Managing to the New Regulatory Reality: Doing Business Under the Dodd-Frank Act

By Gregory P. Wilson and Richard K. Davis

How to manage and profit from the new financial regulatory reality

Now, more than ever, navigating the new financial regulations is paramount for the survival of many large institutions. Managing to the New Regulatory Reality: Doing Business Under the Dodd-Frank Act provides the most important, need-to-know lessons for private sector management, boards of directors, policymakers, and even regulators, shedding light on the movement from crisis to panic, regulatory reform to winning under continuing financial regulatory uncertainty.

• Reviews the causes of 2008's financial crisis, and assesses its impact on multiple stakeholders
• Describes and analyzes the impact of the immediate U.S. and G20 policy and regulatory reactions on financial institutions that the crisis response triggered
• Explains the legislative policies, and examines how institutions and the financial services industry can make these new policies and regulations work for them

All financial institutions, but especially large companies, will have to aggressively manage to the new regulatory reality. Managing to the New Regulatory Reality is the must-have survival guide to sustaining profitability despite all the new red tape.

• Language: English
• Publisher: Wiley
• Release date: Jan 20, 2011
• ISBN: 9781118023006

Book preview

Part One: Understanding the Immediate Political Reactions

The year 2008 will be etched in U.S. financial history as a transformational shift in terms of how the American political establishment views the financial services industry in this country. What once was a relatively benign relationship in a growing economy before the crisis—all things considered—has now become an openly hostile and wary one on both sides as the crisis recedes but the aftermath of the recession lingers. While this is understandable in the short run given what we have experienced as a nation, its long-term implications are likely to have a negative impact on consumers, investors, economic growth, and jobs in the new regulatory reality unless that relationship is realigned with greater balance in mind for our economy.

In 2008, we witnessed an unprecedented policy and regulatory response to the financial crisis along multiple dimensions. While it is hard to focus on just two such responses when reviewing the overall reaction, two stand out. The first is the passage of the Emergency Economic Stabilization Act of 2008 (EESA) on October 3, 2008, which created the Troubled Asset Relief Program (TARP) at the Treasury Department. The second is the Group of Twenty (G20) Leaders’ Summit on November 15, 2008, in Washington, DC, which set in motion a reinvigorated multilateral process to devise a new international financial order to govern the behavior of financial firms in the global economy.

This approach to the dizzying spiral of events during that period may seem unfair, especially given the way that both policymakers and regulators truly pushed the envelope to contain the crisis by leveraging every authority they had—and then some. Certainly, the heroic efforts of the Treasury Department, the Federal Reserve, the FDIC, and other regulators in 2007–2008 sought to minimize the impact of the crisis and stabilize the financial markets pending real reforms. People are free to disagree with some of the individual policy calls, as former FDIC chairman Bill Isaac has done in his provocative book, Senseless Panic, which also deserves a good read for a different point of view on some of those critical actions.¹

Yet most of those early decisions and interventions to stabilize the financial system, while transformational for some of the specific companies involved and important for changing the context of the ensuing policy debates, did not have as great a direct impact on what I describe as the new regulatory reality as either EESA or the G20. EESA was transformational because it was the first domestic legislative response to the crisis that impacted the financial services industry directly by dragging the taxpayer into the emerging public policy debate. Similarly, invoking the G20 process was historic for its unprecedented international response to what correctly was viewed as a global catastrophe that demanded concerted effort by the leading nations of the world.

Others have documented the myriad responses of the Treasury Department, the Federal Reserve, and other regulators from the beginning of the crisis. Former Treasury Secretary Henry M. Paulson, Jr., offers a unique insider’s view, which I highly recommend for additional context for Part Two. Serious students of the crisis also can thank both the Federal Reserve Bank of St. Louis² and the Federal Reserve Bank of New York³ for their continuing timelines of events since the crisis began to unfold in 2007.

Part One reviews the immediate political and policy reactions to the financial crisis. Chapter 1 offers a recap of the events leading up to and including the enactment of EESA. Chapter 2 then reviews the rise of the G20 to rebuild a new international regulatory architecture and promote global standards. Finally, Chapter 3 outlines the beginnings of the new regulatory reality, especially some of the major implications I see resulting from the immediate crisis reactions in Washington—implications that are still with us today.

