Tuesday, November 11, 2008

Using the TARP as a Golden Parachute

At the insistence of House Republicans an optional guarantee program for troubled assets was inserted into the Emergency Economic Stabilization Act of 2008 (the "Act"). Section 102 of the Act allows the Treasury Secretary to establish an insurance program for any yet to be determined classes of troubled assets. At the SIFMA Summit of the TARP (Monday November 10, 2008) there was a brief discussion about this section and how many of the Act's conditions may not apply to this section. In particular, it was suggested that limits on executive compensation and corporate governance do not apply.

The law firm of Davis, Polk and Wardell released an analysis of the Act in which they stated

Interestingly, a number of the more general provisions of the Act that apply to TARP do not, by their terms, seem to apply to the Guarantee Program. This may be a result of the hasty drafting of the Act.

To clarify, Section 101 of the Act allows the Treasury Secretary to establish a Trouble Asset Relief Program ("TARP") to purchase troubled assets, while section 102 requires that the Treasury Secretary establish the insurance program. Section 102 states:

If the Secretary establishes the program authorized under section 101, then the Secretary shall establish a program to guarantee troubled assets originated or issued prior to March 14, 2008, including mortgage-backed securities.

By the language of the Act, now that the TARP has been established the guarantee option must be established.

Further in the Act the rules of executive compensation and corporate governance are established. Section 111 limits executive pay, includes a paragraph on bonus claw backs and prohibits golden parachutes. Presumably, these restrictions were intended to apply to any company that seeks assistance under the Act. Specifically, section 111 states

Where the Secretary determines that the purposes of this Act are best met through direct purchases of troubled assets from an individual financial institution where no bidding process or market prices are available, and the Secretary receives a meaningful equity or debt position in the financial institution as a result of the transaction, the Secretary shall require that the financial institution meet appropriate
standards for executive compensation and corporate governance. The standards required under this subsection shall be effective for the duration of the period that the Secretary holds an equity or debt position in the financial institution.

What the Act actually states is that the pay limits and corporate governance only apply if assets are purchased. There is no mention of section 102 or any assets that are guaranteed by the Treasury. This is a loophole that will likely be exploited. Instead of selling assets to the TARP a financial institution is better off having the asset guaranteed by the Treasury and then hold the asset to maturity. Not only will the financial institution benefit from the guarantee it will not have to limit executive compensation or tear up golden parachutes.

Another windfall for the banks in the Act is the prohibition against unjust enrichment. The intent of paragraph (e) of section 101 "Preventing Unjust Enrichment" is to make sure financial institutions do not take advantage of the American taxpayer. Specifically, the Act prevents the financial institution from selling assets to the government at a price above cost. However, this prohibition does not apply to assets acquired in a merger or acquisition. The Act states:

This subsection does not apply to troubled assets acquired in a merger or acquisition, or a purchase of assets from a financial institution in conservatorship or receivership, or that has initiated bankruptcy proceedings under title 11, United States Code.
Add this to a September change in the tax code and you have a bonanza for financial institutions.

On September 29, 2008 the IRS issued notice 2008-83 which amended section 382 of the tax code. Section 382 limited the losses a bank can use when those losses are "acquired" in a merger or acquisition. The intent of the rule was to prevent banks from buying up loss making companies solely as a tax shelter. IRS notice 2008-83 suspended those limits for banks purchasing other banks. It is this change that allowed Wells Fargo to acquire Wachovia without "government assistance", in fact, this change was announced 4 days before the Wells Fargo/ Wachovia deal.

The CFO of Wells Fargo estimated that Wachovia had $74 billion in losses on its loan portfolio, prior to the IRS rule change only about $1 billion could be used as a tax deduction. With the rule change it was estimated by tax expert Robert Willens in a Wall Street Journal article, that Wachovia losses would now be worth $20 billion to Wells Fargo, well above the purchase price of roughly $15 billion.

Once the deal is completed, Wells Fargo can sell those troubled assets to the TARP and use the tax deduction. Or better yet, use the guarantee option of the Act and keep the assets on the books. In this way Wells Fargo will pay a premium for insurance, but will be able to hold the assets to maturity as an insured investment.

The Act was written quickly and broadly which resulted in discrepancies. Coupled with other agency actions the unintended consequence is a windfall for healthy banks.....perhaps was intended?

Disclosures: I am long RKH and may purchase other financial positions.

1 comment:

Jason said...

Once again Congress has failed to use its congressional oversight to protect the American people.

"Fool me once
Shame on you
Fool me twice
Shame on me."
--Chinese Proverb