House Financial Services Committee Hears Bipartisan Consensus That Regulatory Structure Is Outdated

Financial Reform Watch October 19–25, 2008

Financial Reform Watch is a Blank Rome Government Relations LLC series of alerts developed for our colleagues needing to keep current on Washington's response to the turmoil in the financial markets.

Friday, October 24—12:30 p.m. EDT

October 23 was a busy day for Federal Deposit Insurance Corporation Chairman Sheila Bair. In the morning, she testified before the Senate Banking Committee and made headlines about what the FDIC is doing to assist homeowners avoid foreclosures. In the afternoon, she presided over an FDIC Board of Directors meeting wherein the board adopted an interim rule for implementing the Temporary Liquidity Guarantee Program.

Under the Emergency Economic Stabilization Act of 2008 (EESA), the Treasury Secretary has authority to modify mortgage loans in order to prevent foreclosures. Senate Banking Committee Chairman Chris Dodd claims authorship of those provisions in the bill. However, in recent days, Congressional Democrats have complained the Bush Administration is putting too much emphasis on shoring up banks and not enough on helping homeowners directly. In fact, earlier in the week, House Financial Services Committee Chairman Barney Frank (D-MA) and Rep. Maxine Waters (D-CA) wrote a joint letter to President Bush urging him to appoint Bair “to head a government-wide effort to supervise and coordinate” a foreclosure reduction program.

Bair has been calling for more homeowner assistance for weeks and used yesterday's testimony to address those concerns directly. While the EESA gives the Treasury Secretary the authority “to use loan guarantees and credit enhancements to facilitate loan modifications and prevent avoidable foreclosures,” she said the FDIC is examining the use of loan guarantees “as an incentive for servicers to modify loans.” According to Bair’s outline, the government would set standards for loan modifications, guarantee those that meet the standards, and then convert unaffordable loans into ones that have long-term sustainability. She assured Senators, “The FDIC is working closely and creatively with Treasury to realize the potential benefits of this authority.” Committee Chairman Christopher Dodd (D-CT) responded favorably and said he believed Secretary Paulson was supportive of moving forward on this soon.

Later in the day, Bair was focused again on bank liquidity. The interim rule for the FDIC’s Temporary Liquidity Guarantee Program (TLGP) takes effect immediately, however the agency will still accept comments for 15 days. To avoid systemic risk, the FDIC crafted the TLGP to include two components: the debt guarantee program, which temporarily guarantees newly-issued (between October 14, 2008 and June 30, 2009) senior unsecured debt; and the transaction account guarantee program, which is a temporary guarantee program (through December 31, 2009) for funds in “certain non-interest bearing transaction accounts” at FDIC insured institutions. Enrollment in the TLGP is automatic. Institutions have until November 12, 2008 to opt-out, after which time the FDIC will charge fees for participation. A copy of the interim rule can be downloaded here.

Thursday, October 23—10:00 a.m. EDT

Events of yesterday continued to demonstrate how major elements of the current financial crisis are inter-related. First, with the world waiting to see how a new administration in Washington will approach the financial crisis, President Bush's announcement of a November 15 summit of international leaders puts the discussion of a new regulatory regime for the financial sector squarely in the middle of the U.S. presidential transition. While both Sens. John McCain and Barack Obama praised the summit, it will present the winner of the November 4 election with an interesting quandary—how to participate in and/or react to the event. It may also force the hand of the president-elect to name his economic team before the summit takes place. Doing so will allow the administration-in-waiting to have a more organized response to the events of the summit.

Second, the impacts of the financial crisis on the U.S. auto industry may be putting additional pressure on the $700 billion rescue package enacted on October 3. As potential car buyers continue to face a credit crunch, bipartisan leaders of the Michigan congressional delegation yesterday urged the Treasury to make a portion of the funds available to back auto loans. The request came from House Energy and Commerce Committee Chair John Dingell (D-MI) and Rep. Fred Upton (R-MI). If Treasury takes up that suggestion, funds available to supply capital to community banks or purchased troubled mortgages would be reduced.

Third, a House hearing yesterday took testimony from the leaders of the three major bond rating agencies—Moody's, Standard & Poors, and Fitch. The hearing examined the extent to which those firms’ participation in the mortgage backed securities market may have created conflicts of interest for them that call into question all of their work—including their rating of municipal debt. As the cost of borrowing for state and local government becomes a potential drag on their ability to undertake countercyclical projects, a lack of confidence in the ratings system would only exacerbate the problem.

With jobless claims up by 15,000 from last week and many well-known U.S. companies projecting significant layoffs, economic pressures continue to worsen. The Dow Jones Industrial Average dropped over 500 points yesterday. The Senate Banking Committee will hear today from FDIC Chairman Sheila Bair and Neel Kashkari, the Treasury’s Interim Assistant Secretary for Financial Stability charged with overseeing the implementation of the Emergency Economic Stabilization Act of 2008. Given all the bad news, it will be interesting to see if these officials have any positive developments to report.

Tuesday, October 21—6:30 p.m. EDT

Testimony from academics and industry during today’s House Financial Services Committee hearing produced broad bipartisan consensus that the current regulatory structure is outdated. Testifying on behalf of industry were leaders from the Independent Community Bankers Association (ICBA), the Financial Services Roundtable, the American Bankers Association (ABA), and the Securities Industry and Financial Markets Association. As the committee’s first major hearing following the federal financial rescue efforts, it covered a wide swath of issues outlined below.

