In October 2008, the U.S. Treasury launched the Capital Purchase Program (CPP) under the Troubled Asset Relief Program (TARP), pursuant to which the Treasury has invested nearly $200 billion in over 500 financial institutions. Almost from the start, the boards and managements of many TARP-recipient institutions have focused on when and how to get out from under Uncle Sam’s umbrella.
The stress test results have now been released, and Secretary Geithner has said that adequately capitalized financial institutions “will have the opportunity to repay” their TARP capital. Conventional wisdom has been that many institutions will rush to repay the government capital. Repurchasing this capital would appear to secure several clear advantages, including the opportunity to repurchase the related warrants at low valuations, the elimination of TARP-related restrictions on executive compensation and the reduction of government influence on governance and management.
There are several issues, however, that should be considered in determining whether to redeem TARP capital. The board and management of TARP recipients should consider whether repayment will require raising new capital today and the cost of that capital, the financial institution’s future capital needs and the potential sources of capital and the likelihood of continued government, shareholder and public scrutiny of compensation practices even after the TARP repayment.
The first part of this bulletin briefly describes the conditions to repayment and the requirements regarding the source of funds for repayment. The second part discusses issues that the board and management of financial institutions that received TARP capital should consider in determining whether to repay the Treasury.
CONDITIONS TO REPAYMENT AND SOURCES OF FUNDS
The terms of the contracts governing the CPP investments permit repayment only with the consent of the financial institution’s primary Federal regulator and require repayment during the initial three-year period after issuance to be funded entirely with the proceeds of cash sales of Tier 1 perpetual preferred stock or common stock. The economic stimulus bill, however, directed the Secretary of the Treasury to permit a TARP recipient to redeem TARP capital, after consultation with its primary Federal regulator, without regard to the source of the funds or the lapse of any period of time.
The May 6th Joint Statement issued by Treasury Secretary Tim Geithner, Federal Reserve Chairman Ben Bernanke, FDIC Chairman Sheila Bair and Comptroller of the Currency John Dugan outlined several conditions to the repayment of TARP funds:
• “Supervisors will carefully weigh an institution’s desire to redeem outstanding CPP preferred stock against the contribution of Treasury capital to the institution’s overall soundness, capital adequacy, and ability to lend, including confirming that [bank holding companies] have a comprehensive internal capital assessment process.”
• “All [bank holding companies] seeking to repay CPP will be subject to existing supervisory procedures for approving redemption requests for capital instruments.”
• In order to repay, the 19 banks which underwent the stress testing process must demonstrate, based on their post-repayment capital structure, that at the end of 2010, assuming the adverse macroeconomic scenario employed in the stress tests, they will have a Tier 1 risk-based ratio of at least 6% and a Tier 1 common risk-based ratio of at least 4%.
• Additionally, these 19 banks must be able to demonstrate their “financial strength by issuing senior unsecured debt for a term greater than five years not backed by FDIC guarantees, in amounts sufficient to demonstrate a capacity to meet funding needs independent of government guarantees.”
Previously, in testimony before the Congressional Oversight Panel on April 21, 2009, Secretary Geithner had said the “ultimate test” for repayment would be whether an individual bank’s repayment would result in a reduction in the overall credit available to the economy.
Based on the above, it appears that, legally and practically speaking, the required source of funds for repayment of TARP funds will depend primarily on an institution’s financial strength, capital adequacy and liquidity, as determined by the Federal Reserve (or Office of Thrift Supervision in the case of thrift holding companies). Moreover, the approval of the regulator for any redemption (as opposed to mere consultation) may be required under existing supervisory procedures (for example, under Federal Reserve regulations and policies, if the redemption would reduce consolidated net worth by 10 percent or more or have a “material effect” on the institution’s capital base). Strong financial institutions with adequate capital and liquidity may be allowed to repay TARP capital with funds from any source, including cash on hand or retained earnings. Less well-capitalized financial institutions, however, may be required to adhere more closely to the original terms of the CPP and repay at least a substantial portion of the TARP funds with the proceeds of Tier 1 capital issuances.
…continue reading: Throwing Off the TARP – Implications of Repaying Uncle Sam