Overview            

President Obama has signed into law a sweeping bill that revises federal deposit
insurance and imposes new restrictions on an array of financial-industry recovery
programs.  The FDIC changes come at a time of broad debate over how deposit
insurance should be assessed on large and/or systemic-risk institutions, with the law
giving the FDIC power under Treasury control to impose new premiums on parent
holding companies should any of the ongoing systemic-risk programs result in loss to
the Deposit Insurance Fund.  Any such premiums would likely need to be charged
only after any such loss is realized, creating the potential for both costly and
procyclical charges on bank and S&L holding companies.  The changes to the
recovery programs – TARP, PPIP and others under Treasury, the FRB and FDIC –
may affect investor willingness to participate because of new duties, disclosures and
other constraints.  In addition, the law now gives Treasury flexibility to address the
warrants it has taken after providing emergency capital to the banking industry,
possibly easing negotiations now under way as banks seek to repay this capital and
exit the program.   

In addition, the law attempts to increase foreclosure-prevention loan-modification
activities.  These could reduce foreclosures, but likely add risk to the Federal Housing
Administration that, down the road, could lead to larger reform of federal housing
finance.  Among the more contentious provisions in this part of the law is language to
provide a more robust safe harbor for servicers supporting mortgage modifications,
perhaps increasing these efforts at potential cost to investors.   

Impact

Because of the wide scope of this law, key sections are discussed below.

Deposit Insurance

The law makes significant changes in federal deposit-insurance coverage,
including extending the current $250,000 limit for several additional years.  
Advocates of higher coverage pushed for permanent extension, but Congress was
unwilling to do so out of fears that this would increase FDIC risk and resolution costs.  
The higher the limit, opponents argue, the greater the incentives for depositors to seek
yields at higher-risk banks that must pay higher rates to attract customers.  Advocates
counter, however, that high coverage limits encourage funding flows to smaller
insured depositories without access to capital markets.   

Smaller institutions also have been smaller users of new FDIC facilities such as
the temporary liquidity guarantee program (TLGP). They fear that these programs
will lead to costly losses at the Deposit Insurance Fund (DIF) for which they, not big
banks and non-bank TLGP users, would be forced to pay.  Concerns here were
inflamed when the FDIC proposed a twenty basis point special assessment.  The final
FDIC rule3 not only reduced the assessment, but also changed the base on which it is
calculated from deposits to assets, somewhat alleviating small-bank concerns.  At the
same time, the new law includes a larger FDIC line of credit to the Treasury, giving it
resources with which to operate under stress without a short-term, high-cost
assessment that could worsen strains within the banking system and, opponents argue,
disproportionately hurt small institutions.

The law also addresses small-bank fears in another major way:  for the first time,
the FDIC is authorized to charge premiums on the parent holding companies of
insured depositories.  To be sure, it could only do so after a systemic-risk
determination (now in force) has been made by other regulators with consent of the
President and, even then, only with concurrence from the Treasury Department.  In
addition, the law suggests – but does not make clear – that the holding-company
assessment could only be charged by the FDIC after a loss to the DIF, not in
anticipation of it.  However, given that a systemic-risk determination is already in
place and clear signs from the FDIC of its desire to charge a new premium, the agency
is likely quickly to move forward with the rules required by the law to detail how this
premium would be assessed.   

This issue is sensitive not only in its own right, but also in the context of broader
systemic-regulation and resolution concerns.  The Treasury Department has proposed
legislation to empower the FDIC to resolve troubled systemic-risk financial
institutions, on which the FDIC would need to come up with a premium along the
lines of the one now authorized in law to pay for any costs associated with systemic
resolution.  The Treasury approach would, however, permit advance imposition of
some form of systemic-risk premium, permitting the FDIC to amass funds in advance
instead of perhaps being allowed to charge only surviving firms after losses related to
systemic institutions or programs have occurred.

TARP Capital

One of the hottest issues pending for banks of all sizes now is the degree to which
they may repay capital obtained in 2008 under the Troubled Asset Relief Program
(TARP).  Several small banks have been able to repay TARP capital and large banks
are hoping the FRB and Treasury shortly will permit them to do so.  Among the most
difficult challenges in these negotiations is treatment of the Treasury’s warrants, as
required under the Emergency Economic Stabilization Act (EESA).  The new law
permits a more flexible approach to these warrants instead of immediate redemption at
potentially high cost to the bank, making treatment of warrants now a matter that can
be negotiated between banks and the Treasury.  It is, however, likely that Treasury
will, based on this new authority, establish a uniform warrant policy that over time
will determine how this issue will be addressed in a consistent fashion for all banks
seeking to repay the TARP.

