Summary and Analysis of the Troubled Asset Relief Program

The United States is in the midst of the worst financial crisis since the Great Depression. The credit markets are barely functioning, numerous financial institutions are failing, and real estate values are plummeting. What started as a breakdown of the credit markets has spread throughout the entire economy. In an attempt to strike at the heart of the current credit crisis, the Emergency Economic Stabilization Act of 2008 (the “Act”) establishing the Troubled Asset Relief Program (the “Program”) was enacted on Oct. 3, 2008 in an effort to “restore liquidity and stability to the financial system of the United States.” (Act at '2(1)). This article cuts to the substance of the Program, examining the provisions dealing with the actual purchase, management, and sale of troubled assets, with an eye toward the financial community.

Program Overview

Under the Program, the Secretary of the Treasury (the “Secretary”), acting through a newly created Office of Financial Stability, is authorized to purchase “troubled assets” from “any financial institution.” (Act at '101(a)). Alternatively, the Program permits the Secretary to guaranty troubled assets. (Act at '102). In establishing and running the Program, the Secretary is permitted to designate “financial agents of the Federal Government” and form vehicles “to purchase, hold and sell financial assets and issue obligations.” (Act at '101(c)(3) and (4)). The Act gives the Secretary significant authority and discretion to be exercised in a manner to protect the value of personal investments, minimize foreclosures, boost the economy, maximize the return on investments, and provide accountability to the public. (Act at '2).

Eligible Assets

“Troubled assets” are defined broadly as “residential or commercial mortgages and any securities, obligations, or other instruments that are based on or related to such mortgages,” originated or issued on or before March 14, 2008, and “any other financial instrument that the Secretary ' determines the purchase of which is necessary to promote financial market stability. ' ” (Act at '3(9)(A) and (B)).

A wide range of financial assets are eligible for purchase under the Program. Almost all real estate related instruments are generally contemplated. Treasury has also interpreted troubled assets to include direct equity investments in banks. The voluntary Capital Purchase Program was enacted to encourage financial institutions to build capital to increase the flow of financing to support the economy.

Under the Capital Purchase Program, the Secretary is authorized to purchase up to $250 billion of senior preferred shares in qualifying U.S. controlled banks, savings associations, and certain bank holding companies. The Secretary will determine specific eligibility and allocations for an interested financial institution after consultation with the appropriate federal agency that regulates such financial institution. Both the warrant provisions and executive compensation limits discussed later are applicable to the Capital Purchase Program. The deadline for election to participate in the program is Nov. 14, 2008.

Eligible Sellers

The Secretary may purchase troubled assets from any “financial institution” defined as “any institution ' established and regulated under the laws of the United States or any State ' and having significant operations in the United States, but excluding any central bank of, or institution owned by, a foreign government.” (Act at '3(5)).

To be eligible to sell troubled assets, a financial institution must not only be established in the United States, but also must be regulated here. Federal and state chartered banks, insurance companies, broker-dealers, mutual funds, registered investment companies, and employee retirement plans are all eligible sellers. Any such institution may be owned by a non-U.S. entity other than a foreign government. The voluntary Capital Purchase Program has its own requirements for institutions which qualify under that program.

Program Limit and Term

The aggregate purchase price of troubled assets “outstanding at any one time” under the Program (the “Program Limit”) may not exceed $250 billion, which may be raised by Presidential certification to $350 billion and, unless rejected within 15 days after notice by Congress, further raised to $700 billion. (Act at '115). The Secretary's authority to purchase, commit to purchase or insure troubled assets (the “Program Term”) expires on Dec. 31, 2009, provided that the Secretary may extend such date to not later than Oct. 3, 2010. (Act at '120(a) and (b)).

For the duration of the Program Term, the Program will consist of a revolving fund (the “Fund”) that may be increased as assets are removed from the Fund. Sales or liquidations of troubled assets by the Fund will reduce the amount considered “outstanding.” After the Program Term, the Secretary will no longer be authorized to make commitments to purchase new assets or issue new guarantees; however, the Program will continue until all purchased assets have been sold or liquidated (and all guarantees have expired). During this time, the assets will continue to be serviced and managed for the Fund. It is probable that most sales and other financial transactions involving purchased assets will take place after the Program Term, when markets have, it is hoped, stabilized and losses are more determinable.