Creation of a Select Committee on Financial Reform—Chairman Barney Frank and several members supported this idea. In addition to Financial Services Committee members, a select committee would include members from the House Committees on Oversight and Government Reform, Agriculture, and Ways and Means. One of the academic witnesses, University of Rochester President Joel Seligman, suggested a commission modeled after the 9-11 Commission.

Derivatives—What role did credit default swaps play in the financial crisis? Should there be increased capitalization requirements for derivatives’ issuers? The questions remain, but most agreed on the need for increased oversight of complex financial derivatives.
Broad-based Reform—Former Federal Reserve Vice Chairman Alice Rivlin suggested a range of new mortgage regulations, including uniform minimum standards requiring minimum down payments and documentation; elimination of adjustable rates and pre-payment penalties; authority for bankruptcy judges to renegotiate mortgage loans; and the requirement that the buyers of securities, not the sellers, pay rating agency fees. The ABA echoed the opinion of several panelists who support creating a federal regulator charged with monitoring the entire economy in order to identify financial fault-lines that might lead to systemic risk. There was also discussion of the Paulson "blueprint" Treasury issued last spring that would consolidate financial regulators into three areas: a market stability regulator (the Fed); a new prudential financial regulator (covering the roles of the Office of Comptroller of the Currency, the Office of Thrift Supervision, and the National Credit Union Administration); and a new business conduct regulator (capturing some roles of banking regulators, the Commodity Futures Trading Commission, and the SEC).
Mark-to-market Accounting—The industry panel overwhelmingly opposed mark-to-market accounting rules. Chairman Frank, who was not receptive to this idea during the TARP legislative negotiations, acknowledged that a modification may be needed.

These issues will continue to be the subject of intense debate for the foreseeable future. There are nine different House and Senate hearings scheduled in the next two weeks with Congress not even in session.

Tuesday, October 21—10:15 a.m. EDT

Reports in the media today indicate that the Treasury Department is considering using part of the $250 billion from the initial tranche of financial rescue money to support acquisitions by stronger banks of weaker ones. In retrospect, there was a foretelling of this strategy in the announcement of the initial round of recapitalization transactions with the "big 9" institutions. At that time, Treasury announced that of the $25 billion given both to Bank of America and Wells Fargo, a $5 billion portion in each case was to support their recent acquisitions.

This new emphasis on restructuring the banking system raises some important questions about how deep the Treasury Department plans to go in assisting banks farther down the food chain. On Monday, Secretary Paulson indicated that all "qualifying" regional and community banks would receive capital under the recapitalization program—implying that assistance would not be limited due to a lack of available funds. At the same time however, Treasury has made it clear that not all applications for capital infusion will be accepted.

Adding the emphasis on restructuring the industry raises the question of whether Treasury is going to start picking winners and losers. If they do, the power of Washington over the banking system would appear to be even stronger than many had contemplated under this program.

In other news this morning, the Treasury Department announced the selection of PricewaterhouseCoopers LLP and Ernst &Young to help with the implementation of the Troubled Asset Relief Program (TARP). Treasury said in a release that the firms will "help the Department with accounting and internal controls services needed to administer the complex portfolio of troubled assets the Department will purchase, including whole loans and mortgage backed securities." The contracts will go through September 30, 2011. Treasury valued the PricewaterhouseCoopers contract at $191,469.27 and the Ernst & Young contract at $492,006.95.

Monday, October 20—1:00 p.m. EDT

A short time ago, Treasury Secretary Hank Paulson announced some much-awaited details about the Department’s Capital Purchase Program (CPP). The Treasury will invest $250 billion of capital to U.S. financial institutions in the form of preferred stock. Nine of the largest banks have already agreed to participate in the CPP, which leaves $125 billion remaining. Paulson stressed that the program will not be implemented on a first-come-first-served basis, stating, "Sufficient capital has been allocated so that all qualifying banks can participate."

The Department has developed a single application form for qualified, interested banks to submit to their primary federal regulator – the Federal Reserve, the Federal Deposit Insurance Corporation, the Office of Comptroller of the Currency, or the Office of Thrift Supervision. Once a bank’s primary regulator reviews the application, the regulator will forward the bank’s application to Treasury’s Office of Financial Stability for approval. Paulson said Treasury will "give considerable weight" to the recommendations of the federal regulators. The terms will be the same for all applicants and regulators will use a standardized review process. Treasury will announce all transactions within 48 hours of execution, however, the Treasury will not publicly reveal any applications that are withdrawn or denied. The application deadline remains November 14, 2008.

Institutions participating in the CPP must accept restrictions on executive compensation, including a ban on golden parachutes and a clawback provision. Treasury will also receive warrants for common shares. In addition, Treasury expects participating banks to work with homeowners to avoid foreclosures.

Secretary Paulson encouraged broad participation from banks, including healthy banks, to increase lending around the country. He explained, "Our purpose is to increase confidence in our banks and increase the confidence of our banks, so that they will deploy, not hoard, their capital."

Attached is a copy of the CPP application along with a question and answer sheet of process related issues.

To view the Financial Reform Watch alerts from previous weeks:

Notice: The purpose of this newsletter is to review the latest developments which are of interest to clients of Blank Rome. The information contained herein is abridged from legislation, court decisions, and administrative rulings and should not be construed as legal advice or opinion, and is not a substitute for the advice of counsel.