February 2009

The Top 10 Ways to Deal with Toxic Assets

BY NICOLE IBBOTSON AND KEVIN PETRASIC

The recent re-branding of the Troubled Asset We all know by now that there are no easy Relief Program (TARP) as the “Financial Stability answers and yes, it will take time for this to be Plan” (FSP) by Treasury Secretary Timothy resolved; but we still do not know how it will be Geithner and his subsequent roll-out of the FSP resolved. There have been numerous solutions outline and, more recently, the Capital put forth by national and international finance Assistance Plan (CAP) has done little to stem the and economic experts for the bad asset problem fallout of the ongoing financial crisis. Rather that will allegedly guide us out of this mess. than having a stabilizing effect, the lack of meaningful detail and transparency has The following top ten list contains those solutions appeared further to roil the markets. The reason, that stand out for their promise, creativity of course, is the bad assets – still there hanging and/or sheer audacity. While we reserve like a weight on the neck of the American judgment for the reader on the merits of each, it economy. While criticism focused on the lack of is likely that one or more of the following, either detail and direction in the FSP and a confusing alone or in tandem, may hold the keys for how rationale for the CAP, the main issue remains: to resolve the current economic crisis. In there still exists a lack of consensus among addition to addressing some of the pros/cons for industry experts on how to remove toxic assets each proposal, we describe whether the proposal off ’ existing balance sheets. includes elements similar to those described in Treasury Secretary Geithner’s outline for dealing Private equity funds and investment companies with bad assets pursuant to the FSP. First, it is complain that until the U.S. government important to understand the “toxic asset” issue establishes a plan to valuate and liquidate these and the challenges it presents. bad assets, there will be no purchasers willing to step forward with solutions. Issue: Valuating “Toxic Assets”

While much has been written about the Based on long-standing guidance, banks are weakness of the FSP, there have been few required to carry assets at “fair value,” which is analyses of the possible ways to address its the price received to sell an asset in an orderly perceived shortcomings. The most striking transaction between current marketplace absence in the FSP is any direction on how to participants. Most of the “toxic assets” now on resolve the bad asset problem. Clearly, this has ’s balance sheets are real estate and further spooked an economy already writhing in mortgage-related assets, including derivative or the throes of the worst financial crisis since the other bundled securities backed by residential Great Depression. mortgages. Falling real estate values coupled with recent and continually increasing

1

homeowner defaults and home foreclosures allowing banks to set the prices (i.e., colluding directly impair these assets. This has created a banks could signal pricing intentions and keep downward spiral as the value of these assets has prices artificially high, thus reducing the loss for plummeted and most markets for real estate- such institutions). Of particular concern, if related assets have seized up. The result is that Treasury pays too much for assets, taxpayer there are no willing buyers, and there is no losses could quickly mount. market. And without a market, there is no “fair value.” Conversely, if Treasury pays too little for the assets, the auction could accelerate an already Arguably, an asset price must be over-valuated difficult pricing situation. If institutions sell if there are no purchasers willing to pay the securities at fire-sale prices, rather than at or asking price. The net effect is that the fair value near hold-to-maturity prices, banks holding of these assets is diminished. similar assets would be forced to write down their values to match the auction price. This Under mark-to-market accounting, banks are could speed up bank failures, erode banks’ required to mark down assets to reflect the capital base and further restrict the ability of current market or “fair value.” Marking down banks to borrow and lend. asset values leads to further loss of investor confidence and may force institutions to sell This plan was ultimately abandoned for a these assets at fire-sale prices which increases number of reasons, including (i) that the bundled banks’ leverage and reduces capital ratios. assets are too diverse with little available Effectively this creates a spiral effect of further comparative information; (ii) determining an declining funding liquidity, further write-downs, optimal price was too difficult; (iii) the further distressed asset sales and, potentially, government was unwilling to risk inaccurately additional bank failures. While the problem is valuating these assets; and (iv) the reliability of clear, the challenge is how to solve it. the auction method itself was questioned.