Asset Acquisition and Insurance

Purchases of Troubled Assets

The centerpiece of the Program is the Secretary's ability to purchase troubled assets from ailing financial institutions in an attempt to stem the write-downs and losses being taken by such institutions. By establishing “market” prices for troubled assets and providing liquidity to the market, the Program also seeks to encourage private participants to begin purchasing mortgage-related and other structured products as well. In furtherance of these goals, Treasury will publish program guidelines within the earlier of two days after the first asset purchase or 45 days after enactment of the Act. (Act at '101(d)). Given the breadth of affected assets and institutions, we expect the program guidelines to be general, ensuring broad discretion and flexibility in their implementation.

Process and Pricing

In making purchases under the Program, the Secretary has broad discretion to purchase assets subject to the requirement that the Program “minimize any potential long-term negative impact on the taxpayer.” (Act at '113(a)(1)). In that regard, the Secretary must purchase assets at the lowest price consistent with the Act's purposes and is encouraged to use market mechanisms, such as auctions and reverse auctions, to accomplish that goal. (Act at '113(b)(2)).

Purchases may be made directly from an institution or through an open market auction process. In cases where the Secretary determines it is necessary to purchase directly from an institution, the Fund must obtain “meaningful” equity or debt interest in the selling institution, and significant executive compensation limits will be imposed on such institution. (Act at '111(b)). Furthermore, the Capital Purchase Program lays out detailed warrant provisions and requirements for when Treasury will make a direct investment in the equity of a qualifying financial institution.

Establishing the price at which the Fund will purchase troubled assets will be the key to its success. There are billions of dollars of private funds available to purchase distressed assets. For the most part, these funds have not been activated yet because potential sellers are unwilling to take the losses that would result from the prices that potential purchasers are seeking. There will be significant pressure to balance the demand to maximize the return to taxpayers and the need to minimize losses to selling institutions.

Indications to date, including testimony by Federal Reserve Chairman Ben S. Bernanke, indicate that prices will give greater consideration to expected losses and future cash flows than current distressed market prices. However, more distressed institutions or institutions with less exposure to certain asset types may be willing to sell at lower prices. Once prices have been established for a particular class of assets, there will be pressure on other institutions to mark (or sell) their similar assets at similar prices. In addition, not all assets of the same type are created equal.

The Act expressly permits financial institutions to make a profit on the sale of assets acquired in a merger or acquisition (such as the Merrill, Wamum, and Wachovia transactions) or from an institution in bankruptcy, conservatorship, or receivership (such as IndyMac or Lehman). This provision should make it easier for troubled institutions to find willing merger partners, by not only reducing the risk associated with troubled assets held by such institutions but also making it possible to profit from troubled assets acquired in such transactions.

Purchase Conditions

Congress required that certain punitive conditions be imposed on all but the smallest sellers of troubled assets and authorized the Secretary to impose any other conditions deemed appropriate.

1. Warrants/Senior Debt

In any purchase (other than de minimis purchases of not more than $100 million), the Secretary must receive, in the case of an exchange traded institution, warrants to purchase nonvoting common or preferred stock and, in the case of all other institutions, either warrants or senior debt instruments. (Act at '113(d)). The warrants or debt obtained must be designed to ensure reasonable participation in the appreciation in value of the institution or a reasonable rate of return in the case of debt instruments. (Act at '113(d)(2)(A)(i) and (ii)). Any warrants must contain appropriate market standard anti-dilution provisions. (Act at '113(d)(2)(D)).

2. Executive Compensation

If the Fund purchases assets directly from an institution, the Secretary must also require the institution to “meet appropriate standards for executive compensation and corporate governance.” (Act at '111(b)(1)). Such standards must exclude incentives for senior executive officers of a financial institution to take unnecessary and excessive risks, provide for the recovery of any bonus or incentive compensation paid to a senior executive officer based on earnings or other criteria that are later proven to be materially inaccurate, and prohibit golden parachute payments to its senior executive officer during the period that the Secretary holds an equity or debt position in the financial institution. (Act at '111).

If the Fund purchases any assets through an auction process, and the aggregate purchases from the selling institution exceed $300 million (including direct purchases), the institution will be required to adopt less severe restrictions on executive compensation. (Act at '302(a); see also 26 U.S.C. '162(m)).

3. Market Conditions and Criteria

A variety of market conditions and criteria will be imposed upon the purchase of troubled assets. Standardized purchase agreements presumably will be created for the Program, which will vary depending on the type of assets being purchased and whether the assets are acquired directly or through an auction. Each agreement will need to address delivery and custody issues (including required documentation), due diligence, representations and warranties, and servicing issues. For securities, diligence regarding control rights and other legal priorities and remedies may be crucial.

