Financial Crisis by Marleen van kammen

Corporate Executive Board® Teleconference Materials

What Every Executive Should Know About the Financial Crisis 2 October 2008 • 10:00–11:00 a.m. • 1:00–2:00 p.m. • 2:30–3:30 p.m.

(15:00–16:00 London, 16:00–17:00 Paris) (18:00–19:00 London, 19:00–20:00 Paris) (19:30–20:30 London, 20:30–21:30 Paris)

 Presented by Scott Bohannon, General Manager, Corporate Executive Board

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Legal Caveat The Corporate Executive Board has worked to ensure the accuracy of the information it provides to its members. This report relies upon data obtained from many sources, however, and the Corporate Executive Board cannot guarantee the accuracy of the information or its analysis in all cases. Furthermore, the Corporate Executive Board is not engaged in rendering legal, accounting, or other professional services. Its reports should not be construed as professional advice on any particular set of facts or circumstances. Members requiring such services are advised to consult an appropriate professional. Neither the Corporate Executive Board nor its programs are responsible for any claims or losses that may arise from a) any errors or omissions in their reports, whether caused by the Corporate Executive Board or its sources, or b) reliance upon any recommendation made by the Corporate Executive Board.

Hesitation Has A Price In the last recession, Sun lost market position by failing to agree and act quickly Don’t Hesitate “The one thing that I would do differently from the last downturn is be more proactive around the actions we need to make—instead of being behind the curve, we need to be ahead of the curve. During the last recession, part of the senior management team knew we had to make some big changes, but we were unable to effectively convince the rest of the team to agree with our position.” Michael E. Lehman Former and Current CFO Sun Microsystems, Inc.

Sun Microsystems’ Stock Price Versus Competitors Indexed Tech Bubble Burst

Characteristics of Tech Recession Price-sensitive customers due to slashed budgets Fewer customers due to bankruptcies

Sun’s Response No strategy change during the recession Continued to invest heavily in R&D Failure to adapt new products to meet (at twice the rate of its key competitor) customer demands for cheap, off-theto build more expensive, in-houseshelf alternatives designed products

Sun IBM HP Dell Microsoft

Jan. ’00

June ’00

Jan. ’01

June ’01

Jan. ’02 June ’02

Jan. ’03

June ’03

Jan. ’04 June ’04

Jan. ’05

June ’05

Jan. ’06

June ’06

Jan. ’07

June ’07

Road Map for the Presentation

How did we get here?

How are the U.S. and European governments responding?

How are leading companies responding to the current crisis?

Upcoming guidance and events for your role

Origins of Mortgage-Related Risks Securitization allows banks to transfer credit risk to capital markets and focus on generating fees rather than interest income 3

2 1

Risky borrowers obtain home loans from banks…

…who pool mortgages together and sell them for a fee…

Mortgage Originators (Banks and Brokers)

Individual Borrowers

…by hiring investment banks to package them as securities with different risk layers (“tranches”). To sell desirable tranches, banks keep significant amounts of less-desirable tranches (typically lowestreturn, lowest-risk tranches) for themselves.

I-Banks and Rating Agencies

Investors • Insurers • Hedge Funds • SIVs • Fannie/ Freddie 5

Credit Protection/ Insurers

Investment banks sell the rest of the securities to a wide variety of investors. In some cases, banks park the securities in off-balance-sheet funds, called Structured Investment Vehicles, that the banks themselves sponsor. Insurance (or default protection) is purchased to enhance the credit rating (or hedge the value) of securities.

The role of insurance companies, like A.I.G., in providing credit enhancement or protection made asset values on bank balance sheets dependent, in part, on insurance company solvency. For this reason, regulators viewed the potential bankruptcy of A.I.G., which had a very large CDS portfolio, as posing a systemic risk. Source: Corporate Executive Board research. IRR1AL8UQ1 © 2008 Corporate Executive Board. All Rights Reserved.

Shell Shock Total Market Capitalization, Financial Services Institutions* U.S. Dollars (In Billions) 21 Jun., Bear Stearns Hedge Fund Losses: Two hedge funds with significant subprime mortgage holdings sustain large losses and are forced to dump assets.