Top Ten Proposed Solutions 2. Additional Capital Infusions

1. Seller’s or Reverse Auction Infusing capital into troubled financial institutions has the very obvious positive effect In Fall 2008, Chairman Ben of increasing banks’ available capital. However, Bernanke proposed a reverse or seller’s auction as the public recently discovered, increasing where financial institutions would place bids with banks’ capital does not necessarily increase Treasury for the sale of toxic assets at prices available credit, nor does it do anything they deemed close to held-to-maturity values. immediately or directly to address how to Treasury would then purchase the offers most resolve the toxic assets still sitting on banks’ attractively priced to the government. balance sheets. The first round of TARP funds Underlying this approach is the notion that, after were directly invested in financial institutions these purchases, banks would have a basis for with few conditions on the use of such funds. As valuing toxic assets. Rather than using fire-sale a result, TARP I has been criticized as failing to prices, which would accelerate capital mark encourage banks to use infused capital to extend downs, the auction prices would provide a better loans to businesses and consumers. gauge. Also, taxpayers would benefit to the extent that assets are purchased for a price Advocates of capital infusion for the second lower than hold-to-maturity value. round of TARP funds ($350 billion) emphasize attaching strings to the grant of such funds to Critics of this proposal pointed to the difficulty in prevent the same failed result. The House of evaluating the hold-to-maturity value, as well as Representatives passed a bill in January 2008

2

which implemented accountability and their investment of TARP funds in banks via an transparency by restricting use, requiring increase in available credit. It remains to be reporting and monitoring by regulators, seen whether these conditional capital infusions allocating funds to particular types of businesses will fix the . The track record so far and small financial institutions, among others. is not particularly optimistic. Although it is unlikely to be considered by the Senate, the bill has had a significant influence on 3. Suspending Mark-to-Market Accounting Secretary Geithner’s FSP. Many bank executives and banking groups The CAP component of Geithner’s FSP contains a advocate suspension of mark-to-market capital infusion element with the following accounting temporarily or permanently. On the conditions: up-side, this would stop the spiral of marking down assets, reducing investor confidence, and Banks desiring TARP II funds must undergo a lowering available capital. “stress test” to determine the extent to which they require additional capital. On the down-side, this invites speculative valuation by substituting the internal valuation of Banks receiving TARP II funds must submit initial a subjective management team for an illiquid “intended use” plan and monthly use reports market price. It also provides less transparency which are available to the public. and potentially widely varying valuations by institutions for the same underlying assets. This Recipients of TARP II funds must participate in plan has been rejected by most governmental mortgage foreclosure mitigation programs, and regulators because the consequences appear too are restricted from (i) paying excess dividends, undesirable. More fundamentally, diverging from (ii) repurchasing privately-held shares until TARP mark-to-market accounting creates a financial II funds are repaid, (iii) acquiring healthy firms system structure not subject to the same rules in cash deals, and (iv) various executive as the markets and industries it serves. compensation arrangements. 4. Write Down and Fire-Sale At the heart of the new CAP is the notion that banks requiring additional capital will have six Many Wall Street traders and analysts suggest months to raise it from private sources. Those that banks should write assets down and add unable to do so will receive federal government capital, no matter what the costs. This would funding with all the strings attached. The require banks to disgorge their toxic assets for problem, of course, is that banks with capital whatever price they can get, even if this means holes are not particularly attractive investments. selling for pennies on the dollar. Bank analyst It is difficult to understand why private investors Meredith Whitney recommended this approach in would put a dime in an institution that has a big mid-2008. Shortly thereafter, Merrill Lynch sold capital hole. More fundamentally, it is to Loan Star Funds over $30 billion worth of questionable that a savvy investor would put any collateralized debt obligations for the bargain money in an institution that has a capital hole, price of $6.7 billion, or 22¢ on the dollar, particularly if the federal government appears compared with the 36¢ valuation Merrill Lynch ready to fill that hole six months from now. And had for these assets the preceding quarter. certainly investors will want to know what the hole is before making any investment – that may The benefits of this approach include removing be the greatest challenge. toxic assets as quickly as possible, and providing the opportunity for banks to begin restoring their At the same time, Congress has made it clear capital. This is an obvious favorite of private that it expects taxpayers to receive an upside for equity investors since they stand to gain the