Due Diligence. It is expected that the Fund will perform some level of due diligence with respect to troubled assets that it purchases under the Program. Any such diligence would be potentially more extensive for residential or commercial whole loans, REO properties and participation interests (collectively, “Real Estate Assets”) than for securities. Items which should be explored include property value, legal compliance, borrower credit files, borrower credit, including updated credit scores and other customary borrower and collateral due diligence.

Representations and Warranties. There is a significant difference in sellers' representations and warranties in the market today compared with a year ago. Sellers are making fewer representations, and, as noted above, purchasers must rely more on due diligence. However, it is unclear the extent to which the Fund will require representations and warranties on Real Estate Assets that it acquires. At a minimum, it is expected that sellers will be required to warrant good title; however, whether the Fund will insist on market standard “whole loan” representations and warranties is unclear. The Fund should weigh the value of representations and warranties against the creditworthiness of the particular seller.

Servicing and Control Issues. Servicing and control issues will be a significant factor in determining which assets the Fund purchases and how it prices them. Real Estate Assets will command a higher price if sold “servicing released,” in which case, the Fund will be able to sell the servicing rights to a servicer selected by the Fund. Given the modification and homeowner protection requirements of the Act, it is likely that the Fund will attempt to control the appointment of servicers to the greatest extent possible.

The Fund may also acquire subordinate tranches of residential and commercial mortgage-backed securities and other securities (“Real Estate Securities”), which may include the “first loss” or “B-piece” or pieces. By purchasing such positions, the Fund may be able to acquire control over the servicing or obtain some form of special servicing rights for servicing delinquent mortgage loans or REO, which may be particularly appealing to the Fund with respect to its foreclosure mitigation directive. Through these rights, the Fund could control the servicing of the mortgage loans with generally the same financial impact as if the Fund owned the mortgage loans directly.

Acquisition Vehicles

The Act permits the Secretary to establish vehicles “to purchase, hold, and sell troubled assets and issue obligations.” (Act at '101(c)(4)). Subject to the general purposes of the Program, there is no restriction on the type or number of vehicles that the Secretary may establish.

The Secretary will not have to consider the tax, limitation of liability, and bankruptcy issues that private institutions must consider when forming entities to hold assets. As a result, the form of vehicle used will likely relate more to convenience, flexibility, and suitability for the assets being held and the types of obligations that may be issued.

Troubled Asset Insurance

As an alternative to selling assets to the Secretary, financial institutions may request that the Secretary guarantee the timely payment of principal of, and interest on, troubled assets, including mortgage-backed securities. (Act at '102). The limit on the Secretary's spending authority for the Program will be reduced by the excess of the “total outstanding guaranteed obligations [over] the balance in the Troubled Assets Insurance Fund.” (Act at '102(c)(4)).

The insurance program seems most appropriate for senior/super-senior securities that have little risk of loss but are nonetheless depressed in value given the general lack of liquidity. These securities are highly illiquid in the current environment and given the low risk, premiums should be low, and, with a TARP guaranty, these otherwise distressed securities would have the benefit of the equivalent of the full-faith and credit of the U.S. government, increasing their value and liquidity. On the other hand, the high premiums required to cover expected losses are likely to discourage the use of the insurance program for riskier assets. Targeted use of the insurance program, however, could result in a very efficient use of amounts available under the Program Limit.

Management and Servicing

The basic provisions related to the Secretary's general authority to manage assets purchased under the program are straightforward and extremely broad. (Act at '106(a), 106(b) and 101(c)(4)). This broad authority is qualified with respect to residential products by the requirement that the Secretary “encourage the servicers of the underlying mortgages ' to minimize foreclosures [and] to facilitate loan modifications to prevent avoidable foreclosures.” (Act at '109(a)).

The Act further provides that, except as established in any contract, a servicer of pooled residential mortgages will be deemed to act in the best interests of all investors if the servicer implements a workout plan involving reasonable loss-mitigation measures, including partial payments. This further broadens protections which were granted to servicers pursuant to '1403 of the Housing and Economic Recovery Act. This provision, along with '109(b), effectively opens up the safe harbor to situations where the loan is not in default and to non-owner occupied residences.

