[House Document 110-161]
[From the U.S. Government Publishing Office]
110th Congress, 2d Session - - - - - - - - - - - - House Document 110-161
OMB REPORT UNDER THE EMERGENCY ECONOMIC STABILIZATION ACT, SECTION 202
__________
COMMUNICATION
from
THE DIRECTOR, THE OFFICE OF MANAGEMENT AND BUDGET
transmitting
THE FIRST REPORT OF THE ESTIMATED COST OF ASSETS PURCHASED UNDER THE
EMERGENCY ECONOMIC STABILIZATION ACT OF 2008, AS REQUIRED BY SECTION
202
January 3, 2009.--Referred to the Committee on Financial Services and
ordered to be printed
Executive Office of the President,
Office of Management and Budget,
Washington, DC, December 5, 2008.
Hon. Nancy Pelosi,
Speaker of the House of Representatives,
Washington, DC.
Dear Madam Speaker: Enclosed and as transmitted to the
President of the United States is the Office of Management and
Budget's (OMB) first report of the estimated cost of assets
purchased under the Emergency Economic Stabilization Act of
2008 (EESA), as required by section 202.
OMB is required to submit this report to the President and
the Congress no later than sixty days after the first exercise
of authorities granted under Section 101(aa) of EESA, and
semiannually thereafter. Consistent with the requirement to
analyze transactions up to thirty days before publication, this
report analyzes the cost of transactions completed by November
6, 2008.
OMB will continue to work closely with the Department of
the Treasury to consider the budgetary impacts of this
important program.
Sincerely,
Stephen S. McMillin
(For Jim Nussle, Director).
Enclosure.
Identical letter sent to the President of the Senate.
OMB Report Under the Emergency Economic Stabilization Act, Section 202
The Emergency Economic Stabilization Act of 2008 (Pub. L.
110-343) authorizes the Department of the Treasury to purchase
and insure certain types of troubled assets for the purposes of
restoring liquidity and stability to the financial system of
the United States. Section 202 of the Act requires the Office
of Management and Budget (OMB) to report the estimated cost of
assets purchased and guarantees issued pursuant to the Act. OMB
is required to submit the report no later than sixty days after
the first exercise of authorities granted under Section 101(a)
of the Act, October 6, 2008.\1\ Consistent the requirement to
analyze transactions up to thirty days before publication, this
report analyzes transactions through November 6, 2008.
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\1\The appointment of Assistant Secretary of Financial Stability,
Neel Kashkari (interim) on October 6, 2008, by the Department of the
Treasury (Treasury) was the first exercise of authority under the
Emergency Economic Stabilization Act.
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Purchases
As of November 6, 2008, Treasury had purchased $115 billion
in preferred stock and warrants for future purchases of common
stock from eight financial institutions, as outlined in
Treasury's first transaction and tranche reports on the Capital
Purchase Program. The preferred stock is senior to common stock
and pays a dividend at an annual rate of 5 percent during the
first five years and 9 percent after five years. The stock is
an equity transaction and therefore has no stated maturity, but
the institution issuing the preferred stock can redeem the
shares under certain terms. As of November 6, Treasury also had
made a commitment to purchase $10 billion in preferred stock
from a ninth institution. Treasury had not issued any
guarantees of troubled assets.
Cash Flows and Impact on the Deficit and Debt
Section 123 of the Emergency Economic Stabilization Act
(EESA) states that the cost of Treasury purchases under the
Troubled Asset Relief Program (TARP) are to be estimated under
the Federal Credit Reform Act (FCRA) of 1990 (2 USC 661 et
seq.), with discount rates adjusted for market risks. FCRA
requires accrual budgeting only for ``direct loans'' or ``loan
guarantees,'' as defined in FCRA. As of the writing of this
report, Treasury's Capital Purchase Program has made equity--
not loan--purchases, and has not issued guarantees, and thus
the cash flows are reflected on a cash basis and not on an
accrual basis. Table 1 displays the estimated impact of these
purchases on the deficit and Federal debt as of the writing of
this report:
TABLE 1: CAPITAL PURCHASE PROGRAM
[In billions*]
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2009-
2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2018
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Disbursements...................................... 115.0 ....... ....... ....... ....... ....... ....... ....... ....... ....... 115.0
Stock Dividends, Expected.......................... ....... ....... ....... ....... ....... ....... ....... ....... ....... ....... .........