Aug.–Sept., Fed Intervention: Fed cuts discount rate to 5.75% and lends $2 B to ease credit woes. It begins to cut interest rates and continues to make cuts for seven straight meetings.

22 Jan., Cut in Interest Rates: The Fed makes the single deepest cut in interest rates (from 4.25% to 3.5%) in more than two decades.

3,000 300,000,000%

6 Sept., Fall of the Giants: Treasury Secretary Henry Paulson announces takeover of Fannie Mae and Freddie Mac.

15 Sept., Financial Crisis: Bank of America acquires Merrill Lynch; Lehman Brothers files for bankruptcy, the largest of its kind.

3,000

Feb., Failure in Auction-Rate Securities: $330 B ARS market collapses amid the credit crisis; more than $51 B in securities are targeted for repurchase.

14–16 Mar., Bear Stearns Collapses: JPMorgan and Fed bail out Bear Stearns; JPMorgan acquires Bear for $10 a share. 2,100 210,000,000%

29 Sept., World in Shock U.S. Stocks Tumble: Down $1.1 trillion in market value, oil plunges, and Treasury bonds rally after lawmakers reject Bush administration’s $700 B mortgage and bank bailout plan. Crisis Reaches Europe: New failures hit European institutions in at least four countries.

16 Sept., Saved by the Fed: Fed agrees to provide A.I.G. a two-year loan of up to $85 B and, in return, gains nearly 80% ownership of the insurer.

Citigroup Buys Wachovia: Fed helps orchestrate deal; Citigroup will pay $1 a share.

26 Sept., WaMu Fails: JP Morgan buys branch network of Washington Mutual as thrift is seized by regulators in largest bank failure in U.S. history.

2,100 14 Dec., Rescue Mission: Citigroup assumes $58 B of debt and takes over seven troubled SIVs (Structured Investment Vehicles). 11–20 Dec., Banks Announce Losses: UBS announces write-downs of $10 B; Bear takes $1.9 B write-down; Morgan Stanley posts $3.59 B loss and $9.4 B write-down on mortgage assets.

1,200 120,000,000% Q3 7/6/2007 2007

Q4 10/5/2007 2007

Q1 1/4/2008 2008

Q2 4/4/2008 2008

$ Q3 7/4/2008 2008

1,200 Sept. 2 9/2/2008 2008

Sept. 8 9/8/2008 2008

Sept. 12 9/12/2008 2008

19–26 Sept., End in Sight? SEC temporarily bans short-selling; Paulson proposes $700 B bailout plan. Sept. 18 9/18/2008 2008

Sept. 24 9/24/2008 2008

Sept. 29 2008

Source: Wall Street Journal; Bloomberg, Inc.; CNN Money Inc.; Corporate Executive Board research.

Of Mice and Men Key mistakes

Speculative Real Estate Bubble Fueled by abundant, cheap liquidity, a speculative bubble develops as real estate prices rise in key property markets in the United States and Europe.

Misaligned Incentives Originators lack sufficient incentive to properly police borrower credit because they are transferring credit risk to investors.

Poorly Understood Risks Despite questionable credit risk underlying securities, rating agencies certify the safety (credit-worthiness) of super-senior tranches.

Excessive Leverage Investors and banks use large amounts of short-term debt to purchase securities, making them vulnerable to declines in asset values or to disruptions in short-term funding markets.

Investors

Individual Borrowers

Mortgage Originators (Banks and Brokers)

I-Banks and Rating Agencies

• Insurer • Hedge Funds • SIVs • Fannie/ Freddie

Credit Protection/ Insurers

Hindsight Is 20/20 Flawed assumptions 1

Securitization Spreads Credit Risk Predictably • In reality, some banks retained significant concentrations of credit risk via super-senior CDO tranches and off-balance-sheet SIVs. • The involvement of insurers created interdependencies with unpredictable risk cascading effects.

Rating Agencies Provide Reliable Credit Ratings In retrospect, rating agencies either lacked expertise or proper incentives to provide accurate risk evaluations.

Investment Bank Advisory and Fee-Based Businesses Require Relatively Little Equity Capital The conventional approach to allocating capital to bank advisory businesses has proven overly-focused on credit/market value-at-risk and failed to protect against revenue volatility caused by losses in confidence.*

* In The Cost of Money (2003), the Corporate Executive Board’s treasury practice recommended banks increase economic capital allocations for feebased businesses by applying total risk charges (that reconcile debt and equity views of risk) based on a detailed practice from Morgan Stanley. Source: Corporate Executive Board research.