In addition, the Secretary may use loan guarantees and credit enhancements to facilitate loan modifications to prevent avoidable foreclosures. (Act at '109(a)). If the Secretary were to make available credit enhancement that covered specific loans that had been modified, this could alter the equation of the servicer's net present value determination. If credit enhancements were added that eliminated re-default risk, the servicer would effectively be able to offer more favorable modification terms to the borrower while still complying with its contractual duties under the securitization documents.

Thus, under the Program, the Secretary has a very meaningful opportunity to bring market pressure to bear on servicers to adopt specific approaches to loan modifications and workouts, not only for whole loan pools purchased under the Program but also for mortgage-backed securities.

Sale and Financing of Purchased Assets

The provisions regarding the sale of assets purchased under the Program are brief and to the point. (Act at '106(c) and 113(a)(2)). It is unlikely that troubled assets purchased under the Program will be resold quickly. The primary purpose of the Act is to “restore liquidity and stability. ' ” (Act at '2(1)). Actual losses on most troubled assets are expected to be significantly less than the decline in market value on those assets. Thus, by removing troubled assets from the market and the balance sheets of financial institutions, the Secretary can hold assets until the market stabilizes and the actual losses become more certain.

When assets are resold, it is expected that in many cases new securities will be created, taking into account then-current assumptions about losses and required spreads. In such cases, existing securities would be repackaged into new securities. Due to the Program Limit, it is also possible that some assets may be repackaged to increase credit enhancement (reducing or eliminating expected losses) and resold fairly quickly, thereby increasing the number of troubled assets that the Program can purchase.

Conclusion

The Secretary has significant authority to provide stability and liquidity to the capital markets through the Program. There will be many opportunities for financial institutions to participate in the process, as sellers managers, servicers, advisers, or investors. We are confident that the financial community will bring its collective knowledge, experience and, of course, capital, to bear on rebuilding the capital markets and providing (rational) financing for individuals and businesses around the world.

Erik D. Klingenberg is a partner in the Structured Finance practice at Thacher Proffitt & Wood LLP and chair of the Troubled Asset Relief Program interdisciplinary group. Klingenberg's practice involves all aspects of commercial and residential mortgage-backed securities, asset-backed securities, collateralized debt obligations, and other structured products. He may be reached at [email protected] or 212-912-7400.

The United States is in the midst of the worst financial crisis since the Great Depression. The credit markets are barely functioning, numerous financial institutions are failing, and real estate values are plummeting. What started as a breakdown of the credit markets has spread throughout the entire economy. In an attempt to strike at the heart of the current credit crisis, the Emergency Economic Stabilization Act of 2008 (the “Act”) establishing the Troubled Asset Relief Program (the “Program”) was enacted on Oct. 3, 2008 in an effort to “restore liquidity and stability to the financial system of the United States.” (Act at '2(1)). This article cuts to the substance of the Program, examining the provisions dealing with the actual purchase, management, and sale of troubled assets, with an eye toward the financial community.

Program Overview

Under the Program, the Secretary of the Treasury (the “Secretary”), acting through a newly created Office of Financial Stability, is authorized to purchase “troubled assets” from “any financial institution.” (Act at '101(a)). Alternatively, the Program permits the Secretary to guaranty troubled assets. (Act at '102). In establishing and running the Program, the Secretary is permitted to designate “financial agents of the Federal Government” and form vehicles “to purchase, hold and sell financial assets and issue obligations.” (Act at '101(c)(3) and (4)). The Act gives the Secretary significant authority and discretion to be exercised in a manner to protect the value of personal investments, minimize foreclosures, boost the economy, maximize the return on investments, and provide accountability to the public. (Act at '2).

Eligible Assets

“Troubled assets” are defined broadly as “residential or commercial mortgages and any securities, obligations, or other instruments that are based on or related to such mortgages,” originated or issued on or before March 14, 2008, and “any other financial instrument that the Secretary ' determines the purchase of which is necessary to promote financial market stability. ' ” (Act at '3(9)(A) and (B)).

A wide range of financial assets are eligible for purchase under the Program. Almost all real estate related instruments are generally contemplated. Treasury has also interpreted troubled assets to include direct equity investments in banks. The voluntary Capital Purchase Program was enacted to encourage financial institutions to build capital to increase the flow of financing to support the economy.