Notes

1. William M. Isaac with Philip C. Meyer, Senseless Panic: How Washington Failed America (Hoboken, NJ: John Wiley & Sons), 2010.

2. Federal Reserve Bank of St. Louis, The Financial Crisis: A Timeline of Events and Policy Actions, at www.stlouisfed.org, which starts on February 27, 2007, until the present and includes links to press releases for major events.

3. Federal Reserve Bank of New York, www.ny.frb.org. Go to research>global economy to find a timeline of domestic actions that includes Federal Reserve policy actions, market actions, and other policy actions; there also is an international timeline that tracks the moves of G7 countries and includes bank liability guarantees, liquidity and rescue interventions, and other market interventions.

CHAPTER 1

Immediate U.S. Reaction

The Emergency Economic Stabilization Act of 2008

To set the context for Part Two, a quick memory jog of the immediate events leading up to the passage of EESA should be helpful. With the passage of time, it is easy to forget—or deliberately not want to recall—how close to the precipice we really were as events seemed to spiral downward out of any one regulator’s control. This chapter highlights the prelude to the crisis and then the action steps leading to the enactment of EESA.

ALL ROADS ULTIMATELY LEAD TO CONGRESS

Starting in early 2007, the fallout from the housing bubble collapse and the subprime debacle became increasingly clear. On February 27, 2007, the Federal Home Loan Mortgage Corporation (Freddie Mac) announced that it would no longer buy the most risky subprime mortgages and mortgage-related securities as the opening salvo in residential real estate debacle; later, on September 7, 2008, the Federal Housing Finance Agency (FHFA) placed both Freddie Mac and the Federal National Mortgage Association (Fannie Mae) into government conservatorship under the Treasury Department under new authority contained in the Housing and Economic Recovery Act of 2008.¹ On July 24, 2007, Countrywide Financial Corporation, one of the nation’s largest subprime lenders, warned of difficult conditions in an SEC filing; by January 11, 2008, Bank of America announced that it would acquire Countrywide in a $4 billion, all-stock transaction, which subsequently would only add to the bank’s loan problems.

On June 7, 2007, Bear Stearns told investors that it was suspending redemptions from its High-Grade Structured Credit Strategies Enhanced Leverage Fund, and then on July 31, it liquidated two mortgage-backed securities (MBS) hedge funds. Less than a year later, on March 24, 2008, JPMorgan Chase acquired Bear Stearns with term financing from the Federal Reserve Bank of New York. On August 10, 2007, the Federal Reserve Board announced that the discount window, as always, was available as a source of funding to financial institutions; after launching a series of escalating new liquidity facilities with names like Term Auction Facility (TAF), Term Securities Lending Facility (TSLF), and Primary Dealer Credit Facility (PDCF), the Board issued a statement on August 10, 2008, between its regular Federal Open Market Committee (FOMC) meetings, that the downside risks to the economy have increased appreciably.

Nor was this wholly a U.S. phenomenon. There are many international examples, but one that attracted the most attention on the global stage was a relatively small U.K. bank failure. On September 14, 2007, the U.K. Chancellor of the Exchequer authorized the Bank of England to provide liquidity support after a series of depositor runs for Northern Rock, a little-known bank in the scheme of things, but the U.K.’s fifth-largest mortgage lender. By February 17, 2008, Northern Rock was nationalized by the U.K. Treasury to prevent its collapse.

With this as background, the crisis began to spiral out of control in September 2008, during what would become the Great Financial Panic, far surpassing the financial panic of 1907.² A staccato chain of almost daily events and headlines brought the financial markets to the point where Treasury Secretary Paulson knew he would have to ask Congress for extraordinary authority to do what was necessary to stop potential financial market free fall. In his biography, Secretary Paulson states that he knew on the weekend of September 13, 2008, he would have to inform President Bush that he would have to go to Congress for new powers and $700 billion in funding to manage the crisis.³

The crescendo of events in mid-September 2008, including placing Freddie Mac and Fannie Mae into conservatorship, forced Secretary Paulson’s decision. More bad news followed immediately in those days after Secretary Paulson was preparing to go to Capitol Hill with his extraordinary request just weeks before the Presidential election.