Bank Credit Crunch Collapsing real estate values (which underpin mortgage security values)…

…cause a crisis of confidence in bank solvency

Case-Shiller Home Price Index June 2005 to June 2008

Daily TED* Spread September 2008

210

TED* spread reaches new high. 4%

TED

Lack of confidence in bank balance sheets creates fear in bank lending markets.

185

Spread

30-Day TED Average

160

June 2005

June 2008

U.S. Foreclosures 1.3 M

20 29 / 9/

08 20 21 / 9/

17 /

08 20 13 / 9/

08 5/ 9/

726 K

08 9/

79%

* The TED spread measures the difference between the three-month U.S. Treasury Bill and the three-month Eurodollar Future (as represented by LIBOR). It is a negative indicator of banks’ willingness to lend to one another. 2006

2007

Myth Versus Reality Notwithstanding the usual scapegoats, the crisis was caused, in reality, by poorly understood risks, leadership failures, and flawed business models

Myth

Fair value accounting caused the crisis. “If we only eliminated mark-to-market accounting rules and loosened regulatory capital constraints, banks could wait out the market volatility alleviating any capitalization issues.”

Short-sellers are to blame. “Unfettered short-selling was the cause of Bear, Lehman, and A.I.G.”

Reality

This argument recalls Keynes’ old line, “the market can stay irrational longer than you can stay solvent.” While fair value accounting forced banks to recognize losses, these losses reflected real declines in real estate assets underpinning the securities. Additionally, U.S. accounting rules (reasonably) allow banks to use internal models to price illiquid (level III) assets so long as assumptions are disclosed (they are not forced to mark down to zero). Blaming accounting rules is a bit like blaming the radar gun for your speeding ticket.

The short-selling ban failed to prevent stock declines of more than 50% at Ambac and Farmer Mac (two companies listed in the 18 September ban). While some short sellers may have acted improperly or illegally by spreading false rumors, short sellers generally perform a valuable function by adding information and liquidity to the market. Enhanced disclosure and prudent restraints (e.g., uptick rule, borrow rule) may reduce the risk of abuse, but an outright ban on short-selling is likely to undermine rather than build confidence in financial markets.

Road Map for the Presentation

How did we get here?

How are the U.S. and European governments responding?

How are leading companies responding to the current crisis?

Upcoming Guidance and Events for Your Role

Varied European Government Intervention Exposure to U.S. and local sub-prime varies significantly across Europe leading to different approaches in Government intervention Russia

United Kingdom Government nationalized B&B with specific assets sold to Banco Santander for €777 M

Government to lend the country’s three largest banks €28.6 B for a minimum of three months

Government negotiated sale to Lloyds TSB for €19.1 B

Germany

Ireland

Government in consort with private banks bailed out Hypo Real for €35 B

Government introduces guarantee scheme with a pledge of €400 B to cover bank deposits

France Switzerland

French Government, currently holding EU presidency, contributed to e6.4 B rescue of Dexia

€32.1 B in write-downs to date €2.0 B in write-downs to date

Level of Government Intervention Inactive

Iceland

Reactive Proactive

Benelux Government bought a 75% stake in Glitnir, the country’s third-largest lender, in a €e600 M deal

Governments of Belgium, Luxembourg, and the Netherlands injected €11.2 B of capital into Fortis

Source: The Financial Times; Wall Street Journal; BBC; BusinessWeek; Corporate Executive Board research.

