We turn now to examining the Capital Purchase Program, the principal form of capital injection used by the United States during the financial crisis. As the earlier part of this book has discussed in detail, the collapse of Lehman Brothers triggered widespread turmoil in the global financial market beyond the expectations of Chairman Bernanke and Secretary Paulson.1 Just two days after its bankruptcy, the Federal Reserve had to extend an $85 billion emergency credit facility to AIG, even though some might have considered a capital injection by Treasury to be the better response. The market was deeply confused by the government’s seemingly ad hoc bailout decisions. Who will be bailed out? Who will be let go? Following Bear Stearns’s rescue a few months before, it was assumed that others would also be bailed out. When Lehman sent the opposite message, the rescue of AIG just days later was insufficient to stop contagion fueled by the continuing guessing game. The government finally abandoned its ad hoc approach, which had so far relied heavily on the Federal Reserve and the FDIC, and decided to adopt a comprehensive and proactive plan with direct involvement by the Treasury.
After the rescue of AIG on September 16,2 it was highly uncertain that a bailout plan could be quickly approved. Initially, members of Congress were outraged by Secretary Paulson’s original three-page proposal—some called a “term sheet”—for granting Treasury broad authority to purchase $700 billion of toxic assets.3 Even after the proposal was greatly elaborated, it was rejected by the House of Representatives on September 29, 2008, by a vote largely along party lines (with Republicans opposing).4 The S&P500 plummeted 8.5 percent after the failure.5 The Senate voted two days later to pass a revised bill and the final bill passed the House on October 3 only after many members of Congress reluctantly switched positions.6 It was signed into law by President Bush on October 3.
The resulting Emergency Economic Stabilization Act of 2008 (EESA) established the Troubled Asset Relief Program (TARP) to stabilize the US financial system.7 The core of the recapitalization plan under TARP was the Capital Purchase Program (CPP), under which “healthy, viable” financial institutions would receive capital injections from Treasury.8
The first nine recipients—the systematically important banks in the United States—had already agreed to the recapitalization plan when Secretary Paulson announced the plan on October 14, 2008.9 Many of these banks were actively seeking to augment their capital bases or merge with a stronger bank at the early stage of the financial crisis. Shortly before the announcement of the Capital Purchase Program, both Goldman Sachs and Morgan Stanley were able to secure financing from sources such as Warren Buffet and foreign investors.10
The CPP was a program open to all qualified financial institutions approved by their respective banking regulators, whether large or small.11 The government wanted the healthy as well as less healthy major banks—the first nine recipients—to take government assistance to avoid publicly identifying any banks as insolvent. However, it appears that analysts could independently distinguish the relative health of the banks.12 As we will see, other countries did not follow this all banks approach. While it is clear that politics favored giving support to small as well as large banks, the failure of small banks (unless cumulatively significant) would not have endangered the system. The demand for CPP investments by smaller banks soared after the market considered receiving CPP funding as getting on the “survivor list” and those not receiving the investments as too unhealthy to be rescued.13 Also adding to the demand was the opportunity the CPP presented for small banks to obtain a relatively cheap source of funding through the program. Between October 2008 and December 2009, Treasury invested a total of $205 billion in 707 banking institutions.14 Although the initial investments in the nine financial institutions in October 2008 accounted for more than half of the total CPP investments15 and ten of the largest firms received almost 70 percent of the funds under the CPP,16 Treasury made numerous smaller investments in institutions of less than $100 million in assets.17
Participating financial institutions received capital injections under the same standard terms irrespective of their financial health.18 Most investments were in the form of perpetual preferred shares, although those firms that could not issue preferred shares (e.g., S corporations) issued subordinated debt instead.19 At the later stages of its investments in Citigroup, AIG, and other financial institutions, the US Treasury replaced its preferred stock with common stock.20 But this replacement did not oust common entirely, it just diluted it.21 Apart from the obvious benefit of savings on interest payments, one reason cited by the recipient banks for the conversion was the market’s view that tangible common equity is an important measure of financial strength, even if preferred stock would also qualify for tier I capital.22 Treasury agreed because it would be easier to sell the common than preferred when it later exited from its capital position.23In the end, only about 50 banks, mainly small community banks, issued subordinated debt instead of preferred shares.24
Preferred stock was also the primary investment tool used by the Reconstruction Finance Corporation during the Great Depression.25 Many scholars have compared the current financial crisis with the Great Depression and pointed out that the Reconstruction Finance Corporation (RFC) became successful only after it switched from making loans to troubled banks to making preferred stock investments because the more RFC lent, the less likely that unsecured creditors could recoup their investments.26 As a result studies have found that the more banks borrowed from the RFC during the Great Depression, the more likely they were to fail.27 Bailout therefore plays a role that may not be fulfilled by other forms of public assistance.