On September 14, the Federal Reserve was forced temporarily to abrogate its sacrosanct rules on transactions with affiliates, known as Section 23A, to allow insured banks to lend to provide liquidity to their affiliates that normally would be funded in the tri-party repo market. Then on September 15, a double whammy: Bank of America decided to buy Merrill Lynch & Company for $50 billion, and Lehman Brothers Holdings filed for Chapter 11 bankruptcy protection, an event that shook markets around the world and increased the growing sense of sheer panic.

The next day, September 16, the Federal Reserve Board authorized an unprecedented loan of $85 billion to American International Group (AIG), under its unusual and exigent circumstances powers in Section 13.3 of the Federal Reserve Act. As if that was not enough for one day, the Reserve Primary Money Fund broke the buck and fell below $1 par, directly as a result of Lehman’s failure.

On September 17, the Treasury announced a Supplementary Financing Program to raise cash for Federal Reserve initiatives, and the Securities and Exchange Commission (SEC) announced a temporary ban on short selling for all financial sector stocks. The following day, the FOMC expanded its existing swap lines with foreign central banks by $180 billion and authorized new swap lines with the Bank of Canada, the Bank of England, and the Bank of Japan. On September 19, the U.S. Treasury tapped the Exchange Stabilization Fund, a little-known tool at the Secretary’s disposal, to launch a temporary guaranty program of $50 billion to guarantee investments in money market mutual funds as a direct result of the Reserve Primary Money Funds liquidity problems.

Following those whirlwind events, the Secretary sent draft legislation to Congress for his Troubled Asset Relief Program (TARP) funding on September 20, 2008. His three-page bill, amounting to roughly 850 words in broad outline form, was a marvel of simplicity and directness in its request for sweeping new authority to manage the crisis on behalf of the U.S. Government. Later, Secretary Paulson candidly would admit that sending such a simple, straightforward request to Capitol Hill was a political mistake.⁴ Congress ultimately would pass a far more scripted and demanding bill, with equally sweeping new detailed provisions for oversight, transparency, and limits on executive compensation.

The next day, September 21, the Federal Reserve expedited the approvals for Morgan Stanley and Goldman Sachs, the last large U.S. investment banks still standing, to become bank holding companies, bringing them under its jurisdiction for the first time in history. While the Federal Reserve continued to expand its swap lines with central banks around the world during the following week, more mega-mergers were in store. On September 25, following worries of depositor runs, JPMorgan Chase acquired the banking operations of Washington Mutual Bank (WaMu) after a systemic risk determination that required the approval of President Bush that its acquisition would be the least cost to the U.S. taxpayers. WaMu experienced more than $16 billion in deposit outflows and several composite ratings downgrades by examiners and rating agencies that led to its collapse. In one of the most significant acquisitions of the crisis, JPMorgan Chase significantly enhanced its footprint by 2,200 branches in more than 15 states, with a total of $300 billion in assets.⁵ This is one of the benefits of individual companies maintaining a fortress balance sheet and good regulatory and political relationships before and during a financial crisis.

Still, the deals were not over. On September 29, the FDIC announced that Citigroup would purchase the banking operations of Wachovia, with a loss-sharing arrangement on a $312 billion pool of loans. Citigroup was to have absorbed the first $42 billion in losses, with the FDIC absorbing any losses above that amount. In exchange, Citigroup was to give the FDIC $12 billion in preferred stock and warrants to share in any upside returns. The only minor complication for Citigroup was that on October 3, the same day President Bush signed EESA into law after final Congressional approval that same day, Wells Fargo jumped into the Wachovia acquisition with a competing proposal to buy it without any FDIC assistance. The FDIC was forced to allow the Wells Fargo offer stand, as opposed to using its own funds, and the rest is now history.⁶

What a month! With that as a quick background, let’s turn to turn to the Paulson Plan and better understand the impact of a bill of this magnitude and how it became a law in less than two weeks—an extraordinary task for the Administration and Congress even in a financial crisis.

HOW A CRISIS BILL BECOMES AN EMERGENCY LAW

The Executive Branch Proposes

Back up for a moment to Treasury Secretary Paulson’s conversation with President Bush the weekend of September 13, 2008. With events escalat­ing over the next few days, Secretary Paulson told the President again on September 17 about the need to bring Congress into the solution equation.