3

most benefit from implementation of this plan. institution to issue certificates to the FDIC in The difficulties lie in finding buyers with exchange for “full faith and credit” notes issued sufficient capital who are sophisticated enough by the FDIC that such banks could count as to assess and buy the toxic assets. Credit capital on their balance sheets. In effect, this extensions are increasingly difficult to come by would enable the bank to restore its capital so so private funding is necessary. that it could resolve the troubled assets that appear on its balance sheet over a longer time This plan severely impacts banks and their horizon. existing equity holders. Banks would suffer meaningful asset impairments and forego any The benefits of a guarantee-type approach upside recovery (i.e., lost opportunities of include the immediate impact of a program that holding to maturity). For many institutions this is can be implemented with virtually one not a viable option since doing so would make announcement that grabs investor and depositor them instantly insolvent. Losses under this attention. It also keeps assets at the institutions approach are borne by the banks and their that originated and have the most familiarity equity holders, and would generally avoid with them. taxpayer losses (barring taxpayer assistance). The drawbacks include the historically weak 5. Government Guarantees and impact of such announcements on overall public Insurance confidence, as well as the unknown liability that the government assumes. Under this approach, In the fall of 2008, Britain announced that it it is not possible to quantify the extent of would insure its banks against the worst losses potential loss to the government and taxpayers, on their toxic assets. The U.S. government has thereby creating a significant economic also implemented various forms of additional disincentive. In addition, significant concerns guarantees and insurance. First, the FDIC raised have been expressed that retaining bad assets federal deposit insurance levels to $250,000 for on bank balance sheets, even though individual accounts and, pursuant to its guaranteed, will discourage private capital from Temporary Liquidity Guarantee Program investing in such institutions. (“TLGP”), eliminated a maximum coverage cap for corporate accounts. Also as part of the TLGP, Secretary Geithner’s FSP also includes a Small the FDIC is providing guarantees of certain Business and Community Bank Lending Initiative senior unsecured debt of depository institutions that seeks to increase the availability of SBA and their holding companies. In addition, loans by increasing the guarantee of such loans Treasury has back-stopped certain systemically from 75% to as high as 90%. The plan does not important banks’ losses in connection with assets preclude further guarantees and insurance assumed in assisted acquisitions (e.g., Bank of implemented at a later date. Again, guarantees America’s purchase of Merrill Lynch). and insurance ultimately subject taxpayers, rather than banks and their equity holders, to An interesting variation of this theme is the potential loss, often without any tangible upside federal government’s use of net worth since there is generally no compensation for the certificates, similar to those used to infuse level of risk assumed by the government. capital into sick or failing thrifts during the thrift crisis of the late 1980s. While that program was 6. Bad Bank or Fencing Off subject to significant criticism, it did enable many institutions to work through relatively A much discussed concept is for the government serious difficulties. While it is not a permanent to create a central “bad bank” (or several bad solution for a capital-strapped bank with banks) that purchase the toxic assets from significant troubled assets, it would permit an banks. This approach has been utilized in 4

isolated situations in the U.S. and was purchasing mortgages at a discount and implemented broadly, with limited success, in renegotiating the terms with the existing Japan to save its troubled banks during the homeowner to keep them in their homes at 1990s. For this approach to be effective there payments levels they could afford. must be a clean break between the existing financial institution and the bad assets. The A number of experts have spoken strongly in objective is to enable the institution to unburden support of this approach, particularly since it itself of severely impaired assets so it can accomplishes the objective of removing troubled resume normal lending activities, as well as mortgages from bank’s balance sheets and out capital raising and deposit-taking activities. of underperforming mortgage-related securities, while also preventing foreclosures. A hybrid version of the bad bank and guarantee approaches is the so-called fencing off approach The drawbacks are the staggering costs and in which toxic assets on a bank’s balance sheet massive scale likely needed for this type of are sold and/or guaranteed to neutralize their program, as well as the difficulties in establishing impact on the institution. a mechanism for determining which assets would be purchased by HOLC. As with a seller’s Critics of the bad bank plan point out that such a auction, pricing would be a particularly program would invariably politicize the buyout challenging issue, as would servicing and/or process of toxic assets, which could lead to monitoring the mortgage loans and real estate- potentially enormous losses to taxpayers for related assets held by HOLC. Finally, there are poor purchasing decisions, conflicts of interest, additional challenges with how to administer the political corruption, interference from interest program in a manner that is open to all potential groups, poor management by governmental sellers, and potential mark-to-market issues as officials, and other inefficiencies typically related soon as the federal government begins to buy to government transactions (time, money, mortgages and mortgage-related assets. centralized decision-making, etc.). 8. Private Equity Participation in These types of government-oriented solutions “Tarpics” or Government Fund also lack competitive aspects that promote an effective market mechanism, including the An idea popular among private equity investors efficiencies of true private “at-risk” capital is to make private capital the centerpiece of any investments and the participation of . Partnering private capital with knowledgeable private “for-profit” managers. government funds to buy banks’ toxic assets This approach also fails to solve the issue of may be accomplished through a broad group of asset valuation and loss allocation (i.e., newly capitalized secondary financial institutions, taxpayers or bank equity holders) because it has called TARP Investment Companies (“Tarpics”). the same problem as a seller’s auction; namely, In fact, this is a variation of the FSP’s CAP. pay too little and hurt the banks, pay too much Generally, this involves the government and hurt the taxpayers. contributing capital along with private equity 7. Home Owners’ Loan Corporation firms to establish these Tarpics. This approach is targeted at jump-starting the closed secondary An often discussed, but apparently not seriously asset markets, which would lead to faster and considered option is recreating the Home more efficient asset valuation. In addition, it is Owners’ Loan Corporation (“HOLC”) which was envisioned that this would offer banks a greater employed by the federal government as one of range of liquidity options and expand the overall the programs to pull America out of the Great availability of credit. Depression. The program involved the HOLC