Public-Private Investment Program (PPIP)

The law imposes a series of new requirements on the PPIP, reflecting concern
that the complex programs could result in conflicts of interest or other insider
transactions that result in large losses to the FDIC and/or Treasury.  As a result, the
law requires that any PPIP program (which may come under various agencies) must
have rules in place to address these issues, doing so in conjunction with the Special
Inspector General for the TARP (SIGTARP).  These rules do not go as far as one
proposal flatly to bar PPIP participants from buying and selling within the program,
but the rules will almost surely make it far more difficult for banks or other entities to
be on more than one side of a PPIP transaction.  They will also almost surely slow the
PPIP both for whole loans and legacy mortgage-backed securities (MBS), despite
Treasury efforts to advance at least the latter program as quickly as possible.
In addition to the conflict requirements, the law also imposes a new, express
fiduciary duty on PPIP fund managers both to the government and their investors.  
The law does not define how this “fiduciary duty” is to be determined – for example,
whether it is a broad duty or one tied to the fiduciary obligation of trustees under
applicable state law.  Whether and how Treasury defines this term in the agreements it
must reach with PPIP fund managers will determine the degree to which the standard
heightens legal and reputational risk for fund managers and, perhaps, makes some
reluctant to pursue the program.   
 
Hope for Homeowners (H4H)

Revisions to this program are intended to make it a successful tool in the battle
against mortgage foreclosures.  Congress first established H4H last year in connection
with GSE reform and other mortgage efforts, and then revised the program in
EESA in early October when it became clear that the conditions initially imposed
on it were leaving it virtually unused.  Even with the subsequent liberalization,
however, H4H remained almost untouched through early 2009, when the Obama
Administration tapped it as a critical part of its foreclosure-prevention effort.
Reflecting this, the new law goes beyond the flexibility provided last year to make it
far easier for lenders, servicers and borrowers to use H4H to refinance troubled
mortgages with significant amounts of principal elimination that bring the new loan
into better alignment with current market conditions and, thus, improve the long-term
prospects for loan repayment and home ownership.

While this program will now be easier to use, its resulting risk to the Federal
Housing Administration (FHA) will exacerbate problems in an already weak federal
mortgage-insurance system.   The President’s FY2010 budget showed this program
with only a very bare positive benefit to taxpayers.  The new law seeks to strengthen
FHA by imposing strict new controls on lenders and requiring the Department of
Housing and Urban Development (HUD) to address current and potential weakness.  
However, if these reforms take time or are only partially successful, ongoing risk in a
volatile housing market could combine with losses in the H4H program to push FHA
into a deficit.  This could lead to significant changes down the road to FHA with far-
reaching impact on mortgage origination and securitization.

Foreclosure Prevention

In part to encourage participation in H4H, the law includes a new, broad safe
harbor for mortgage servicers designed to insulate them from legal risk as they modify
mortgages packaged into MBS held by third-party investors.  Investors had feared that
the safe harbor could create incentives for large servicers – who are almost all also
large originators and investors – to disadvantage third parties with regard to second
liens and similar holdings associated with MBS modification.  Congress addressed
this to some degree in the final law, but it still creates substantial legal-risk insulation
for servicers.  Indeed, it does so without the express reference to maintaining prior
contracts included in earlier versions of the servicer safe harbor, perhaps giving
servicers stronger grounds on which to alter mortgage terms.

The law also revises Treasury’s EESA authority to implement the President’s
program, limiting aid only for new or modified mortgages that comply with applicable
GSE conforming loan limits.  Most recently, this is $729,750, meaning that even large
loans are eligible for Treasury assistance.  However, very large ones now could not be
assisted through Treasury, perhaps forcing significant principal reduction and
refinancing through H4H or sole reliance on private-sector foreclosure-prevention
efforts.  Advocates of this approach argue it ensures that very wealthy individuals do
not benefit from Treasury assistance, and it is likely also to reduce risk in the
foreclosure-prevention program because very large loans are often higher risk ones.
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