Based on the account in his memoirs, Secretary Paulson had reached the limits of his ability to use duct tape and bailing wire to prevent the markets from simultaneous freezing and collapsing. He turned to top Treasury aides, Neel Kashkari, Assistant Secretary for International Economics and Development, and Phil Swegel, Assistant Secretary for Economic Policy, for their so-called Break the Glass plan to recapitalize the banks, which they had worked on the previous spring.⁷ Instead of the weeks that the Administration had to work with Congress on the 2008 stimulus package or later housing government-sponsored enterprise reforms, market developments gave the Paulson team only a matter of days to get a bill through Congress.

Congress Disposes

With the three-page bill sent to Capitol Hill, the next step was a quick set of hearings to unveil the plan and start the arduous task of finding a majority of votes in an increasingly partisan Presidential and Congressional election, which by then was only six weeks away. In the normal course of the legislative process, it can take months and even years from the time a bill is introduced until it is enacted into law.

The Normal Process

Just by contrast, when I served at the Treasury Department, it took almost a year when we were in the middle of the savings and loan (S&L) crisis to get an admitted half-measure through Congress—the Competitive Equality Banking Act of 1987 (CEBA)—due to strong opposition from much of the S&L industry at that time. CEBA was a partial solution at best, giving the old Federal Savings and Loan Insurance Corporation (FSLIC) only limited funds to resolve a growing number of insolvent thrifts. Over time the problems grew worse with inadequate resources, so one of the first acts after President George H.W. Bush’s inauguration was the introduction and subsequent passage of the Financial Institutions Reform, Recovery, and Enforcement Act of 1989.⁸ In retrospect, the S&L debacle that I observed from an office inside the Treasury Department was a minor blip compared to what the United States faced in 2008. The S&L crisis and slow legislative response played out over years, not days.

Normally, Congress would hold oversight hearings to review an issue or problem, a bill is introduced, then that bill typically goes through another set of hearings in both a subcommittee and sometimes a full committee session. When hearings are completed, if there is broad enough support, the chairman of the subcommittee or full committee will convene a mark-up session to amend the bill, and, assuming it passes, send it to the full House of Representatives or Senate for further consideration and amendment there. Once it passes either one of those chambers, the same process starts again in the other chamber—hearings, mark-up, and onto a floor vote. Once both chambers have passed their respective versions of the legislation, the House and Senate then meet in a conference committee to resolve their differences before passing the conference committee’s report in each chamber again before sending it to the President for his signature. Other times, the House and Senate will forgo a conference committee and simply play ping-pong with a bill, forcing one chamber or the other to accept the other’s work, or amend it, and then continue the game back and forth. This is the normal legislative process, which again can take months and even years to complete.

The Legislative Process in a Crisis

Yet the Great Panic of 2008 was anything but normal, forcing a rapid response from first the Executive Branch of our government and then the Legislative Branch. Just as the Federal Reserve had responded since the outset of the crisis with liquidity support to the financial system, the Paulson Plan as originally proposed was a simple request for $700 billion to restore financial institutions to greater solvency by cleansing their balance sheet of bad assets, primarily mortgage loans and mortgage securities, and only later by equity injections. Under Treasury Secretary Paulson’s proposal, the Treasury would buy bad assets from banks, allowing them in turn to clean up their balance sheets and rebuild their capital. This was proposed in the hopes of more lending into the real economy as best they could to help avoid the full impact of a growing recession.

After sending his proposal to Congress, a vastly abridged version of the normal legislative process was required given the enveloping financial market collapse. After sending his bill to Congress over the weekend, both Secretary Paulson and Chairman Bernanke testified before the Senate Banking Committee on Tuesday, September 23, and again in front of the House Financial Services Committee on Wednesday, September 24. The chief Administration proponents of the plan testified with locked arms in defense of the plan as critically important for the survival of our markets, but they were met with immediate skepticism and unquestioned opposition from unbelieving members of Congress, most of whom were only a few weeks away from their own reelection. This was the last issue on which they wanted to be judged by angry voting taxpayers on November 4, but it was only the opening salvo for taxpayers, whose anger continues today at the so-called bailout of large failing banks and their management teams.

Popular anger and rising Congressional alarm dominated the two days of hearings. As the debate proceeded, it became clear that most committee members had received thousands of phone calls and emails from their constituents encouraging them to vote against any Wall Street bailouts. While space doesn’t permit a full recounting of Congressional angst, a few quotes will help to set the stage for the changing regulatory reality that was just then beginning. Since I used to be on the staff of the predecessor committee in the House, I’ll use my old committee for illustrative purposes, but you will find the same concerns and arguments for and against the draft legislation in the Senate Banking Committee hearing on September 23, 2008, as well.