Eight Critical Components of the Draft U.S. Emergency Stabilization Act of 2008 1. Broad Power to Stabilize the Financial Markets. The Treasury Secretary has broad, sweeping power under the Troubled Asset Relief Program (“TARP”) to stabilize the U.S. financial markets. 2. Potential Suspension of FAS 157. The Act (Sec. 132) gives the SEC authority to suspend FASB Statement 157 (i.e., the mark-to-market accounting requirement) for any issuers or any class or category of transaction. 3. Purchases of Troubled Assets from Retirement Funds. The Act authorizes the Treasury Secretary to purchase Troubled Assets from retirements* for corporations with retirements funds whose value has been substantially compromised by investments (even indirect) in Troubled Assets. This provision MAY provide an avenue for relief; however, at this time, it is unclear how the Act’s provisions would apply in these instances. 4. Not All Financial Institutions May Benefit from the Act. Financial institutions do not have the right to participate; we will likely see many more financial institutions fail. The Treasury Secretary is charged with deploying a scarce set of funds and to take into account the “net present value to the tax payer” of the purchases and guarantees made. 5. U.S. National Debt Will Increase Sharply and Potentially Permanently. There is nothing in the Act that requires TARP to NOT increase the national debt; the deficit will increase dramatically in the short term. The national debt ceiling was raised to $11.315 trillion; the President is required to submit legislation in five years from now proposing how to recover any shortfall from financial institutions; there is no guarantee such legislation will pass or that a feasible method of recovery will exist.

* As defined by clauses (iii), (iv), (v) and (vi) of section 402(c)(8)B of the Internal Revenue Code of 1986 (excluding nonqualified deferment plans as defined by clause of section 409(A)). IRR1AL8UQ1 © 2008 Corporate Executive Board. All Rights Reserved.

Source: Corporate Executive Board research.

Eight Critical Components of the U.S. Emergency Stabilization Act of 2008 (Continued) 6. Frequent Shocks to the Financial System May Persist. The Act creates a number of incentives that favor auctions and open-market transactions for Troubled Assets over direct purchases which will periodically and suddenly create new pricing information. The Treasury will also need to issue large amounts of debt to finance TARP which may produce substantial swings in interest rates and dollar exchange rates, as well as highly correlated commodity prices. 7. Early Look at Potential Broad Executive Compensation Changes. The Act provides an early look at how executive compensation may change, especially regarding tax deductibility; limits include: 1) restrictions on golden parachutes; 2) limits on incentives that threaten the value of the financial institution; 3) provisions for the recovery of compensation based on earnings/gains that later prove materially inaccurate; and 4) tax deductibility limits with the $1 million cap falling to $500,000 and golden parachutes even more likely to be treated as non-deductible*. 8. Criminal Enforcement Like the Post-Enron Period. The Act tightens up fraud provisions around use of FDIC protection claims and directs key players to cooperate fully with the FBI in investigations related to the financial crisis. Executives should expect far-reaching investigations that extend not just to financial institutions, but also to their advisors, customers, and partners who helped create mortgaged-back securities or transacted in them.

Recent Additions to the Draft Act 1. Tax breaks for businesses and alternate energy 2. Higher limit for insured bank deposits

* Note that the executive compensation limitation draws a line between companies that participate via direct sales of assets and those that participate via open auctions, clearly favoring the latter. IRR1AL8UQ1â&#x20AC;&#x201A;ÂŠ 2008 Corporate Executive Board. All Rights Reserved.

Source: Corporate Executive Board research.

Late Breaking Change

Road Map for the Presentation

How did we get here?

How are the U.S. and European governments responding?

How are leading companies responding to the current crisis?

Upcoming Guidance and Events for Your Role

Unsettling Environment = Unprecedented Prudence Bold changes in strategy generally are not appropriate for the next three months

“No-Brainer” Near-Term Messages Vague, feel-good objectives and minimal exposure to risky, uncertain strategic assumptions Build strong relationships with our customers Increase operational efficiency Become a learning organization Grow profitably These near-term messages need metrics but provide clarity to the organization without making bold bets on the future.

Tactical Activities to Protect from a Weak Credit Market Deploying tactical responses that will protect the financial integrity of your company is imperative The Three Certainties of the Crisis

Action Items to Protect Your Companyâ&#x20AC;&#x2122;s Financial Integrity

Pricing and availability of credit for corporations will further tighten.

Liquidity scenarios: Rerun liquidity scenarios discounting your ability to draw down on the full extent of your credit facilities. Facility renewals: Prepare now for difficult credit facility renewal conversations with banks; conduct a relationship health-check. Working capital: Tighten organizational focus on working capital management.

Asset price deflation and financial institution de-leveraging will apply further downward pressure on the economy.

