An In-depth Analysis of Treasury’s Financial Stability Plan

This post is based on a client memorandum by Randall Guynn and Margaret Tahyar of Davis Polk & Wardwell.

The Treasury’s recently announced Financial Stability Plan reshapes the ground rules for capital injections into financial institutions, increases the size and scope of a previously announced non-recourse lending facility by the Federal Reserve, launches the idea of a public-private investment fund to purchase legacy or toxic assets from financial institutions and sets aside funds for the homeowner assistance plan outlined by President Obama on February 18. As has been widely noted, however, the plan is long on aspiration but short on detail.

Among the new features of the plan is a mandatory comprehensive “stress test” for banking institutions with assets in excess of $100 billion. Although “stress testing” is a term of art in the financial services and risk management realm and is an element of the risk-based approach taken by Basel II, the sense in which it will be applied by Treasury is unclear. The memorandum explores the possible meaning.

The plan also contemplates, but does not detail, ongoing measures to further enhance public disclosure of financial health. Political calls for more disclosure in the current environment, however, disguise the complexity of the issues that will have to be sorted out in order to arrive at a functional solution. Some of these challenges discussed in the memorandum include the possible necessity of international coordination in order to shape new norms for financial institution disclosures and the implications of the ongoing debate over mark-to-market accounting and dynamic provisioning.

In an effort to restart the currently illiquid market for legacy assets, Treasury announced the creation of the Public-Private Investment Fund. The key new feature of this initiative, compared to earlier discussions regarding an aggregator bad bank, is an element of private capital participation, although the specifics of this public-private partnership are still unclear. The memorandum discusses some of the challenges, including whether pricing mechanisms will indeed be easier to design due to private sector involvement.

Hardly any market has been more affected by the recent market turmoil than the private label securitization market. The pendulum appears to have swung from a failure of the financial markets to properly recognize and price the huge risks of certain securitization classes to a situation where securities backed by any asset class not also explicitly or implicitly backed by the government are virtually impossible to bring to the market. While banks have been broadly accused of being responsible for reduced lending activity, latest data published by Treasury shows that in fact, the absence of a functioning securitization market is the greatest contributor to a decline in lending. Therefore, it should come as no surprise that the implementation of a facility announced by the Federal Reserve in November of last year to revive the asset-backed securities markets, the Term Asset-Backed Securities Loan Facility, is greatly anticipated. The memorandum discusses salient features of the facility, including the manner in which it will allow for the participation of unregulated funds, and its potential expansion as part of the government’s plan.

The memorandum is available here.

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