Preferred stock has several advantages over other instruments. First, it can be structured to qualify for the firm’s tier I capital, while retaining debt-like characteristics of deductible interest payments that could be relevant to investors who might later buy the stock from the government. Since cumulative perpetual preferred stock does not qualify as tier I capital under the US Basel IIII rules,28 this capital treatment will require the preferred stock to be noncumulative perpetual with no dividend rate step-ups. On the other hand, interest payments, if made on preferred stock, put a burden on the financial institution that common stock does not. A second advantage of preferred stock is it allows the government, as preferred stockholder, to rank between debt holders and common stockholders in terms of priority. It is therefore possible to dilute or eliminate common stockholders’ interests while protecting the value of the company’s other debt securities. Third, preferred stock does not put the government in the limelight as the outright owner of an institution, even though it may exert considerable influence on management through contractual arrangements granting the holder voting power and/or veto power on strategic issues, as well as the power to appoint directors and remove the board.29
One of the drawbacks of preferred stock is that it preserves the claim of common shareholders, thus giving them an upside in the case of recovery. Given the complete paybacks of most financial firms that received TARP assistance, and all the large ones including AIG, the preservation of this upside is significant. Arguably, for moral hazard purposes, it would be better to dispossess equity entirely in any capital injection program, or at the very least heavily dilute it.
Below is a summary of the key investment terms under the CPP. According to the Congressional Oversight Panel, the documentation for CPP investments was “quite similar to, and appears to be based on,” the documentation for Warren Buffet’s earlier investment in Goldman Sachs.30
As of December 31, 2014, 673 of the 707 financial institutions that received capital under the CPP had exited the program.31 254 of the firms that had exited as of that date did so via repurchase of their preferred shares or subordinated debentures and 185 institutions had their investments sold at auction.32 In addition 137 community banks refinanced their CPP investments into Treasury investments under the Small Business Lending Fund and 28 banks converted their CPP investments into investments under the Community Development Capital Initiative under TARP.33 Thirty-two of these exits occurred via bankruptcy or receivership.34
The US government made it clear that it was only reluctantly helping troubled banks when the TARP bailout legislation was passed. Chairman Bernanke said: “Government assistance should be provided with the greatest reluctance and only when the stability of the financial system, and thus the health of the broader economy, is at risk. In those cases when financial stability is threatened, however, intervention to protect the public interest may well be justified.”35 The sentiment was echoed by then-Secretary Paulson: “We regret having to take these actions. Today’s actions are not what we ever wanted to do—but today’s actions are what we must do to restore confidence to our financial system.”36
More important, bailouts are now regarded as politically taboo under the anti-bailout consensus in Washington, and concern with capital injections, even more so than with lender of last resort or guarantees, is at the heart of the bailout concern. While those powers were severely restricted, the capital injection program was abolished altogether.
Authority to make and fund commitments to purchase assets under the TARP programs, including the CPP, could only take place for a limited period of time, as prescribed by the 2008 Emergency Economic Stabilization Act (“EESA”) that created TARP. Pursuant to Section 120 of the EESA, TARP authority was initially set to terminate on December 31, 2009, but the Treasury Department had authority under that section to extend the TARP commitment period to October 3, 2010.37 In December 2009, the Treasury Department did so.38 In July 2010, the Dodd–Frank Wall Street Reform and Consumer Protection Act separately decreased TARP purchase authority from $700 billion to $475 billion.39 Dodd–Frank also expressly prohibited TARP authority under the EESA from being used to incur any obligation for a program or initiative that was not initiated before June 25, 2010.40
Accordingly, no new funds can now be committed to a TARP program and no new TARP programs can be established. Furthermore Section 106(d) of the EESA requires that when recipients of funds that were disbursed by TARP programs pay back their funds that such funds be deposited with the US Treasury, so that they cannot be used to further fund any future disbursements.41 In other words, TARP funds cannot be reused once then have been disbursed to a private borrower and paid back to the US Treasury. Dodd–Frank made this point crystal clear, by amending the EESA’s text to remove any potential ambiguities in the language about the funds’ reuse.42 However, the Treasury has the statutory authority under Section 106(e) of the EESA to continue to disburse the funds that were already allocated for each TARP program before October 3, 2010, but have not yet been actually disbursed to private borrowers.43
Standardized investment terms under the Capital Purchase Program
Note: This summary is based on the acquisition agreement for Treasury’s investment in JPMorgan Chase investment, which is available at http://www.treasury.gov/initiatives/financial-stability/programs/investment-programs/cpp/Documents_Contracts_Agreements/JPMorgan_Chase_Agreement_Dated_26_October_2008.pdf, and information in July SIGTARP Report, supra note 1592, at 76.
a. By design, the Treasury will not explicitly exercise day-to-day control of the CPP recipients. Such control is indirectly achieved through measures such as a contractual requirement on management compensation and Treasury’s implicit threat to take over the bank by converting its holdings into common stock.
b. American Recovery and Reinvestment Act of 2009, Pub. L. No. 111–5, 123 Stat. 115.
c. The difference in treatment of public and private companies largely stems from the fact that Treasury will hold privately issued securities with no readily available market prices. Treasury may also, as a result, hold the securities for a longer period of time.
d. American Recovery and Reinvestment Act of 2009, supra note 1607, at 516–20.