Under the Capital Purchase Program, the Secretary is authorized to purchase up to $250 billion of senior preferred shares in qualifying U.S. controlled banks, savings associations, and certain bank holding companies. The Secretary will determine specific eligibility and allocations for an interested financial institution after consultation with the appropriate federal agency that regulates such financial institution. Both the warrant provisions and executive compensation limits discussed later are applicable to the Capital Purchase Program. The deadline for election to participate in the program is Nov. 14, 2008.

Eligible Sellers

The Secretary may purchase troubled assets from any “financial institution” defined as “any institution ' established and regulated under the laws of the United States or any State ' and having significant operations in the United States, but excluding any central bank of, or institution owned by, a foreign government.” (Act at '3(5)).

To be eligible to sell troubled assets, a financial institution must not only be established in the United States, but also must be regulated here. Federal and state chartered banks, insurance companies, broker-dealers, mutual funds, registered investment companies, and employee retirement plans are all eligible sellers. Any such institution may be owned by a non-U.S. entity other than a foreign government. The voluntary Capital Purchase Program has its own requirements for institutions which qualify under that program.

Program Limit and Term

The aggregate purchase price of troubled assets “outstanding at any one time” under the Program (the “Program Limit”) may not exceed $250 billion, which may be raised by Presidential certification to $350 billion and, unless rejected within 15 days after notice by Congress, further raised to $700 billion. (Act at '115). The Secretary's authority to purchase, commit to purchase or insure troubled assets (the “Program Term”) expires on Dec. 31, 2009, provided that the Secretary may extend such date to not later than Oct. 3, 2010. (Act at '120(a) and (b)).

For the duration of the Program Term, the Program will consist of a revolving fund (the “Fund”) that may be increased as assets are removed from the Fund. Sales or liquidations of troubled assets by the Fund will reduce the amount considered “outstanding.” After the Program Term, the Secretary will no longer be authorized to make commitments to purchase new assets or issue new guarantees; however, the Program will continue until all purchased assets have been sold or liquidated (and all guarantees have expired). During this time, the assets will continue to be serviced and managed for the Fund. It is probable that most sales and other financial transactions involving purchased assets will take place after the Program Term, when markets have, it is hoped, stabilized and losses are more determinable.

Asset Acquisition and Insurance

Purchases of Troubled Assets

The centerpiece of the Program is the Secretary's ability to purchase troubled assets from ailing financial institutions in an attempt to stem the write-downs and losses being taken by such institutions. By establishing “market” prices for troubled assets and providing liquidity to the market, the Program also seeks to encourage private participants to begin purchasing mortgage-related and other structured products as well. In furtherance of these goals, Treasury will publish program guidelines within the earlier of two days after the first asset purchase or 45 days after enactment of the Act. (Act at '101(d)). Given the breadth of affected assets and institutions, we expect the program guidelines to be general, ensuring broad discretion and flexibility in their implementation.

Process and Pricing

In making purchases under the Program, the Secretary has broad discretion to purchase assets subject to the requirement that the Program “minimize any potential long-term negative impact on the taxpayer.” (Act at '113(a)(1)). In that regard, the Secretary must purchase assets at the lowest price consistent with the Act's purposes and is encouraged to use market mechanisms, such as auctions and reverse auctions, to accomplish that goal. (Act at '113(b)(2)).

Purchases may be made directly from an institution or through an open market auction process. In cases where the Secretary determines it is necessary to purchase directly from an institution, the Fund must obtain “meaningful” equity or debt interest in the selling institution, and significant executive compensation limits will be imposed on such institution. (Act at '111(b)). Furthermore, the Capital Purchase Program lays out detailed warrant provisions and requirements for when Treasury will make a direct investment in the equity of a qualifying financial institution.

Establishing the price at which the Fund will purchase troubled assets will be the key to its success. There are billions of dollars of private funds available to purchase distressed assets. For the most part, these funds have not been activated yet because potential sellers are unwilling to take the losses that would result from the prices that potential purchasers are seeking. There will be significant pressure to balance the demand to maximize the return to taxpayers and the need to minimize losses to selling institutions.

Indications to date, including testimony by Federal Reserve Chairman Ben S. Bernanke, indicate that prices will give greater consideration to expected losses and future cash flows than current distressed market prices. However, more distressed institutions or institutions with less exposure to certain asset types may be willing to sell at lower prices. Once prices have been established for a particular class of assets, there will be pressure on other institutions to mark (or sell) their similar assets at similar prices. In addition, not all assets of the same type are created equal.