Forecasting and planning: Run stress tests (more extreme scenarios) on the most critical drivers of your plan (e.g., holiday sales for retail, energy costs for materials). Seek opportunities in talent and assets: Now is the time to be opportunistic in seizing distressed assets and talent; develop and execute a shopping list.

Corporate risk monitoring mechanisms are inadequate.

Counterparty exposure: As credit markets tighten, defaults among suppliers and/or customers are likely to rise significantly in the next 12 months; develop good risk monitoring processes and credible risk mitigation plans. Fraud: Increase focus on fraud risk assurance; slow economic times tend to bring increased incidence of fraud, which carry additional headline risk. Risk integration: While tone at the top is the most important risk mitigation mechanism, assess the extent to which risk management is an integrated component of key business processes (e.g., planning, communications, project management) versus a standalone, check-the-box exercise.

Heightened Importance of Communication from Leadership: To maintain confidence in a crisis, step up the frequency of your communications and make sure you are delivering a clear message to your teams, colleagues, and investors. Source: Corporate Executive Board research. IRR1AL8UQ1â&#x20AC;&#x201A;ÂŠ 2008 Corporate Executive Board. All Rights Reserved.

The Executive Committee Agenda Six ways the current capital market crisis impacts the drivers of your short- and medium-term operating plans should form the basis of your executive committee agenda for the coming months

1. Plan for Increased Cost and Reduced Availability of Credit 2. Reorient Sales and Marketing Around the Impaired Economic Condition of Your Customer Base 3. Develop a Concrete Response to a Radically Changed Picture of Supplier Capacity and Viability 4. Ensure an “Activist” Response to Emerging Market Talent Opportunities 5. Balance Aggressive (but Small) M&A with Equally Aggressive Due Diligence 6. Overinvest in Ethical Management and Tone at the Top

Executive Committee Agenda Items

1. Plan for Increased Cost and Reduced Availability of Credit Retraction of debt financing is taking place against the backdrop of unprecedented capital availability globally Survival Mechanisms 1

Leverage healthy relationships with healthy suppliers to structure more attractive financing

Ratchet up your ability to self fund by reducing investment in working capital

Research Support

Optimizing Working Capital: Tactics to Improve Cash Efficiency

Beta’s Customer Profitability Assessment

Sun Microsystems’ Process Excellence Cash Management Initiative

QRS’ Supplier Risk Scorecard

Borealis’ Working Capital Management Approach 4

Build/retain credibility with investors by focusing communications on crisp, differentiated messages

Plan for cash needed in the next 9 to 18 months rather than just next month

Research Support

Activating the Financial Brand: How the Best Companies Use Key Messages to Stand Out in the Market

Beta Company’s Liquidity Survival Horizon

Message Absorption Diagnostic: A powerful tool for measuring whether the investment community hears and believes your company’s key strategic messages

Executive Committee Agenda Items (Continued)

2. Reorient Sales and Marketing Around the Impaired Economic Condition of Your Customer Base Capacity to buy is more unevenly distributed than at any time in recent memory Customer Targeting Strategies 1

B2B Markets Adjust sales and marketing targeting methods to better reflect creditworthiness of customers and their own industry conditions. Further, where your balance sheet allows, use creative terms as a competitive weapon; where it doesn’t, upgrade value-added services. 2

B2C Markets Expect wildly uneven growth across regional markets and demographic segments. While consumer dependence on credit rose to unhealthy levels in several Western European countries and the United States, this dependence was highly localized. 3

Target customers whose ability to pay is still robust (or even increasing). Pricing, an underexploited lever in even the best of times, becomes a critical discipline as customer fortunes diverge and input prices fluctuate wildly. Research Support

Air Products and Chemicals’ Customer Segmentation Rules of Engagement Square D’s Opportunity Fit Matrix Air Products and Chemicals’ Customer Intimacy Protocols

Executive Committee Agenda Items (Continued)

3. Develop a Concrete Response to a Radically Changed Picture of Supplier Capacity and Viability Suppliers have radically different demand for their services and radically different levels of economic stability Active Supplier Management

Evaluate Evaluate your your suppliers’ suppliers’ own own demand demand positions to help your procurement positions to help your procurement team team target target opportunities opportunities for for advantaged advantaged pricing pricing and and service service terms. terms. Research Support Syngenta’s Stress-Tested Supply Frameworks