The House Financial Services Committee Starts

The one-day House Financial Services Committee hearing on September 24 only heard from Secretary Paulson and Chairman Bernanke and started with an unusual twist. Chairman Barney Frank (D-MA) allowed his fellow committee members to take the witness stand first to voice their concerns, before proceeding to the administration witnesses. Chairman Frank deferred any substantive comments himself, but Subcommittee chairman Paul Kanjorski (D-PA) typified many Congressional concerns as well as the level of rhetoric that prevailed during the debate. If we do decide that the Treasury plan is the proper course, we must protect the taxpayers, Chairman Kanjorski stated; their interests must trump those of corporate fat cats and cowboys capitalists. In a statement more foreboding, and more indicative of what I describe at the new regulatory reality, he concluded his remarks by flatly proclaiming: The era of deregulation is over. As many of us on this side of the aisle [Democrats] have long believed, only regulation can save capitalism from its own excesses.⁹

Representative Dennis Moore (D-KS) echoed these sentiments: The current crisis is the result of a combination of irresponsible financiers pushing the limits of the marketplace, and the Administration that failed to properly regulate the financier’s actions in the public interest.¹⁰

Republicans also were critical of the Paulson plan. After declaring the pending House vote one of the most important in his career, Representative Jeb Hensarling (R-TX) viewed the administration’s approach as a basic assault on a free market economy. On the one hand, we may have financial peril, Representative Hensarling declared; on the other hand, we may have taxpayer bankruptcy for the next generation and many of us view this as a slippery slope to socialism, where the fundamental role of the Federal Government in a free enterprise economy is irrevocably changed.¹¹

Committee chairman Frank was committed to moving forward, expediting the normal legislative process by skipping the usual Committee mark-up session and proceeding straight to the House floor for a vote the following week. First, however, he had to finish drafting his own version of the Paulson Plan. During the hearing, other members of his committee foreshadowed new additions that would be included in the chairman’s remark that were not part of the Administration’s original draft. After calling on his fellow committee members to work fast, work smart, and map a way out of the crisis, Representative Bill Foster (D-IL) signaled a smoldering but growing concern among Democratic members—executive compensation: An equally important issue is the misalignment of incentives between CEO pay and shareholders’ interests. This is at the root of the crisis.¹²

Following repeated calls from Democratic members of Congress to make a national appeal, President Bush went on national television during prime time on Wednesday, September 24, to make his case for this urgent legislative request to stop the market free fall. Then, on Thursday, September 25, the two Presidential contenders, Senator John McCain (R-AZ) and then Senator Barack Obama (D-IL), met with President Bush and other Congressional leaders in the White House Cabinet Room in an attempt put aside partisanship in a fiercely contested election and show solidarity on this issue to voters, consumers, financial markets, and the world. But according to Secretary Paulson’s account and other press reports, a happy ending for this story was not yet in the cards.¹³

The House Acts, Fails, and Markets Collapse

Congress continued to work behinds the scenes with the Administration over the weekend. On Monday, September 29, the House of Representatives launched its effort, led by Speaker Nancy Pelosi (D-CA), a former member of the House Financial Services Committee, and Committee chairman Frank. The debate on both sides of the political aisle was fierce, with supporters urging rapid passage to stem the impending financial market collapse if Congress did not act. Opponents countered by questioning the need to act in haste and tap taxpayers by effectively socializing private sector losses without fully sharing in previous private sector gains.

It is at this point that the growing taxpayer debate began in earnest on new provisions not in the original Paulson Plan, such as limits on executive compensation for TARP recipients. It is also here, though not as overtly, that the seeds were sown for taxing banks in the future to pay for losses not only for any taxpayer losses from this crisis through a provision called recoupment, but also for future potential crises through an Orderly Dissolution Fund, but more on that in Part Three.

Forgoing the normal procedures after the hearing the week before, Chairman Frank and Speaker Pelosi opted to use as a legislative vehicle a bill, H.R. 3997, the Defenders of Freedom Tax Act of 2007, which amended the Internal Revenue Code of 1986 to provide tax relief for members of armed services, volunteer firefighters, and Peace Corps volunteers. This was a bill that had already passed the House and the Senate and needed to be passed before Congress adjourned for the elections. It was a convenient vehicle with some obvious benefits for broader appeal to members of Congress beyond the negative aspects of having to vote for a taxpayer bailout so close to elections.

