Recent Government Initiatives Force Banks To Make Important Decisions

Monday, May 4, 2009 - 01:00

In a further effort to lessen the turbulence within the nation's financial markets and, in particular, the banking industry, the Obama administration on Feb. 10, 2009, introduced the Financial Stability Plan (the Stability Plan) and presented a broad outline of its initiatives to the American public. Treasury Secretary Timothy Geithner discussed the importance of credit markets to the economy as a whole and explained that the Stability Plan was intended "to help restart the flow of credit, clean up and strengthen our banks, and provide critical aid for homeowners and for small businesses." The Stability Plan recognizes that the perceived lack of transparency and accountability that accompanied the first round of Troubled Asset Relief Program (TARP) funding was a source of public frustration, and as a result, according to Geithner, the administration is "fundamentally reshaping the government's program."

The Stability Plan - often referred to as TARP Part II - calls for increased oversight and establishes a balance sheet "stress test" that financial institutions must pass prior to receiving capital assistance from the government. While certain details of the stress test have yet to be disclosed, the fact sheet accompanying the announcement explains that it will include a realistic and forward-looking assessment of whether the institution has the capital necessary to continue lending and to absorb the potential losses that could result from a more severe decline in the economy than projected. Institutions that participate in the Stability Plan will also be required to adhere to conditions designed to ensure that each dollar of capital assistance results in increased lending; limit executive compensation; commit to mortgage foreclosure mitigation; and restrict dividends, stock repurchases and acquisitions. All equity purchases made under the Stability Plan will be placed in a separate entity - the Financial Stability Trust - established to manage the government's investments in financial institutions.

In addition to modifying the capital purchase program, the Stability Plan also establishes the Public-Private Investment Fund (the PPI Fund), which seeks to address the inherent complexity in pricing the toxic assets the TARP program was initially intended to purchase. Through the PPI Fund, the government will provide financing to help leverage private capital and help restart a private but government-leveraged market for real estate-related assets that are at the center of the economic crisis. While the Treasury Department is still seeking input from market participants and considering a range of possibilities in regard to a pricing mechanism, ultimately up to $1 trillion in financing will be injected into the PPI Fund.

The Stability Plan also calls for the implementation of two lending initiatives. The first, the Consumer and Business Lending Initiative (the CBL Initiative) - to be funded by up to $1 trillion - is intended to revive the secondary lending markets and reduce borrowing costs. The CBL Initiative recognizes the important role that securitization plays in freeing up funds to allow additional loans to be made. The CBL Initiative, by expanding the resources of the Term Asset-Backed Securities Loan Facility (TALF), which was announced in November of last year but will not commence funding until March 25, will support the purchase and packaging of loans by providing financing to private investors. The initial plan is to use $100 billion of Treasury funds to leverage $1 trillion in lending from the Federal Reserve. In addition to expanding the resources of the TALF program, the CBL Initiative also expands its reach to include commercial mortgage-backed securities. Moreover, the CBL Initiative will remain free to include other asset classes in the future, including residential mortgage-backed securities and assets collateralized by corporate debt.

The second lending initiative, the Small Business and Community Lending Initiative (the SBCL Initiative), seeks to address the damage inflicted upon small businesses as a result of increased capital constraints of banks and the inability to sell Small Business Administration (SBA) loans on the secondary market. While funding levels have yet to be disclosed, the SBCL Initiative will be used to finance the purchase of SBA loans in an effort to unfreeze the secondary markets. The SBCL Initiative will also increase the government's guarantee on SBA loans to 90 percent and reduce fees and paperwork related to the processing of small-business loan applications.

Finally, the Stability Plan had initially called for a comprehensive mortgage foreclosure relief program with government funding of up to $50 billion. Since the time of the announcement, however, the funding level has been increased to $75 billion, with details more clearly set forth in President Barack Obama's announcement of the Homeowner Affordability and Stability Plan (the Homeowner Plan) and the component "Making Home Affordable" Loan Modification Program (the Modification Program). The Homeowner Plan is intended to help seven million to nine million homeowners restructure or refinance their mortgages in order to avoid foreclosure. It recognizes that many homeowners are unable to refinance and take advantage of historically low rates due to a precipitous decline in property values. The decline has left these homeowners owing more than what their homes are worth. The Homeowner Plan provides the opportunity for these homeowners to refinance through Fannie Mae and Freddie Mac.

The Homeowner Plan also aims to reduce the amount of monthly payments for an additional number of qualified mortgage holders through the Modification Program, guidelines for which were announced by the Treasury Department and federal regulators on March 4.

The Modification Program includes a reduction of interest rates to a level sufficient to bring the borrower's monthly mortgage payment to an amount no greater than 38 percent of his or her income. From there, the government will match further reductions in interest payments dollar for dollar with the lender until the rate is reduced to 31 percent of the borrower's income. Reductions to the 31 percent mark are to be accomplished first by attempting to lower the interest rate to two percent. From that point, if the 31 percenttarget has not been reached, servicers must attempt to extend the loan to a 40-year period. Finally, if the 31 percent target has still not been reached, servicers are required to forbear principal. Servicers may choose to reduce principal; however, there is nothing in the Modification Program that requires them to do so. Each eligible loan may receive only one modification, which would last until Dec. 31, 2012, after which time the interest rate would increase by 1 percent per year or such lesser amount as may be required until the rate reaches the relevant interest rate cap, when it would become fixed for the remaining loan term. Modifications are available for loans originated prior to Jan. 1, 2009.

The Modification Program also contains incentives for servicers, borrowers and lenders to encourage participation in the program. The servicer incentives include an upfront incentive payment of $1,000 for each eligible modification and Pay-for-Success payments of up to $1,000 per year for three years as long as the borrower remains in the program. Borrowers are eligible for bonus incentives that go straight toward reducing the principal amount by up to $1,000 per year for up to five years. Finally, one-time bonus incentives of $1,500 and $500 are available to lenders and servicers, respectively, for modifications made while borrowers are still current on their mortgage payments.

While questions remain as to what impact the Stability Plan and the related Homeowner Plan will have on the nation's economic recovery, questions also abound for bankers and financial institutions impacted by the recent developments. For example, which institutions will be subject to the "stress test" and what will such a test involve? Moreover, in addition to present requirements and mandates, the Stability Plan provides broad latitude to impose additional conditions and restrictions. Financial institutions should carefully consider the potential for future restrictions and evaluate the impact of their decision to participate in one or more of the various programs.

Both authors are Members of Stradley Ronon's Business Practice Group. Chistopher S. Connell, a Partner, focuses his practice on real estate and banking law, and Daniel C. Knox, an Associate, focuses his practice on general business matters.

Please email the authors at cconnell@stradley.com or dknox@stradley.com with questions about this article.