Redemptions, and Exercised Warrants................ -3.9 -7.0 -6.5 -20.2 -19.3 -16.4 -10.4 -9.5 -8.3 -8.8 -110.4
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Net Outlays.................................... 111.1 -7.0 -6.5 -20.2 -19.3 -16.4 -10.4 -9.5 -8.3 -8.8 4.6
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*Components may not sum to totals due to rounding.
The table shows an initial disbursement of $115 billion in
2009 to purchase preferred stock. As stated above, this amount
corresponds to purchases made prior to November 6, 2008. The
table also includes the sum of estimated dividend payments that
Treasury will receive, estimated redemptions that will occur
each year, and estimated net proceeds from the exercise or sale
of warrants, based on the initial disbursement of $115 billion
dollars. The table shows that redemptions are predicated to
increase in 2012 through 2015, when the incentives are greater
for financial institutions to redeem shares, including the fact
that the dividend rate on the shares will increase from 5
percent to 9 percent after five years. It also shows that
Treasury is expected to recover nearly all of the $115 billion
in disbursed funds in the first ten years of the program.
See the Alternative Valuation section of this report for an
analysis of the cost of the Capital Purchase Program using the
net present value of the expected cash flows.
Method for Estimating the Cash Flows of Preferred Stock
Cash flows to and from the government occur when the
preferred stock is purchased, when the government receives
dividend payments, and when the preferred stock is redeemed
(``called'') by the financial institution or sold by Treasury.
OMB developed an analytical model to project these cash flows
on an annual basis, incorporating the following risks
underlying the cash flows:
Credit risk--the risk that closure or failure of
the institution will forestall the payment of principal (or
value of stock sales or redemptions) and dividends to the
Treasury. OMB takes this risk into consideration by factoring
in the strength of the issuing firm, as evidenced by its market
value.
Call risk--the risk that the financial institution
will buy back the preferred stock in scenarios where it is
relatively cheaper for the institution to get financing in the
open market, when market interest rates are low and therefore
the returns on these securities are more valuable to the
Treasury, and not buy it back in scenarios where it is not.
Call risk derives primarily from uncertainty about Treasury
rates and about future levels of credit risk.
Dividend Curtailment Risk--the risk that the
institution will stop paying dividends. The terms of the
preferred shares prohibit the institution from paying dividends
to common stock holders unless they pay dividends on the
preferred stock, but companies can forgo dividends on all types
of equity including the preferred stock.\2\ OMB takes this risk
into consideration by factoring the strength of the issuing
firm in its cash flow projections.
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\2\For banks that are subsidiaries of bank holding companies
(BHCs), dividends on the preferred stock are cumulative, meaning that a
bank would need to pay the accumulated amount of all unpaid dividends
on preferred stock before recommencing payment of dividends to common
stock holders. For banks that are not subsidiaries of BHCs, dividends
are non-cumulative, meaning that the bank would not need to make up
past unpaid dividends before recommencing payment of dividends to
common stock holders. The risk of dividend curtailment is substantially
mitigated for cumulative preferred stock, although it still leads to a
reduction in net present value due to the time value of money, and a
higher exposure in the case of bank closure.
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The model is probabilistic, meaning that it projects cash
flows under a number of different scenarios and then weights
the likelihood of the different scenarios to obtain the annual
expected cash flow of the investment.
The model estimates how cash flows vary depending on 1)
current interest rates that affect the call decision; and 2)
the strength of a financial institution's assets and net equity
position that affect dividend curtailment or possible failure
(credit risk).\3\ The component of the model used to determine
the effect of interest rates builds on models used for other
government programs with interest rate risk exposure such as
Federally guaranteed student loan programs. The component of
the model used to determine the effect of the financial
institutions' strength is based on the model used to project
bank failures in the context of Federal bank deposit insurance.