Unfortunately, space does not allow me to do justice to the three days and roughly 245 pages of Congressional debate on the amended Paulson Plan. To get a better feel for the understandable skepticism, partisan vitriol, and high political theater in the final weeks before a hotly contested pre­sidential election, the serious student of financial history and political legerdemain should go straight to the Congressional Record and read the back-and-forth debate.¹⁴ All I can do in the next several pages is offer some highlights that have a direct bearing on the new and developing regulatory reality as it unfolded during these few days as financial markets waited nervously for Congress to act.

After the House approved the procedural rule that structures the terms of debate and amendment by a vote of 220 yeas to 198 nays—a good first signal for what Congressional leaders knew was going to be a close vote on final passage,¹⁵ Chairman Frank opened the debate on his new compromise plan. He invoked the national interest on this tough vote, which he knew was going to be unpopular: [T]he need to act to avoid something worse from happening than is already happening.¹⁶ Taking up the Administration’s request, he rightly wanted to avoid a disaster and acknowledged a lack of confidence in our financial system that is pervasive.¹⁷ With a sense of foreboding, Chairman Frank closed his arguments with an impassioned plea to his colleagues: [I]f we defeat the bill today, it will be a very bad day for the financial sector of the American economy.¹⁸

As Chairman Frank foresaw, September 29 was a disaster for Secretary Paulson and the Administration—and financial markets. After intense debate, the House ultimately rejected the new Democratic version of the plan by a vote of 228 nays to 205 yeas—almost simultaneously roiling both U.S. and global financial markets.¹⁹ According to a New York Times analysis, 40 percent of Democrats opposed the bill, while 67 percent of Republicans opposed it. In a sign of nervousness about how voters would view this particular vote, 60 percent of members who voted against the bill won their last election in 2006 by less than five percentage points.²⁰

By the end of the day, the Dow fell roughly 7 percent, its single largest drop ever, while the S&P 500 lost 8.8 percent, its worst day since the 1987 stock market collapse. According to Secretary Paulson, more than $1 trillion in stock market value was lost that Monday²¹—all for the lack of just 13 votes in the House to reach the majority of 218 needed to be successful. That’s roughly $77 billion for each of those 13 missing votes needed to send the bill to its next stop, the U.S. Senate.

The Senate Sweetens the Pot

Even that negative but relatively close loss in the House didn’t mean the end of the Paulson Plan, however. After all, this was Washington, and there are other ways to move legislation even after it fails in one chamber. Often, a failure on one side of Capitol Hill dooms a bill to oblivion, never to see the light of day again. But these were not normal times, and the legislative action quickly moved to the Senate to resurrect the initiative. The devastating market reaction on Monday proved to be a further call to action. In a tested Washington tradition commonly known as sweetening the pot, Senate leadership began adding more sweeteners, which had to be done before Congress adjourned and which would appeal to a broader political base.

Since the House bill, H.R. 3997, had been rejected, the Senate leadership found another House-passed bill as its new legislative vehicle, H.R. 1424, the Paul Wellstone and Pete Domenici Mental Health and Addiction Equity Act, which had passed the House in March. These sweeteners included the Energy Improvement and Extension Act of 2008 and the Tax Extenders and Alternative Minimum Tax Relief Act of 2008. The Senate had passed the tax extenders bill just the week before, by a vote of 93 yeas to just 2 nays. Senate Majority Leader Harry Reid (D-NV), after railing against the titans of Wall Street and CEOs with golden parachutes, went on to talk about so many other good things in this bill that would make it hard for any Senator to oppose. For example, the Majority Leader stated that the alternative minimum tax (AMT) fix would save the middle class $60 billion at a time when they needed it most. He also noted that Nevada in particular would benefit from an almost unnoticed provision known as payment in lieu of taxes, where the federal government pays for tax losses that are the result of federal land holdings. Coincidentally, the federal government owns 87 percent of Nevada, according to Senator Reid,²² so the Majority Leader had an extra local reason to see this bill enacted before he let the Senate adjourn for elections. The old adage that all politics are local is alive and well in Washington to this day.