TARP programs for banks have essentially been wound-down, as there are no funds allocated to banks generally that have not been used. The only reason that the programs are not completely wound down is that certain small banks that received $625 million funds from these programs have yet to repay these funds. As noted above, these funds must be paid straight to the US Treasury, thus once they are repaid these TARP programs will cease to exist.44 Since minimal commitments remain in the TARP programs, and no new commitments to these programs can be made, there is no standing TARP authority to capitalize future troubled banks. The below table details the status of these programs, ordered from largest to smallest based on the initial investment. The “Initial Investment” column refers to the total amount Treasury invested in the particular TARP program. The “Lifetime income (cost)” column refers to the overall income or expenses incurred for the program, from inception to expiration. The source for this table is the Government Accountability Office’s (“GAO”) January 2015 TARP update.
We have already discussed the CPP. The Automotive Industry Financing Program (“AIFP”) refers to Treasury’s investments in automakers Chrysler and GM and other auto financing companies; such investments were justified as needed to stabilize the automotive industry, although no convincing case was made that the failure or restructuring of that industry would be a source of systemic risk45 After the first stage of TARP that involved the CPP, the second stage of TARP assistance included the Systemically Significant Failing Institutions (“SSFI”) program, created to provide support to AIG and subsequently renamed the American International Group, Inc. (AIG) Investment Program.46 According to the Congressional Budget Office (CBO),47 “AIG has fully exited the TARP; the company repaid its line of credit, and the Treasury recouped $34 billion from the sale of its shares of AIG common stock at an average price of about $31— bringing the total amount repaid or recovered to $54 billion out of the $68 billion originally disbursed. The final net subsidy cost to the Treasury for [sic]the assistance that was provided to AIG through the TARP was $15 billion.”48 However, because the Treasury (with the Federal Reserve) also supported AIG through non-TARP assistance in exchange for common shares of AIG, the Treasury will actually wind up with a net profit of $5 billion on its overall AIG assistance.49 The Federal Reserve profited $17.7 billion on its overall AIG assistance.50
Additionally the Targeted Investment Program (“TIP”) refers to Treasury’s case-by-case investments in critical financial institutions; only Citigroup and Bank of America participated in this program, each receiving $20 billion in exchange for preferred stock and warrants.51
Remaining financial-crisis TARP commitments as of Jan. 2015, reproduced per GAO update (apart from housing programs)
Note: US Government Accountability Office, Troubled Asset Relief Program 1, 10 (Jan. 2015), available at http://www.gao.gov/assets/670/667833.pdf.
The Public–Private Investment Program (“PPIP”) refers to Treasury’s purchase of residential and commercial mortgage-backed securities in coordination with private firms.52 The Community Development Capital Initiative (“CDCI”) refers to Treasury’s investment in Community Development Financial Institutions through which Treasury received preferred stock and subordinated debentures.53 The Small Business Administration Securities Purchase Program refers to Treasury’s investments in the secondary markets for government-guaranteed small business loans under the 7(a) SBA loan program.54 The Term Asset-backed Securities Loan Facility (“TALF”) refers to Treasury’s further investments in the securitization market, enabling credit access throughout the crisis period.55 The Asset Guarantee Program refers to a program that provided federal government guarantees for financial institution assets; only Citigroup participated in this program, while Bank of America also considered it.56 Through this program, Citigroup received loss protection on $301 billion of assets.57 Finally, the Capital Assistance Program was created to provide capital to financial institutions that were unable to meet stress test requirements under the Supervisory Capital Assessment Program; this program was ultimately not funded or initiated.58
Ultimately the ten TARP programs described above invested a total of $412 billion, with only $12.4 billion outstanding as of 2014.59 As of October 9, 2015, TARP has recovered 98.7 percent of funds invested.60 However, the remaining $625 million in CPP assets, $465 million in CDCI assets, and 13 percent share in Ally Financial acquired through the AIFP program will likely turn these modest losses into a net profit. It is worth noting that, aside from the relatively minor loss from the CDCI illustrated above, TARP losses are not attributable to the bank investment programs; instead, the AIFP and AIG Investment Program are responsible for the most significant losses. The outcome of TARP is broadly consistent with the experience of Fannie Mae and Freddie Mac, which received $187 billion in government aid during the crisis and ultimately returned $192 billion by 2014.61
While TARP has now expired, consideration should be given to provide a standing program for capital injections with significant design improvements from TARP. The program could be on the shelf ready to be used by regulators, subject to appropriate findings and high-level approvals, if events required this. The reality is that currently few would support rational planning for the future, since political opponents would accuse the planners of being pro-bailout.
