Financial Markets in Crisis: Applications Are In

October 9, 2008

The Gibson, Dunn & Crutcher Financial Markets Crisis Group is tracking closely government responses to the turmoil that has catalyzed dramatic and rapid reshaping of our capital and credit markets.

We are providing updates on key regulatory and legislative issues as well as information on legal issues that we believe could prove useful as firms and other entities navigate these challenging times.

This update focuses on the status of the Treasury Department’s implementation of the Troubled Asset Relief Program (“TARP”).

Hiring of Asset Managers

The Treasury Department is moving quickly to implement TARP.  On Monday, it began soliciting proposals for three types of services.  The proposals were due forty-eight hours later, on Wednesday at 5:00 p.m.  The three types of services are:  whole loan asset management; securities asset management; and custodian, accounting, auction management, and other infrastructure services.

Whole loan asset managers will manage a portfolio of dollar-denominated mortgage whole loans, which Treasury will purchase from financial institutions.  These whole loans will include residential first mortgages, home equity loans, second liens and commercial mortgage loans, which were originated on or before March 14, 2008.

Securities asset managers will manage a portfolio of troubled assets including securities, obligations, or other instruments based on or related to residential and commercial mortgages, which were originated on or before March 14, 2008.  These securities will include Prime, Alt-A, and Subprime residential mortgage backed securities (“MBS”), commercial MBS, and MBS collateralized debt obligations.  These assets will not include securities issued or fully guaranteed by Fannie Mae and Freddie Mac.

Treasury also requested proposals for companies interested in providing custodian, accounting, auction management, and other infrastructure services to TARP.  Treasury intends to select one financial agent to provide services such as custody, asset tagging, asset pricing and valuation, cash management, accounting, management reporting, and Federal Government financial reporting, as well as auction management services for reverse auctions and other asset acquisition mechanisms.

The three solicitations included minimum size requirements that prevented many financial institutions from qualifying.  Treasury, however, has indicated that it is likely to issue, at a future date, separate solicitations for smaller and minority- and women-owned financial institutions.  Somewhat curiously, the whole loan asset management solicitation states that a separate solicitation “may” be issued whereas the securities asset management solicitation states that a separate one “will” be issued.

Note, too, that section 107 of the EESA makes the Federal Deposit Insurance Corporation eligible for the asset management roles that were the subjects of Treasury’s Tuesday solicitations.

Financial Agent Authority

The Treasury Department has indicated that it may employ either or both of two mechanisms to engage private sector firms – financial agent authority and procurement contracts under the Federal Acquisition Regulation (“FAR”).  Treasury has further indicated that it will use the financial agent authority to hire asset managers.[1]  The Emergency Economic Stabilization Act (“EESA” or “the Act”), which created TARP, declares that Treasury may “designat[e] financial institutions as financial agents of the Federal Government, and such institutions shall perform all such reasonable duties related to this Act as financial agents of the Federal Government as may be required.”[2]  Under the Act, “financial institutions” are defined as “any institution, including, but not limited to, any bank, savings association, credit union, security broker or dealer, or insurance company” established and regulated under United States law.[3]

Compared to the FAR authority, Treasury’s financial agent authority affords the agency much greater discretion in its arrangements with financial institutions.  Describing the relationship, Treasury has explained that, “[t]he designation of a financial institution as a financial agent creates a principal-agent relationship between Treasury and the financial agent.  As in any agency relationship, as agents of the United States, financial agents act upon the instructions of the principal, the Treasury, and answer only to the principal.”[4]  The Court of Appeals for the Federal Circuit has said of the arrangement that, “the government, as principal and in its sovereign capacity, delegates to its financial agents some of the sovereign functions that the government itself would otherwise perform.”[5]  The court likened the hiring process to the appointment of public employees, “which is not a matter of contract even when terms and conditions guide the employment relationship.”  Instead, like an appointment, a financial institution’s financial agency “results from the conferral of a status.”[6]

Financial Stability Oversight Board Meeting

The Financial Stability Oversight Board (“FSOB”), created by section 104 of the EESA, met for the first time on Tuesday, October 7.  We understand that, at the FSOB meeting, it was reported that the program will be sending out requests for proposals from accounting firms and law firms shortly.  Asset managers and the provider of custodial and infrastructure services is likely to be selected by early next week.

Recall that, under section 101 of the EESA,  Treasury is to publish TARP guidelines within 45 days of enactment.  Guidelines must include the mechanisms for purchasing, methods for pricing and valuation, and criteria for identifying troubled assets.  The FSOB hopes to announce program guidelines within two weeks and to begin purchasing assets within a month.

Possible Expansion of Program

In a statement given yesterday, Secretary Paulson commented on Treasury’s ability to “inject capital into financial institutions.”[7]  Until recently, Treasury has focused on purchasing troubled assets from ailing financial institutions, but now, Treasury officials reportedly are trying to find ways to take equity stakes in struggling banks.[8]  This afternoon, it was reported that such a plan would be implemented “soon.”[9]  Paulson cautioned, however, that “even with the new Treasury authorities, some financial institutions will fail.”

Regarding the Secretary’s authority to invest in banks, one might posit that he could do so under his authorities under TARP to buy “troubled assets” (section 101) and to include in the definition of “troubled assets” preferred stock (as “instruments” “related to mortgages” and the purchase of which “promotes financial market stability” (section 3)).   Treasury has not officially stated from where these authorities might derive nor whether the Secretary will exercise them.

Reaction from the Hill

House Speaker Nancy Pelosi wrote Secretary Paulson on Tuesday expressing dismay that the conflict of interest standards promulgated by Treasury allow financial institutions that benefit from TARP to be eligible to participate as asset managers.  She urged Secretary Paulson to strengthen the interim guidelines to avoid the appearance of conflicts of interest and to bolster Americans’ confidence in the plan.[10]

Please view Gibson Dunn’s complete series of updates on the financial markets crisis on our website.