The Senate’s political calculation to sweeten the pot worked. After the Majority Leader requested that all Senators vote from their chairs—an unusual Senate procedure, but understandable given the momentous vote on financial crisis legislation—the Senate passed the bill that same day, by a vote of 74 yeas to 25 nays.²³ Both Senators Obama and McCain voted for the bill, just a month before their Presidential election. The action then quickly moved back to the House of Representatives.

On Friday, October 3, the House took up H.R. 1424, as passed by the Senate. During the consideration of the rule, Representative David Drier (R-CA), the ranking member of the Rules Committee, noted that the bill had been improved by the Senate’s tax provisions as well as the temporary increase in FDIC deposit insurance from $100,000 to $250,000, another provision the Senate added that was not in the original House bill. He urged adoption of the rule and approval on final passage to unclog our banking system and unfreeze our credit markets,²⁴ a recurring theme throughout the day’s debate.

The Senate sweeteners ultimately worked in the House as well. Unlike the first House vote in the negative on H.R. 3997, the House subsequently adopted H.R. 1424 just four days later by an overwhelming vote of 263 yeas to 171 nays.²⁵ More than 73 percent of Democrats supported the bill this time, but only 46 percent of Republicans. President Bush signed the Emergency Economic Stabilization Act into law later that evening.

EESA’S MAJOR PROVISIONS

EESA’s major provisions include the following highlights, many of which set the stage for the new regulatory reality. They include five major elements.

Troubled Asset Relief Program (TARP)

TARP was the heart of Secretary Paulson’s original three-page, $700 billion proposal to buy troubled assets, primarily residential and commercial real estate loans and securities. The new law applied to banks, but also to insurance companies and broker dealers. This critical element survived largely intact with respect to the total amount the administration requested, even though there were limits imposed in terms of the timing of how it could be used (e.g., in tranches of $250 billion initially, then $100 billion with a Presidential certification, and then the final $350 billion if the President requested it and Congress did not disapprove his request using a fast-track procedure in the law).

Otherwise, the Secretary was granted broad discretion to use these funds, including the ability to make equity investments in firms without actually having the government take on any bad assets as originally conceived.²⁶ An Office of Financial Stability was created inside Treasury to manage this new program, with a new Assistant Secretary in charge. To oversee TARP, a new Financial Stability Oversight Board was created, consisting of the Secretary of the Treasury, the Federal Reserve chairman, the FHFA director, the SEC chairman, and the HUD Secretary. Additionally, there were numerous checks and balances added by Congress, including the creation of a special Inspector General, Government Accountability Office audits, and more transparent reporting to Congress and the public.

Recoupment

Recoupment of any losses paid for by the financial sector is another unique feature of EESA, which was not in the Administration’s original proposal. To my knowledge, no similar approach has ever been tried in times of financial crises in the United States or other distressed countries where I have worked.

The provision is as simple and straightforward as it is broad and pro­blematic. Five years after EESA’s date of enactment (October 3, 2013), the director of the Office of Management and Budget in consultation with the director of the Congressional Budget Office, is required to submit a report to Congress on any net TARP shortfall. If there are any losses under TARP after five years, Section 134 requires that the President submit a legislative proposal to Congress that details how the net losses would be recouped from the financial industry at that time to ensure that the TARP losses do not add to the budget deficit or national debt.

There is no recoupment mechanism or allocation formula included in the law, and no definition of who is included in the financial industry. This is, therefore, a broad grant of authority, which President Obama invoked earlier than required under a plain reading of the law, on January 21, 2010.²⁷ More on this issue later.

Protecting Homeowners from Foreclosure

Section 3 of the original Paulson Plan was to promote financial stability and protect the taxpayers, certainly two worthy goals in any crisis. Congress, however, expanded the purpose significantly in Section 2 of EESA to go beyond ensuring liquidity and stability to the financial system to address issues of homeownership and foreclosure among others. Congress demanded that these funds and new authority meet an additional four-part purpose: (A) protects home values, college funds, retirement accounts, and life savings; (B) preserves homeownership and promotes jobs and economic growth; (C) maximizes overall returns to taxpayers of the United States; and (D) provides public accountability for the exercise of such authority.²⁸

Specifically, Congress responded to populist constituent demands, added a new mission to protect homeowners as a quid pro quo for the funding—homeowner assistance in the form of foreclosure mitigation and an expansion of the earlier HOPE for Homeowners. Basically, the secretary is required to implement a plan to maximize assistance to homeowners, including working with HOPE for Homeowners, the FDIC on loan modifications, and consenting to reasonable loan modification requests.