In contrast to the programs described above, TARP housing programs have not been wound down because these programs received funding commitments from TARP before October 2010 and have yet to disburse this all of that funding. But with the rest of TARP, no new commitments can be made after October 2010.
TARP instituted three relevant housing programs: the Making Home Affordable (“MHA”) program, the Hardest Hit Fund, and the Federal Housing Authority (“FHA”) Short Refinance program.62 The MHA program primarily assists borrowers with reducing monthly payments on first-lien mortgages and coordinating efficient short sales.63 The Hardest Hit Fund is focused on those states with the highest unemployment rates; the program specifically seeks to help individuals in those states make mortgage payments and reduce their overall principal.64 Finally, the FHA Short Refinance program enables individuals to refinance when their mortgages exceed the value of their homes.65
The GAO reports that, as of September 2014, 13.7 billion, or 36 percent, of the 38.5 billion in TARP housing program funding has been disbursed.66 Accordingly, each of the housing programs authorized under TARP remain ongoing, as the housing programs still have access to the funds allocated before the October 2010 cutoff applicable to all TARP programs. As described above, these funds were never disbursed to private borrowers, so that is why these programs still have unused funding. The Treasury has extended the time period to disburse these already allocated funds under the MHA program until December 2016, although officials have indicated that an earlier wind-down may occur depending upon “market conditions, program volume, and other factors.”67 Similarly states have until December 31, 2017, to commit funds for the TARP Hardest Hit fund; states are also allowed to continue to spend Hardest Hit funds after 2017 deadline.68 Finally, FHA’s short refinance program was expected to end on December 31, 2014, but was extended by two years until December 31, 2016.69 These disbursements are, of course, limited to the total funding provided to these programs before the October 2010 cutoff. Further extensions to disburse funds from these TARP housing programs beyond 2016/2017 is also feasible, as the EESA does not set explicit deadlines for when TARP programs can disburse unused funds.70 The TARP housing programs are subject to the same statutory scheme as the other TARP programs, but the Treasury makes clear that “the funds committed for TARP’s housing programs were never intended to be recovered,”71 so long as the housing programs continue to operate within the basic parameters and budgets set forth in 2009 and 2010 under TARP. Such ongoing activity ensures that the GAO and other organizations will continue to monitor the TARP wind-down in subsequent years.
A separate question remains. Could Congress “activate” TARP by passing legislation that repeals any prohibition in the EESA and Dodd–Frank on the use of TARP funds? While lending authority has expired, the shell of the program remains. While this is technically possible, it is, of course, politically impracticable in the current climate. One theoretical advantage to such an approach is that the “old” TARP authorities could be quickly activated under similar terms as existed in 2008, instead of drafting language at the last minute like last time. However, this would not be the optimal solution, since it would be preferable to detail a new more detailed TARP that builds on lessons learned from the use of the old TARP.
The EESA TARP authorities are broad and undetailed. Section 101(a) authorizes the Secretary of the Treasury to establish TARP “to purchase, and to make and fund commitments to purchase, troubled assets from any financial institution, on such terms and conditions as are determined by the Secretary, and in accordance with this Act and the policies and procedures developed and published by the Secretary.”72
While the TARP bailout fund to deal with the 2008 banking crisis has expired, it bears mentioning that there is still a standing fund to deal partially with bank failures in the form of the deposit insurance fund. As of June 2014 this fund stood at $51.1 billion,73 and is financed on an ongoing basis by premiums paid by the banks at a rate of between 2.5 basis points and 45 basis points, depending on a bank’s risk category.74 This fund is basically designed to pay off depositors or assist in acquisitions or restructurings, but it can no longer be used for capital injections as part of open bank assistance. Section 1106(b) of Dodd–Frank effectively eliminated the systemic risk exception to the FDIC’s least-cost resolution obligation under the Federal Deposit Insurance Act, thereby foreclosing this possibility. The DIF is not relevant to an OLA resolution, since it is only available when a bank is in receivership, and as designed by the FDIC under SPOE, OLA is intended to restructure only holding companies, not operating subsidiaries such as banks. In any event, $51.1 billion is far short of what would be needed, in a 2008 repeat.