5

Proponents claim this would be much more inefficiencies generally related to governmental beneficial than continuing to pump even more institutions. capital into existing primary institutions that are failing or spiraling towards failure. Executed The FSP incorporates the latter take on private properly, it could reduce both the amount of equity investment through a Public-Private taxpayer funding and the duration of the rescue. Investment Fund. This fund would be financed with public and private capital to purchase toxic By some estimates, there is over $400 billion of assets. Treasury statements suggest that public private capital currently available in private financing would leverage private capital on an equity funds and other entities and institutions initial scale of up to $500 billion with the waiting to capitalize on the distressed loan potential to expand to $1 trillion. markets. However, these funds and institutions are waiting for bargain sale prices that banks are 9. Nationalizing Banks not yet ready to offer. If the government offered In recent weeks, the merits of nationalizing U.S. to match (on a one-to-one or other basis) the banks, or at least several of the largest equity capital contributed by reputable managers systemically important banks, have been hotly interested in forming and operating these debated. Notwithstanding the inherent distrust of Tarpics, it could make up the difference in the nationalization and the perceived irony of a U.S.- price valuations of potential buyers and banks, backed nationalization effort, many argue this thus freeing up the current stalemate. It could has already happened to a certain degree in the also prevent the spiraling mark-down issue for banking industry. Clearly, this was the case non-selling banks, because a private/public when the U.S. government took over Fannie Mae funded market value would help establish a and Freddie Mac. more reasonable valuation than fire sale prices. Bank nationalization was successfully executed This approach has worked for the Small Business by in 1992, which was eventually Administration which has for many years privatized at a profit to the Swedish government. partnered with private equity managers to However, the general view is that the Swedish deploy capital to small businesses through Small experience would not be easy to duplicate in the Business Investment Companies, or SBICs. U.S., in large part because of size of the U.S. Procedural protections used in the SBIC banking system, its much greater role in the program, such as capital commitment fees, world economy, and the overall size of several of redemption periods and capital priority levels, the largest systemically important U.S. banks. could be incorporated into the Tarpic program if needed. Advocates of this approach point to elimination of both the need to valuate toxic assets and Instead of numerous Tarpics, some proponents compensate bank shareholders. Most suggest establishing a single centralized fund in importantly, it would restore public confidence, which private equity contributors could invest. again particularly at systemically important This would encourage consistency in price banks, and free up lines of credit. The losses valuation among banks and potentially more would be born by bank equity holders and transparency in buyout actions if the creditors rather than taxpayers. Variations of government actively manages or operates the this theme include partial nationalization (taking institution. However, this model may fail to out equity holders, but protecting creditors) and incentivize buyers by eliminating the ability of temporary nationalization (government control private managers to operate their own for a designated period of time). restructuring transactions. There could also be