The Secretary has the discretion to use loan guarantees and credit enhancements to avoid foreclosures. The existing HOPE for Homeowners program also was amended by expanding the number of borrowers eligible to participate and loosening the debt-to-income ratio requirement while also increasing the maximum loan-to-value ratio permitted beyond 90 percent.

Executive Compensation

Another major Congressional initiative in response to the Paulson Plan was the inclusion of limits on executive compensation for all TARP recipients. While this was not an outright cap above some preestablished number, it was a significant limitation for those recipients in three major areas: (1) limits on compensation for the senior executive officers (generally the five highest-paid executives) to ensure they do not take unnecessary and excessive risks that could threaten a company’s value; (2) repayment or so-called claw-back requirements for bonuses based on earnings that are later shown to be materially inaccurate; and (3) prohibitions on so-called golden parachutes, that is, severance payments to senior executives in involuntary termination situations.

Congressional Oversight Panel (COP)

The last major element in EESA also was not part of the original Treasury proposal. Section 125 created a new five-member Congressional Oversight Panel as part of the Legislative Branch of government. The duties of this panel are twofold: to review the current state of financial markets and the regulatory system and to submit reports to Congress. In turn, the reports fall into two categories: regular reports every 30 days on Treasury’s administration of the TARP program including the effectiveness of foreclosure mitigation efforts and maximizing the benefits to taxpayers and a special report on regulatory reform by January 20, 2009, in time for the inauguration of the new President.

CONCLUSION

While the extraordinary efforts of the Treasury Department, the Federal Reserve, the FDIC, and other regulatory agencies during the crisis were effective to a point, ultimately the Administration and Congress were forced to come together quickly to enact emergency legislation. It soon became necessary to call on the U.S. taxpayer to backstop an unprecedented initiative to support the financial industry until the panic subsided and longer-term reforms could be debated and considered.

In a matter of days, the Administration and Congress joined forces to enact the Emergency Economic Stabilization Act to do just that—stabilize U.S. financial companies and markets until more lasting solutions could be found. It also bought time to allow for the orderly change of administrations in the wake of the Great Financial Panic. It was amazing that it took place toward the end of a heated Presidential and Congressional election season, but as we have learned from other crises, it sometimes take a crisis to make things happen that politically were not possible before a crisis.

This immediate reaction did in fact set the stage for future reforms the following year. It also clearly set in motion what I describe as the seeds for the new regulatory reality discussed throughout this book.

Notes

1. Public Law 110-289, July 30, 2008. Among other things, this new law authorized the Treasury Department to purchase the housing GSEs’ obligations and created a new regulatory authority, the Federal Housing Finance Agency (FHFA).

2. Robert F. Brunner and Sean D. Carr, The Panic of 1907—Lessons Learned from the Market’s Perfect Storm (Hoboken, NJ: John Wiley & Sons, 2007).

3. Henry Paulson, On the Brink: Inside the Race to Stop the Collapse of the Global Financial System (New York: Business Plus), 2010, p. 217.

4. Paulson, On the Brink, p. 267.

5. Office of Thrift Supervision, OTS Fact Sheet on Washington Mutual Bank, OTS 08-046A, September 25, 2008.

6. Most of these events and dates are taken from the dateline located on the website of the Federal Reserve Bank of St. Louis, www.stlouisfed.org.

7. Paulson, On the Brink, pp. 248–257.

8. FDIC, History of the Eighties, Lessons for the Future (Washington, DC: Author, 1991), Vol. I. See especially Chapter 4, The Savings & Loan Crisis and Its Relationship to Banking, pp. 167–188.

9. Committee on Financial Services, Hearing, Future of Financial Services: Exploring Solutions for the Market Crisis, U.S. House of Representatives, 110th Congress, 2nd Session, September 24, 2008, Serial No. 110-141, p. 25; hereafter House 2008 Committee Hearing.

10. House 2008 Committee Hearing, p. 8.

11. House 2008 Committee Hearing, p. 3.

12. House 2008 Committee Hearing, pp. 20–21.

13. For an amusing but sad account of this meeting at the height of the crisis between Senators McCain and Obama with President Bush, see Paulson, On the Brink, pp.