The Act expressly permits financial institutions to make a profit on the sale of assets acquired in a merger or acquisition (such as the Merrill, Wamum, and Wachovia transactions) or from an institution in bankruptcy, conservatorship, or receivership (such as IndyMac or Lehman). This provision should make it easier for troubled institutions to find willing merger partners, by not only reducing the risk associated with troubled assets held by such institutions but also making it possible to profit from troubled assets acquired in such transactions.

Purchase Conditions

Congress required that certain punitive conditions be imposed on all but the smallest sellers of troubled assets and authorized the Secretary to impose any other conditions deemed appropriate.

1. Warrants/Senior Debt

In any purchase (other than de minimis purchases of not more than $100 million), the Secretary must receive, in the case of an exchange traded institution, warrants to purchase nonvoting common or preferred stock and, in the case of all other institutions, either warrants or senior debt instruments. (Act at '113(d)). The warrants or debt obtained must be designed to ensure reasonable participation in the appreciation in value of the institution or a reasonable rate of return in the case of debt instruments. (Act at '113(d)(2)(A)(i) and (ii)). Any warrants must contain appropriate market standard anti-dilution provisions. (Act at '113(d)(2)(D)).

2. Executive Compensation

If the Fund purchases assets directly from an institution, the Secretary must also require the institution to “meet appropriate standards for executive compensation and corporate governance.” (Act at '111(b)(1)). Such standards must exclude incentives for senior executive officers of a financial institution to take unnecessary and excessive risks, provide for the recovery of any bonus or incentive compensation paid to a senior executive officer based on earnings or other criteria that are later proven to be materially inaccurate, and prohibit golden parachute payments to its senior executive officer during the period that the Secretary holds an equity or debt position in the financial institution. (Act at '111).

If the Fund purchases any assets through an auction process, and the aggregate purchases from the selling institution exceed $300 million (including direct purchases), the institution will be required to adopt less severe restrictions on executive compensation. (Act at '302(a); see also 26 U.S.C. '162(m)).

3. Market Conditions and Criteria

A variety of market conditions and criteria will be imposed upon the purchase of troubled assets. Standardized purchase agreements presumably will be created for the Program, which will vary depending on the type of assets being purchased and whether the assets are acquired directly or through an auction. Each agreement will need to address delivery and custody issues (including required documentation), due diligence, representations and warranties, and servicing issues. For securities, diligence regarding control rights and other legal priorities and remedies may be crucial.

Due Diligence. It is expected that the Fund will perform some level of due diligence with respect to troubled assets that it purchases under the Program. Any such diligence would be potentially more extensive for residential or commercial whole loans, REO properties and participation interests (collectively, “Real Estate Assets”) than for securities. Items which should be explored include property value, legal compliance, borrower credit files, borrower credit, including updated credit scores and other customary borrower and collateral due diligence.

Representations and Warranties. There is a significant difference in sellers' representations and warranties in the market today compared with a year ago. Sellers are making fewer representations, and, as noted above, purchasers must rely more on due diligence. However, it is unclear the extent to which the Fund will require representations and warranties on Real Estate Assets that it acquires. At a minimum, it is expected that sellers will be required to warrant good title; however, whether the Fund will insist on market standard “whole loan” representations and warranties is unclear. The Fund should weigh the value of representations and warranties against the creditworthiness of the particular seller.

Servicing and Control Issues. Servicing and control issues will be a significant factor in determining which assets the Fund purchases and how it prices them. Real Estate Assets will command a higher price if sold “servicing released,” in which case, the Fund will be able to sell the servicing rights to a servicer selected by the Fund. Given the modification and homeowner protection requirements of the Act, it is likely that the Fund will attempt to control the appointment of servicers to the greatest extent possible.

The Fund may also acquire subordinate tranches of residential and commercial mortgage-backed securities and other securities (“Real Estate Securities”), which may include the “first loss” or “B-piece” or pieces. By purchasing such positions, the Fund may be able to acquire control over the servicing or obtain some form of special servicing rights for servicing delinquent mortgage loans or REO, which may be particularly appealing to the Fund with respect to its foreclosure mitigation directive. Through these rights, the Fund could control the servicing of the mortgage loans with generally the same financial impact as if the Fund owned the mortgage loans directly.

Acquisition Vehicles

The Act permits the Secretary to establish vehicles “to purchase, hold, and sell troubled assets and issue obligations.” (Act at '101(c)(4)). Subject to the general purposes of the Program, there is no restriction on the type or number of vehicles that the Secretary may establish.