6

Not surprisingly, there are numerous and vocal effects of the failure of in the critics to this approach. As a threshold matter, fall of 2008. Given the extent of these opponents cite the demise of free enterprise and institutions’ participation in the payment system efficient lending if the government interferes or and the large counter-party risks these takes over the operations of troubled institutions present, ensuring the continued institutions. Historically, nationalized banks have viability of these largest systemically important not been particularly adept at the efficient banks benefits the overall banking system as allocation of credit compared to private banks, much as it does the particular banks themselves. and some suggest it would take many years before such institutions could be “re-privatized.” 10. Debt-to-Equity Conversions

Even if the government merged or sold off banks Another proposed solution is to have the rather than actually operating nationalized government institute mandatory debt-to-equity banks, there are many critics of such forced conversions with or without wiping out existing consolidations. The criticism includes that equity holders. This would involve converting acquiring banks invariably get an outrageously existing bank debt, in inverse order of seniority, good deal at the expense of the taxpayer; a lack into stock (either preferred or common shares). of accountability and transparency on behalf of Unlike a capital injection, which lowers a bank’s governmental officials taking over the failed leverage ratio by raising equity without affecting bank (possibly leading to conflicts of interest or debt, a mandatory conversion would lower the favoritism); and an adverse impact on leverage ratio by both lowering debt and raising competitiveness after the crisis. equity. The total size of the balance sheet (debt plus equity) increases in a capital injection but The recent statement by Treasury and the would remain unchanged in a mandatory debt- federal banking agencies on the details of the to-equity conversion. In the late 1980s, CAP’s stress testing program suggests that tests used this approach in Chile by will be conducted to determine the overall converting then existing debt to equity. exposure of institutions under various economic scenarios. Apparently, the government will tailor This type of conversion provides creditors an its proposed investments in the 25 largest opportunity to regain the equivalent of debt and institutions subject to the stress testing based on interest in the form of dividends and capital the projected vulnerability of the institutions to gains on the stock of the bank. Although the economic factors utilized in the stress tests. creditors may ultimately receive less than the The statement indicated that Treasury will debt owed to them, having a troubled debtor provide capital to these institutions in exchange avoid bankruptcy – or in the case of a bank, for convertible preferred securities. Generally, FDIC receivership – avoids completely wiping out the investments would be converted to common creditors’ interests. Although this approach is stock if/when an institution taps into such dilutive of existing shareholders’ interests, it may funding. be utilized to avoid completely wiping out existing debt holders and shareholders. Some view this as a version of incremental nationalization, and this approach retains the As proponents point out, this plan decisively possibility of full nationalization and/or taking places the bulk of the financial losses on bank over a troubled bank. The plan suggests that equity holders. This is viewed as appropriate, Treasury views some banks as too important to particularly since investors received the gains fail and may effectively take almost all necessary when financial institutions were doing well. actions to prevent a systemic failure. In part, Effectively, a mandatory debt-to-equity this approach is likely driven by the catastrophic conversion would act like a high-speed bankruptcy, forcing banks into a financial 7

restructure. From a policy perspective, this Others suggest regulators should ease certain approach also operates to discourage reckless existing rules to assist banks. One theory is to lending and investments in the future. cut minimum capital requirements, which would permit many banks to continue to meet the The downside, of course, is that a certain revised requirements and, in some cases, amount of losses will be imputed instantaneously upgrade their existing rating. Regulators have to both equity holders and creditors upon a debt- been easing rules to some extent. For example, to-equity conversion. This is not a desirable high-yield interest rate caps were recently proposition for any bank. lowered to permit less than well-capitalized institutions to offer higher deposit interest rates Existing Regulatory Scheme and, thus, attract new depositors. Notwithstanding the various solutions that have Certainly, relying on the status quo is appealing been discussed and debated in recent months, since it avoids Congressional action, which could some experts continue to argue that the existing involve a painful process for the industry given regulatory scheme is adequate to address the various political agendas and potentially toxic asset problems of the banking industry. significant time delays. However, it is amply Institutions that have too many bad assets and evident that the regulators have limited are unable to work their way out of the problem resources, including too few examiners to should be taken over. Proponents argue this will exercise effective industry supervision, strengthen the remaining banks and bolster the overseeing troubled banks under their watch, economy without the need for injecting capital or and taking over failing institutions. If existing implementing new plans. regulatory action was sufficient, of course, it is likely that the current crisis would have been The most powerful tool currently available to resolved by now. Also, given the public desire for banking regulators is the ability to take over action and change, maintaining the status quo troubled institutions with too many bad assets does not appear to be favored by the and placing them into receivership or government and other law and policy makers. conservatorship. This process has been conducted by the FDIC many times since the Geithner’s FSP incorporates elements to bolster beginning of the current recession. When the current regulatory actions. For example, the FDIC takes over a failing bank, it replaces CAP’s new bank stress test will combine the management, restructures the bank by merging efforts of Treasury, the bank supervisors, the or selling all or part of the assets, reassures SEC and accounting standards setters to improve insured depositors, and typically wipes out the bank disclosures and transparency. It also equity holders. Although a disruptive and painful describes a coordinated effort to assess process, it is useful to clear out banks that may exposures: never be again productive lending entities, no matter how much capital is injected. All relevant financial regulators – the Federal Reserve, FDIC, OCC, and OTS – will work Experts call for stronger supervision, regulatory together in a coordinated way to bring more monitoring and action, again using the existing consistent, realistic and forward looking regulatory scheme, by requiring banks to assessment of exposures on the balance sheets develop business plans, raise additional capital, of individuals. or engage in other activities to restore their balance sheets. The tools currently available to While additional details on this concerted effort regulators are very powerful and, according to were recently released, they appear to have some, more than sufficient to resolve the current raised more questions than answers. In any crisis. event, it is clear that, at least for the time being, 8

