US: Implementing the European Solution

Overview: The Federal Reserve and the US Treasury today announced details on their plan to secure financial market stability. The plan has three main points: First, the Treasury has set up a programme to purchase equity shares in a wide array of banks and thrifts on a voluntary basis; second, the FDIC will temporarily guarantee senior debt and deposits in non interest-bearing deposit transaction accounts; and third, the plan included details on the Federal Reserves Commercial Paper Funding Facility (CPFF) programme, which is set to start at October 27. The announced measures are basically equal to the solution implemented by major Euroland countries over the weekend and as such address both the solvency and liquidity issues in the banking system.

Details:

Capital purchase programme: The Treasury is announcing a voluntary capital purchase programme. A broad array of financial institutions is eligible to participate in this programme by selling preferred shares to the US government.

Under the programme, the Treasury will purchase up to USD250bn of senior preferred shares on standardised terms. The programme will be available to qualifying US controlled banks, savings associations, and certain bank and savings and loan holding companies engaged only in financial activities that elect to participate before 17:00 (EDT) on November 14, 2008. The minimum subscription amount available to a participating institution is 1% of risk-weighted assets (RWA). The maximum subscription amount is the lesser of USD25bn or 3% of RWA.

The senior preferred shares will qualify as Tier 1 capital, will rank senior to common stock and will pay a cumulative dividend rate of 5% per annum for the first five years and will reset to a rate of 9% per annum after year five. They will be non-voting and callable at par after three years. Prior to the end of three years, companies have an option to buy-back the preferred shares held by the Treasury and the Treasury may also transfer the senior preferred shares to a third party at any time.

In conjunction with the purchase of senior preferred shares, the Treasury will receive warrants to purchase common stock with an aggregate market price equal to 15% of the senior preferred investment. The exercise price on the warrants will be the market price of the participating institution's common stock at the time of issuance, calculated on a 20-trading day trailing average.

The Financial institutions that choose to participate in the programme must meet certain standard such as restrictions on compensation paid to senior executives.

Guarantee on bank debt and deposits: After receiving a recommendation from the boards of the FDIC and the Federal Reserve, and consulting with the President, Secretary Paulson signed the systemic risk exception to the FDIC Act, enabling the FDIC to temporarily guarantee the senior debt of all FDIC-insured institutions and their holding companies, as well as deposits in non interest-bearing deposit transaction accounts. Regulators will implement an enhanced supervisory framework to assure the appropriate use of this new guarantee.

Commercial paper programme: Beginning October 27, the CPFF will fund purchases of commercial paper of 3 month maturity from high-quality issuers. The CPFF will be structured as a credit facility to a special purpose vehicle (SPV). The SPV will serve as a funding backstop to facilitate the issuance of term commercial paper by eligible issuers. The Federal Reserve Bank of New York will commit to lend to the SPV on a recourse basis. The New York Fed will be secured by all the assets of the SPV.

The SPV will purchase US dollar-denominated commercial paper directly from eligible issuers at a spread over the 3 month OIS rate. This effectively sets a ceiling on how high the 3 month OIS-Libor spread can go. The spread is set at 100 basis points for unsecured commercial paper with an additional 100bp surcharge if the issuer does not provide a collateral arrangement for the commercial paper – i.e. substantially lower than the current 3 month OIS-LIBOR spread of around 340bp. For asset-backed commercial paper the spread is set at 300bp. In addition at the time of its registration to use the CPFF, each issuer must pay a facility fee equal to 10 basis points of the maximum amount of its commercial paper the SPV may own.

Eligible commercial paper must be rated at least A1/P1/F1 by a major NRSRO and not rated below A1/P1/F1 by any major NRSRO. Note that eligible issuers do not need to be depositary institutions, but can also be ordinary corporate businesses with a sufficient rating.

The SPV will only purchase commercial paper issued by US issuers (including US issuers with a foreign parent). The SPV will accept both unsecured and asset-backed commercial paper.

The SPV is restricted with a single issuer unable to place more CP in the SPV than the average amount of CP of that issuer outstanding in August 2008. Otherwise, there is to be no aggregate limit on the amount of commercial paper the SPV can purchase. The SPV will purchase commercial paper until April 30, 2009 although this termination date can be extended by the Federal Reserve Board.

Assessment and outlook: Following the coordinated measures taken by Euroland authorities over the weekend financial market conditions have already shown signs of improvement. Today's announcement shows that the US authorities have taken the same approach and now targets both liquidity problems as well as solvency issues in the financial sector.

The guarantees on bank deposits and senior debt, which includes interbank lending, should help to make money markets function again as it basically removes counterparty risk. The recapitalisation of banks should ensure that banks can continue their operations and in turn provide financing to businesses and consumers thereby avoiding a major credit crunch. It may very well take a while for both money markets and risk markets to recover but these are very important steps in containing the crisis and ensuring that financial flows can again get to the real economy.

Danske Bank
http://www.danskebank.com/danskeresearch

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