Troubled Asset Relief Program

The U.S. financial system experienced a severe liquidity crisis in September 2008 when a series of distressing events occurred in various key industries. On September 7, 2008, the Federal Housing Finance Agency (FHFA) placed two major Government Sponsored Enterprises (GSE), Freddie Mac and Fannie Mae, into government conservatorship run by the FHFA in order to ensure financial soundness of these two troubled companies and stabilise the mortgage market. This was the most significant U.S. government intervention in private sector in decades.

A week later, the largest bankruptcy filing in the history of U.S. financial system occurred when the Lehman Brothers Holding Inc. filed for bankruptcy on September 15, 2008.1 Consequently, many other financial institutions linked to the Lehman Brothers Holding Inc. incurred significant losses. For instance, the day after, the Reserve Primary Fund, one of the oldest and largest U.S. money market mutual funds, broke the buck due to writing off its debt securities issued by Lehman Brothers Holdings Inc. The failure of the Reserve Primary Fund triggered a run on many other money market mutual funds, which played a pivotal role in providing liquidity in the market place.2

The American International Group Inc. (AIG) was another major financial institution facing liquidity difficulties in the tumultuous month of September. The company suffered from significant losses on its investments on a wide range of financial instruments and dramatic decline in its stock price. Consequently, the AIG’s credit

1 _{On the same day, Merrill Lynch & Co., an investment bank giant that was facing significant losses} attributed to its exposure to Collateralised Debt Obligations (CDOs), was acquired by Bank of America.

2 _{In response to rising anxiety in money market, the U.S. Department of the Treasury launched a}

temporary guarantee program on September 19, 2008. This program provides up $50 billion from the Exchange Stabilization Fund to guarantee to restore the net asset value (NAV) of a participating money market mutual fund to $1 in the event it breaks the buck.

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rating was downgraded by various credit rating agencies, which obliged the company to post significant amount of additional collateral. Unable to meet mounting demands for additional collateral, the company experienced a severe liquidity crisis, which placed the AIG on the verge of collapse.3

With worsening financial conditions, many banks that were already struggling with their mortgage portfolios, started to experience dramatic deposit outflows. Among them was the Washington Mutual Bank (WaMu), the U.S. largest savings and loan association with total assets of over $300 million, which was declared insolvent by the Office of Thrift Supervision (OTS) and placed into receivership of the FDIC on September 25, 2008.4 The failure of WaMu was the largest bank failure in the history of the U.S. banking system, which intensified the pressure on other banking institutions including large banks with ‘too-big-to-fail’ status.5

For the first time in generations, the whole financial system in the U.S. was on the verge of collapse due to a widespread panic and lack of trust among investors and financial institutions. It was out of these distressing conditions that a bipartisan majority of Congress passed and President Bush signed into law the Emergency Economic Stabilization Act (EESA) on October 3, 2008. The EESA authorised the Department of the Treasury to establish Troubled Asset Relief Program (TARP) to stem the panic, restore confidence in the financial markets, and restart economic growth.

Under the TARP, the Department of the Treasury was authorised to either purchase or insure up to $700 billion of troubled mortgage-related assets of financial institutions in order to clean up their balance sheets, enhance market liquidity and stabilise housing and financial markets. However, on October 14, the Department of the Treasury announced a revised version of the original TARP plan and launched Capital

3 _{In an attempt to avoid the disastrous repercussions of AIG collapse, the Federal Reserve Board}

authorised the Federal Reserve Bank of New York to provide an emergency loan of up to $85 billion to the company on September 16, 2008.

4 _{On the same day, all assets, deposits, certain liabilities, and banking operations of WaMu were acquired}

by the JPMorgan Chase for a mere $1.9 billion and at no cost to the FDIC.

5 _{For instance, the day after the seizure of WaMu, Wachovia, the fourth largest U.S. bank at that time,}

appeared to be on the verge of failure due to large deposit outflows and significant decline in its stock price. Eventually, the banking operations of Wachovia Corporation were acquired by Wells Fargo on October 3, 2008.

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Purchase Program (CPP) as an initial program, which was later followed by several other programs under TARP.6

The CPP, as the largest program launched under the TARP, was designed to purchase up to $250 billion of preferred stock and equity warrants from viable financial institutions. Warrants are derivative securities that give the holder the right to purchase a stock at a specific exercise price until the expiration date. For each CPP investment in a publicly traded company, the Treasury received warrants to purchase shares of common stock equal to 15% of the senior preferred stock investment. These warrants are exercisable at any time over a ten year period and with exercise prices set at the 20- trading day trailing average stock price of a company as of the investment date.7

On October 28, 2008, the initial round of CPP investments, $115 billion, was allocated to eight giant banking institutions.8 Over the course of the program, 707 financial institutions, in 48 states, received approximately $205 billion as CPP investments through December 29, 2009.9 In return, the CPP participating banks were subject to certain requirements. The shares purchased by the Treasury under CPP have dividend rate of 5% per year for the first five years and 9% per year afterwards. Also, the Treasury established certain standards and rules applicable to executive compensation practices of CPP recipients, for so long as the Treasury owns their shares or warrants.

6 _{In general, the TARP created 13 different programs which can be broken down into five major}

programs; namely Bank Investment Programs, Credit Market Programs, AIG Assistance Program, Automobile Industry Support, and Housing Programs.

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Upon the redemption of the senior preferred stock investment, an institution can either repurchase its warrants at the fair market value, or the Treasury would sell the warrants to third parties through public auction.

8 _{The first recipients of the CPP investments were Bank of America Corp., Goldman Sachs Group Inc.,}

JPMorgan Chase & Co., Wells Fargo & Co., Bank of New York Mellon Corp., Citigroup Inc., State Street Corp, and Morgan Stanley. To be eligible for TARP funds, Goldman Sachs Group and Morgan Stanley converted from investment banks to bank holding companies in September 2008.

9 _{The treasury also purchased $20 billion in preferred stock from Bank of America Corp. and Citigroup}

Inc. However, since the CPP was notionally designed for viable institutions, this assistance came under a new program called under the Targeted Investment Program (TIP) which was designed to provide additional funds to stabilise institutions that were considered to be systematically significant.

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Some CPP terms and conditions were amended on February 17, 2009, when President Obama signed into law the American Recovery and Reinvestment Act (ARRA). Among other changes, ARRA imposed more restrictions on the executive compensation practices of CPP recipients. Also, the enactment of ARRA eliminated the three year waiting period and allowed recipient banks to repay the CPP funds and exit the program, subject to consultation with the appropriate Federal banking agency.

TARP authority was amended by Dodd–Frank Wall Street Reform and Consumer Protection Act which reduced the authorized amount to $475 billion. The Treasury’s authority to make investment under TARP expired on October 3, 2010, and since then the Treasury has been focusing on winding down remaining TARP investments. Of approximately $245 billion disbursed to banking institutions under Bank Support Programs, the Treasury has received total cash back of approximately $273 billion including net capital repayments, interest and dividends, and warrant proceeds, as of September 2013.