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\3\Short-term risk-free interest rates are based on current
Treasury yields. A firm's financial strength and ability to make
dividend payments is estimated using a ratio of market value of the
firm's total assets (current market capitalization plus total
liabilities) divided by total liabilities (as recorded in the most
recently available financial statement). The estimate of the strength
of a firm's financial position factors in stock price volatility in its
calculation.
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In each of multiple scenarios, the model calculates the
optimal call decision for each bank, the estimated dividends
received by the Government, and the probability of each
scenario. The result is the expected likely cash flows to the
government from the preferred stock purchases.
Method for Estimating the Cash Flows of Warrants
While the call option of the preferred stock benefits the
institution, the warrants for common stock that Treasury
received as part of the transaction benefit Treasury. OMB
values and projects the cash flows of the warrants using a
commonly applied option-pricing approach based on the current
stock price and its volatility. By using the same volatility
parameters as used for the preferred stock model, the model
maximizes consistency between the estimates of the downside
risks associated with the preferred stock and the upside
potential associated with the warrants.
Alternative Valuation
Although OMB is reflecting the equity purchases on a cash-
basis, this report also shows the cost of the preferred stock
purchases under the Capital Purchase Program using the net
present value (NPV) of the expected cash flows.\4\
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\4\While the term of the preferred stock is perpetual life, the
projected cash flows are truncated at thirty years for the NPV
calculations.
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NPV is calculated under two alternative discount rates. The
first alternative discounts the expected cash flows using
current Treasury yields as of the time of preparing this
report, which reflect the government's cost of borrowing. The
single effective discount rate for these purchases is 3.84
percent.\5\ The second alternative view of the cost of TARP
purchases uses a market-risk adjusted rate, as outlined in
Section 123 of EESA. It reflects the higher rate of return that
private investors would demand to compensate for the risk that
future cash flows may be lower than expected due to higher than
expected default rates. The single effective discount rate with
the market risk adjustments is estimated to be 8.79 percent.\6\
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\5\A single effective discount rate is a weighted average of the
rates used to discount the cash flows over multiple periods. Under
FCRA, for example, cash flows are discounted using a ``basket of
zeros'' approach where each period's cash flow is discounted using the
yield of a Treasury zero-coupon bond of a similar maturity. The single
effective discount rate is the one discount rate that generates the
same subsidy cost as the basket of zeros.
\6\It should be noted that these discount rates are based on a
snapshot of current Treasury rates as of the time of preparing this
report, and are not the rates that would be used to value preferred
stock purchases if they were evaluated under FCRA. Under FCRA, the
discount rates for credit transactions executed in fiscal year 2009 are
based on the economic assumptions used to prepare the 2009 Budget,
released in February 2008.
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Table 2 shows the estimated cost of the preferred stock and
warrants:
TABLE 2: ESTIMATED COST OF EQUITY PURCHASES
[In billions*]
------------------------------------------------------------------------
NPV at the
USG's cost of NPV with risk
borrowing adjustments
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Expenditure............................. 115.0 115.0
Present Value of Preferred Stock........ (115.7) (81.9)
Present Value of Warrants............... (11.8) (7.6)
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Net Cost (Gain)..................... (12.6) 25.5
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*Components may not total due to rounding.
This table shows that under the first alternative
(calculating NPV at the Government's cost of borrowing), the
estimated value of the preferred stock and warrants represents
a net gain of $12.6 billion or 11 percent of the initial
disbursement. This means that Treasury is estimated to receive
on average a rate of return on its investment that exceeds the
Government's cost of borrowing, reflecting an estimated overall
net gain to the Government in an average scenario. Under the
second alternative (calculating NPV with adjustments for market
risk), the estimated value of the preferred stock represents a
net loss of $25.5 billion or 22 percent of the initial
disbursement. This means that the estimated average return on
Treasury's investment will not equal what a typical private
investor would demand for an investment facing similar risks
given the private investor has a higher cost of borrowing.
Thus, the return on the investments would represent a net loss
compared with what would typically be demanded by a private
investor.
Future OMB Reports
Section 202 of the Emergency Economic Stabilization Act
requires OMB to submit a recurring report at least semi-
annually. OMB may satisfy this requirement in 2009 and future
years through reporting in the Budget and Mid-Session Review.