the current regulatory scheme will be retained mortgage (and other loan) defaults continue to and increased regulatory actions and guidance escalate. For now, the government appears will continue to be emphasized. unwilling to place the risks associated from these assets solely on investors and creditors. Rather, Conclusion the risks are being shared and absorbed by taxpayers via the provision of government These top ten solutions to address the toxic assistance, including capital and increasing asset issue have been proposed and discussed guarantees. by economic and financial experts around the world. Of course, there are additional variations Efforts to attract private equity highlight to many of these proposals, including opportunities for significant upside, as well as recommendations for combinations of one or spreading and diluting the existing risks to more of the above. The FSP contains a investors. More importantly, the involvement of combination of several of the proposals set forth private capital will expedite the valuation of above, including #2 (Conditional Capital Infusion mortgage and mortgage-related assets currently Plan), #5 (Increased SBA Loan Guarantees), #8 sitting on the books of most banks. It is not clear (Private Equity Investment in Government Fund) which of the various proposals show the most and, of course, certain aspects of the status quo promise to fix the ongoing economic crisis. (Increased Regulator Actions). Whatever the solution, the challenge for the government remains finding ways to restore the The lack of details in the FSP and CAP continue lending and credit markets to get the economy to worry economic experts and the financial running again. world because it highlights and leaves unanswered the main issue of the economic Clearly, the world is watching and waiting to crisis: how to deal with the substantial losses of hear more details on this most critical aspect of the devalued toxic assets. There is still no the Administration’s FSP. Until further guidance consensus on whether bank creditors and is forthcoming, most credit markets will likely investors, or taxpayers will bear the losses and remain stalled and the toxic assets will continue continued risk of loss from these assets as to sit on institutions’ balance sheets.

— — —

If you have any questions concerning these developing issues, please do not hesitate to contact any of the following Paul Hastings lawyers:

Atlanta Washington, D.C. Nicole Ibbotson V. Gerard Comizio 404-815-2385 202-551-1272 [email protected] [email protected]

Kevin Petrasic 202-551-1896 [email protected]

18 Offices Worldwide Paul, Hastings, Janofsky & Walker LLP www.paulhastings.com

StayCurrent is published solely for the interests of friends and clients of Paul, Hastings, Janofsky & Walker LLP and should in no way be relied upon or construed as legal advice. The views expressed in this publication reflect those of the authors and not necessarily the views of Paul Hastings. For specific information on recent developments or particular factual situations, the opinion of legal counsel should be sought. These materials may be considered ATTORNEY ADVERTISING in some jurisdictions. Paul Hastings is a limited liability partnership. Copyright © 2009 Paul, Hastings, Janofsky & Walker LLP.

IRS Circular 230 Disclosure: As required by U.S. Treasury Regulations governing tax practice, you are hereby advised that any written tax advice contained herein or attached was not written or intended to be used (and cannot be used) by any taxpayer for the purpose of avoiding penalties that may be imposed under the 9 U.S. Internal Revenue Code.