Capital Assistance Program (CAP)

The Capital Assistance Program (CAP)

The capital assistance program is aimed at providing direct funding to financial institutions whose capital has been severely affected by losses on their (bad) bets in residential and commercial mortgage related instruments and financial derivatives tied to them or to other financial institutions in trouble. The CAP continues the process started with the Troubled Assert Repurchase Plan (TARP) during the last administration and provides a mechanism for the Treasury to inject capital in the banking system. Unlike the first half of the TARP, where capital was disbursed to institutions in a rather ad-hoc fashion (in large part because the liquidity crisis that ensued after the collapse of Lehman Brothers did not provide much time for careful analysis and deliberations), the Capital Assistance Program provides the framework that the government will follow to provide assistance to banks and other non-bank institutions. The premise for the CAP is relatively simple:

Banks have a large quantity of assets that have depreciated rapidly as a result of the collapse of the housing market;
Those losses are accentuated by the fact that private investors are not willing to purchase mortgage related assets at other than very distressed values (e.g. anecdotal evidence of recent transactions indicates that AAA credits that are current and performing are being negotiated at less than 60 cents on the dollar);
Reflecting those losses on the banks' profit and loss statements and balance sheets has resulted in a steep reduction of tangible capital/equity;
Lax regulation allowed for banks and other institutions to have leverage ratios of 10x or more (30-40x for investment banks), meaning that for a reduction of 10% in the value of the assets that a bank carried results in the bank becoming insolvent - for some investment banks the loss needed to be as small as 3%;
Many banks are dangerously close to having too little capital to continue operating under current capital maintenance rules established by financial regulators;
Private investors fearful of the continued near-term deterioration in the value assessed to the assets owned by the banks are unwilling to provide the needed capital to those financial institutions - those that did earlier in 2008 saw their investments evaporate;
The government is then the only institutions capable of providing capital to the banking system thus becoming the investor of last recourse;
There are at least 3 ways the government can help (or takeover):

Provide capital financing - through the Capital Assistance Program
Buy the toxic (aka legacy) assets from the banks
Takeover the bank and dispose of the assets through the FDIC or other regulator (e.g. Fed)

Under the capital assistance program, for the government to invest in a bank, the bank, in theory, needs to be viable under regular market conditions - meaning the assets that it holds should fetch more than what the current distressed market price says they are worth - given that the government has the luxury of time, it can make a medium to long-term investment without fearing near term mark-to-market losses in the value of the assets and the banks that own them;
Banks need to undergo a test to see if they are:

solvent and do not need of any government assistance;
solvent but need near-term capital assistance from the government to help them through this period and to give them time to raise private capital in the future;
insolvent as the value of their assets is so low that the only viable option is for a government takeover through the FDIC

Capital Assistance Program Details

The capital assistance program calls for the following steps to be taken:

A stress tests that will examine the banks capital requirements under two different forecasts for the economy: one, the baseline that is based on current expectations, and another what considers a more difficult set of adverse conditions hitting the economy:

the baseline conditions are estimated as an average of current economic forecasts on GDP growth and unemployment - the following forecasts will be used: the Consensus Forecast, the Blue Chip Survey, and the Survey of Professional Forecasters.
The stress test calls for an estimate of capital requirements if unemployment goes to 10% and housing prices fall by another 25%;

In the event that the stress test indicates that the bank needs more capital, then the bank will have 6 months to raise the capital in the private markets. If the bank can not raise the capital, then the Treasury will provide the required capital in the form of convertible preferred stock that is convertible into common equity at a price that is 10% below the prevailing price of the stock before February 9th;

The convertible preferred will pay a 9% coupon;

The bank will have 7 years to repay the preferreds; otherwise they will convert to equity;

Recipients will have to follow mandatory executive compensation provisions - pay limits for top executives at those institutions will be set at $500,000; however, stock grants and other forms of non-monetary compensation while conditioned are still allowed - the new pay limits will have to conform to what was announced by the Treasury on February 4th (see here for the official announcement) and amended by Congress in the ARRP;
Institutions receiving Treasury funds are forbidden from contracting lobbyists;

Banks will have to detail their plans for the use of the capital, and provide regular reports until the time when they repay the government by buying back their securities - the public will be able to see the documents submitted;

There will be restrictions on dividends on common stock, preferred, etc.

Financial institutions other than the largest banks can also access the Capital Assistance Program by applying to the Treasury by mid May;
The results of the stress tests will be made available on May 4th.

The plan documents are found under the following links:

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