In (Limited) Praise of Discretion

by Tom Bozzo

Here’s a funny thing about reporting on the bank-recapitalization approach to the TARP. This is (almost) the NYT lede:

Treasury officials say the just-passed $700 billion bailout bill gives them the authority to inject cash directly into banks that request it. [emphasis added]

The AP hears the same on explicit condition of anonymity:

An administration official, who spoke on condition of anonymity because no decision has been made, said the $700 billion rescue package passed by Congress last week allows the Treasury Department to inject fresh capital into financial institutions and get ownership shares in return.

Now I suppose any law is theoretically open to interpretation, but this is a little ridiculous. The more-or-less plain text of the law is that the main limitation is that whatever the Treasury does has to involve a Troubled Asset transaction. Here’s section 113(d) of the Emergency Economic Stabilization Act of 2008:

(d) Conditions on Purchase Authority for Warrants and Debt Instruments-

(1) IN GENERAL- The Secretary may not purchase, or make any commitment to purchase, any troubled asset under the authority of this Act, unless the Secretary receives from the financial institution from which such assets are to be purchased–

(A) in the case of a financial institution, the securities of which are traded on a national securities exchange, a warrant giving the right to the Secretary to receive nonvoting common stock or preferred stock in such financial institution, or voting stock with respect to which, the Secretary agrees not to exercise voting power, as the Secretary determines appropriate; or

(B) in the case of any financial institution other than one described in subparagraph (A), a warrant for common or preferred stock, or a senior debt instrument from such financial institution, as described in paragraph (2)(C).

(2) TERMS AND CONDITIONS- The terms and conditions of any warrant or senior debt instrument required under paragraph (1) shall meet the following requirements:

(A) PURPOSES- Such terms and conditions shall, at a minimum, be designed–

(i) to provide for reasonable participation by the Secretary, for the benefit of taxpayers, in equity appreciation in the case of a warrant or other equity security, or a reasonable interest rate premium, in the case of a debt instrument; and

(ii) to provide additional protection for the taxpayer against losses from sale of assets by the Secretary under this Act and the administrative expenses of the TARP.

(B) AUTHORITY TO SELL, EXERCISE, OR SURRENDER- The Secretary may sell, exercise, or surrender a warrant or any senior debt instrument received under this subsection, based on the conditions established under subparagraph (A).

(C) CONVERSION- The warrant shall provide that if, after the warrant is received by the Secretary under this subsection, the financial institution that issued the warrant is no longer listed or traded on a national securities exchange or securities association, as described in paragraph (1)(A), such warrants shall convert to senior debt, or contain appropriate protections for the Secretary to ensure that the Treasury is appropriately compensated for the value of the warrant, in an amount determined by the Secretary.

(D) PROTECTIONS- Any warrant representing securities to be received by the Secretary under this subsection shall contain anti-dilution provisions of the type employed in capital market transactions, as determined by the Secretary. Such provisions shall protect the value of the securities from market transactions such as stock splits, stock distributions, dividends, and other distributions, mergers, and other forms of reorganization or recapitalization.

(E) EXERCISE PRICE- The exercise price for any warrant issued pursuant to this subsection shall be set by the Secretary, in the interest of the taxpayers.

(F) SUFFICIENCY- The financial institution shall guarantee to the Secretary that it has authorized shares of nonvoting stock available to fulfill its obligations under this subsection. Should the financial institution not have sufficient authorized shares, including preferred shares that may carry dividend rights equal to a multiple number of common shares, the Secretary may, to the extent necessary, accept a senior debt note in an amount, and on such terms as will compensate the Secretary with equivalent value, in the event that a sufficient shareholder vote to authorize the necessary additional shares cannot be obtained.

The law actually requires a contingent equity grant to accompany any TARP asset purchase; it just leaves every salient detail up to the Secretary of the Treasury. So to the question of whether the Secretary can structure TARP purchases as preferred equity injections, the reasonably plain answer from the text of the law is, sure. (See also Krugman, who links Roubini with some backstory.)

This brings us back to a point I made in passing about the blank-check version of the plan: the discretion can be used for good or for ill, and the outcome depends in part on whether Henry Paulson can escape the Davies Conjecture and thus doesn’t end up figuring prominently in Lessons From the Great Depression 2 (by Peter Temin‘s great-grandchild). A la Dodd, the contingent equity arrangements were left much less to the Secretary’s discretion. Interestingly, if you want to recapitalize the banks via TARP, it looks like the current form of the law offers somewhat more options for doing so. Along those lines, if the House Republicans really wanted to forestall nationalization of the banking system, they failed miserably as giving the Secretary discretion not to take a meaningful equity stake is not the same as preventing the Secretary from doing so.

Added: With a h/t to DOLB in the comments, here’s the definition of ‘troubled assets’:

      (9) TROUBLED ASSETS- The term `troubled assets’ means–
        (A) residential or commercial mortgages and any securities, obligations, or other instruments that are based on or related to such mortgages, that in each case was originated or issued on or before March 14, 2008, the purchase of which the Secretary determines promotes financial market stability; and
        (B) any other financial instrument that the Secretary, after consultation with the Chairman of the Board of Governors of the Federal Reserve System, determines the purchase of which is necessary to promote financial market stability, but only upon transmittal of such determination, in writing, to the appropriate committees of Congress.

See especially part (B). Dday has some legislative history at Hullabaloo.