The Secretary will not have to consider the tax, limitation of liability, and bankruptcy issues that private institutions must consider when forming entities to hold assets. As a result, the form of vehicle used will likely relate more to convenience, flexibility, and suitability for the assets being held and the types of obligations that may be issued.

Troubled Asset Insurance

As an alternative to selling assets to the Secretary, financial institutions may request that the Secretary guarantee the timely payment of principal of, and interest on, troubled assets, including mortgage-backed securities. (Act at '102). The limit on the Secretary's spending authority for the Program will be reduced by the excess of the “total outstanding guaranteed obligations [over] the balance in the Troubled Assets Insurance Fund.” (Act at '102(c)(4)).

The insurance program seems most appropriate for senior/super-senior securities that have little risk of loss but are nonetheless depressed in value given the general lack of liquidity. These securities are highly illiquid in the current environment and given the low risk, premiums should be low, and, with a TARP guaranty, these otherwise distressed securities would have the benefit of the equivalent of the full-faith and credit of the U.S. government, increasing their value and liquidity. On the other hand, the high premiums required to cover expected losses are likely to discourage the use of the insurance program for riskier assets. Targeted use of the insurance program, however, could result in a very efficient use of amounts available under the Program Limit.

Management and Servicing

The basic provisions related to the Secretary's general authority to manage assets purchased under the program are straightforward and extremely broad. (Act at '106(a), 106(b) and 101(c)(4)). This broad authority is qualified with respect to residential products by the requirement that the Secretary “encourage the servicers of the underlying mortgages ' to minimize foreclosures [and] to facilitate loan modifications to prevent avoidable foreclosures.” (Act at '109(a)).

The Act further provides that, except as established in any contract, a servicer of pooled residential mortgages will be deemed to act in the best interests of all investors if the servicer implements a workout plan involving reasonable loss-mitigation measures, including partial payments. This further broadens protections which were granted to servicers pursuant to '1403 of the Housing and Economic Recovery Act. This provision, along with '109(b), effectively opens up the safe harbor to situations where the loan is not in default and to non-owner occupied residences.

In addition, the Secretary may use loan guarantees and credit enhancements to facilitate loan modifications to prevent avoidable foreclosures. (Act at '109(a)). If the Secretary were to make available credit enhancement that covered specific loans that had been modified, this could alter the equation of the servicer's net present value determination. If credit enhancements were added that eliminated re-default risk, the servicer would effectively be able to offer more favorable modification terms to the borrower while still complying with its contractual duties under the securitization documents.

Thus, under the Program, the Secretary has a very meaningful opportunity to bring market pressure to bear on servicers to adopt specific approaches to loan modifications and workouts, not only for whole loan pools purchased under the Program but also for mortgage-backed securities.

Sale and Financing of Purchased Assets

The provisions regarding the sale of assets purchased under the Program are brief and to the point. (Act at '106(c) and 113(a)(2)). It is unlikely that troubled assets purchased under the Program will be resold quickly. The primary purpose of the Act is to “restore liquidity and stability. ' ” (Act at '2(1)). Actual losses on most troubled assets are expected to be significantly less than the decline in market value on those assets. Thus, by removing troubled assets from the market and the balance sheets of financial institutions, the Secretary can hold assets until the market stabilizes and the actual losses become more certain.

When assets are resold, it is expected that in many cases new securities will be created, taking into account then-current assumptions about losses and required spreads. In such cases, existing securities would be repackaged into new securities. Due to the Program Limit, it is also possible that some assets may be repackaged to increase credit enhancement (reducing or eliminating expected losses) and resold fairly quickly, thereby increasing the number of troubled assets that the Program can purchase.

Conclusion

The Secretary has significant authority to provide stability and liquidity to the capital markets through the Program. There will be many opportunities for financial institutions to participate in the process, as sellers managers, servicers, advisers, or investors. We are confident that the financial community will bring its collective knowledge, experience and, of course, capital, to bear on rebuilding the capital markets and providing (rational) financing for individuals and businesses around the world.

Erik D. Klingenberg is a partner in the Structured Finance practice at Thacher Proffitt & Wood LLP and chair of the Troubled Asset Relief Program interdisciplinary group. Klingenberg's practice involves all aspects of commercial and residential mortgage-backed securities, asset-backed securities, collateralized debt obligations, and other structured products. He may be reached at [email protected] or 212-912-7400.