Act and is encouraged to use mechanisms, such as auctions and reverse auctions, where appropriate. Where an auction or similar tool is not appropriate, assets may be purchased directly.
Notably, when the Treasury purchases troubled assets from financial institutions, it generally will receive more than just the assets. EESA requires that the Treasury also be given warrants for the right to receive nonvoting stock in the financial institution, or in some cases, a senior debt instrument. This is intended to provide taxpayers with a chance to earn money on equity appreciation in the financial institution or, if a debt instrument is acquired, a reasonable rate of interest on the debt owed.
Finally, in five years, the President is required to submit a legislative proposal to Congress to recoup any losses incurred under TARP from the financial industry. Any proceeds from the sales of troubled assets under TARP will go toward reduction of the public debt.
One of the main new features of the EESA is a provision requiring the Treasury to create a program whereby, instead of selling troubled assets to the Treasury, financial institutions may request that such assets be insured against potential loss. This provision was championed by a group of Republicans in the House of Representatives as a way of instilling confidence in the financial system while protecting taxpayers from losses.
Under the insurance program, participating financial institutions pay premiums that are intended to fund any losses the government incurs. While EESA requires the Treasury to create an insurance program, the Secretary is given discretion to decide whether to guarantee any particular assets. Therefore, the extent to which the insurance mechanism will be utilized is unknown.
Verifying the SEC’s Power to Suspend Mark-to-Market Accounting Requirements
Another new provision in the final version of EESA relates to the Securities and Exchange Commission (“SEC”) accounting rule that requires banks to value their assets at current market rates called “mark-to-market accounting.” As discussed above, fulfilling this requirement can be difficult where the market for a particular type of asset is dysfunctional or even nonexistent. Some have called for the mark-to-market rule to be suspended because it results in inaccurately low values being placed on assets, which hurts the balance sheets of financial institutions.
EESA does not suspend the rule; however, it does call for the SEC to study the effect of mark-to-market accounting on financial institutions and whether changes should be made. EESA also reaffirms the SEC’s authority to suspend the application of mark-to-market accounting as it deems necessary.
On September 30, 2008, while the EESA bill was still being debated, the SEC and the Financial Accounting Standards Board (“FASB”) released guidance related to mark-to-market accounting designed to clarify how it should be applied to illiquid assets. This guidance indicates that where the market is frozen or the transactions in the market are disorderly, institutions may use their own models to determine the fair value of an asset. The SEC and FASB indicated that additional guidance on this rule would be proposed soon.
Increasing FDIC Insurance Coverage
In order to bolster consumers’ confidence in the security of their bank deposits, EESA provides for a temporary increase in FDIC deposit insurance coverage from $100,000 to $250,000 through December 31, 2009. The law also allows the FDIC to borrow as much money from the Treasury as necessary to repay insured depositors if a bank fails. Banks benefit from this measure as well because it provides the additional coverage without raising the amount banks pay in FDIC insurance premiums and encourages people to keep their money in the bank.
Executive Compensation Limits
The new law places several limits on the compensation of executives whose financial institutions sell assets directly to the Treasury under TARP. First, senior executive officers, meaning the top five highest paid executives, may not be given compensation incentives to take unnecessary and excessive risks that threaten the value of the financial institution. Second, a senior executive officer must repay any bonus or incentive the financial institution paid based on statements of earnings, gains, or other criteria that are later found to be materially inaccurate. Third, the financial institution may not make golden parachute payments to senior executive officers.
In addition, any financial institution that sells an aggregate of more than $300 million in assets via auction (including any direct purchases) to the government may not enter into any new employment contract with a senior executive officer that provides a golden parachute in the event the officer is involuntarily terminated or the company goes bankrupt, becomes insolvent, or enters receivership.
EESA also makes several modifications to the Internal Revenue Code so that financial institutions selling assets to the government under TARP (where at least one of the sales is not a direct sale) in an amount that exceeds an aggregate of $300 million may not deduct more than $500,000 for any executive’s compensation in any tax year. Limits are also placed on deductions and other tax treatment for certain golden parachute payments made to executives. This provision applies to compensation of the Chief Executive Officer, the Chief Financial Officer, or anyone who is one of the top three most highly compensated employees for the financial institution.
Consumer Relief and Protection
EESA contains several provisions designed to minimize foreclosures on residential real estate mortgages. To the extent the Treasury and certain other federal agencies (such as the conservator of Fannie Mae and Freddie Mac) acquire assets secured by residential real estate, including multifamily housing, they are required to implement plans to maximize assistance to homeowners and minimize foreclosures.
The Secretary is required to consent to any reasonable request for loss mitigation that arises under an existing investment contract. These measures may include term extensions, rate reductions, principal write downs, and other measures.
While these foreclosure avoidance efforts do not extend to private mortgage loan servicers, the Treasury and other federal agencies holding mortgage-backed assets are required to encourage such private servicers to take advantage of the HOPE for Homeowners Program, which is designed to allow borrowers who are having difficulty making their payments to refinance into a more affordable mortgage through the Federal Housing Administration (“FHA”).
In addition to foreclosure mitigation efforts, EESA contains provisions designed to clamp down on false advertising and misrepresentations that cause people to believe their money is FDIC insured when it is not.
EESA, as enacted, provides judicial oversight of the Secretary’s actions, as well as creating oversight bodies specifically for the purpose of reviewing the work and success of the Secretary’s actions related to EESA.
First, the new Financial Stability Oversight Board (“FSOB”) will consist of the Chairman of the Board of Governors of the Federal Reserve System, the Director of the Federal Housing Finance Agency, the Chairman of the SEC, and the Secretary of the Department of Housing and Urban Development. FSOB’s purpose is to review the Secretary’s actions and policies under TARP and the insurance provisions and to monitor the effect of such actions on American families in preserving home ownership, stabilizing financial markets, and protecting taxpayers.
In addition, a Congressional Oversight Panel (“COP”) will be established to review the current state of the financial markets and the regulatory system and to submit reports to Congress. COP will have five members appointed by the majority and minority leaders of both houses. COP will also receive quarterly reports from FSOB.
EESA also creates the Office of the Special Inspector General for TARP. The Special Inspector General’s duty is to conduct, supervise, and coordinate audits and investigations of the purchase, management, and sale of assets by the Secretary under TARP and the insurance program. The Office of the Special Inspector General is required to report its findings to Congress.
The Secretary is also required to report to Congress every 30 days and at every $50 billion interval of commitments to purchase assets. The reports will include an overview of actions the Secretary has taken, information regarding the obligations incurred and expenditures made under the Act, a detailed financial statement, and other information.
The Comptroller General is charged with providing additional oversight and is required to submit reports to Congress relating its findings every 60 days. It will also perform an annual audit of TARP.
The Secretary’s authority under EESA ends on December 31, 2009, unless the Secretary submits a written certification to Congress justifying the need for an extension, which may not be longer than two years.
After the House of Representative voted down the first version of the law to come up for passage, the Senate took up the bill. The Senate added several provisions to what became the final bill that do not relate to EESA or its purposes. The law extends several tax provisions related to energy credits (see “PTC Gets Extended”) and the alternative minimum tax, provides for equal insurance coverage for treatment of mental and physical health conditions, and contains other unrelated provisions.
EESA is the most recent and most powerful measure the U.S. government has taken to react to the dual crises of credit and confidence that are currently plaguing the U.S. financial system. In the weeks and months to come, America will wait to see how the Treasury develops and utilizes TARP and the other major provisions of this eagerly anticipated law.