Forthcoming

Understand Understand the the strength strength and and stability stability ofof key key suppliers’ financials and quickly determine suppliers’ financials and quickly determine where where you you are are exposed exposed to to unhealthy unhealthy levels levels ofof risk. risk. Research Support Lockheed Martin’s Capability-Based Risk-

Assessment Tool Cadbury Schweppes’ Supplier Financial Analysis Guidelines Volvo’s Configurable Supplier Qualification Screens

Appraise opportunities to backward integrate, asas suppliers’ suppliers’ financial financial self-sufficiency self-sufficiency isis crippled. crippled. Corning’s Adjacency Evaluation Screens Research Support

Forthcoming

Executive Committee Agenda Items (Continued)

4. Ensure an “Activist” Response to Emerging Market Talent Opportunities You do not have the necessary talent in place to succeed five years from now; now is the time to aggressively close this gap Aggressive Talent Acquisition 1

Launch an aggressive performance management process to create “headroom” for emerging leaders and budget room for new hires. Research Support

Forthcoming

Target recruiting strategies for “not-inplay” talent. The best talent—even in the worst economic environments—is almost never out on the street. But slowing growth prospects can create rare moments of disengagement for emerging stars in prominent roles at other companies. Research Support

Wachovia’s Line Outreach Protocols

Pursue a strategy to win the hearts and minds of your own top performers. Although the labor market is softening for some employees, it is never softening for the best and the brightest. Research Support

Driving Performance and Retention Through Employee Engagement E ngage Employees for Higher Performance and Retention Philips’ HIPO Pipeline Stage Gates Standard Chartered’s Integrated Talent Portfolio Review

Executive Committee Agenda Items (Continued)

5. Balance Aggressive (but Small) M&A with Equally Aggressive Due Diligence The adage that great assets are on sale at times like these creates real opportunity to set up future growth, but the potential for significant downside surprises also increases The M&A Balancing Act 2

Reevaluate Reevaluate deal deal pipelines pipelines for for unique unique opportunities. opportunities. The likely “winners” from this series of of events will The likely “winners” from these series events have acquired trulytruly unique assetsassets and capabilities. will have acquired unique and capabilities. Research Support

Ensure Ensure aggressive aggressive due due diligence diligence around around financial financial issues and focus on key success drivers such issues and focus on key success drivers such asas talent, talent, IT, IT and R&D—especially if this downturn lasts lasts several several quarters. quarters.

Doing Deals in a Volatile Environment (CSB) Forthcoming Cendant’s Strategic Deal Index (CSB)

Research Sterling Financial’s Cultural Support Due-Diligence Toolkit (CSB)

Forthcoming

Executive Committee Agenda Items (Continued)

6. Overinvest in Ethical Management and Tone at the Top Difficult times often beget many more instances of less-than-perfect human behavior; counter this risk by closely managing ethical and leadership postures Closely Managed Ethical and Leadership Postures

Manage compliance programs and clarify leadership postures. Executive tone and messaging has the potential to save your company heartache, reputation damage, and outright economic loss. Research Support

Setting the Tone at the Top

Road Map for the Presentation

How did we get here?

How are the U.S. and European governments responding?

How are leading companies responding to the current crisis?

Upcoming Guidance and Events for Your Role

Upcoming Guidance and Events for Your Role Immediate Action Items

1. Visit our regularly updated “Responding to the Credit Market Crisis” Web site, http://www.executiveboard.com/Responding_to_the_Credit_Market_Crisis.html 2. Join your peers across next week for a function-specific teleconference on this issue. To register please visit, http://www.executiveboard.com/Responding_to_the_Credit_Market_Crisis.html • Implications of the Current Financial Crisis for Legal and Compliance; Monday, 6 October, Noon–1:00 p.m. (Eastern)

• Action Steps for Navigating through the Financial Crisis: A Forum for Finance and Strategy Executives; Monday, 6 October, Noon–1:00 p.m. (Eastern)

• What Every HR Executive Should Do (and Not Do) Because of the Financial Crisis; Tuesday, 7 October 9:00 a.m.–10:00 a.m. (Eastern) & 2:00 p.m.–3:00 p.m. (Eastern)

• Recruiting during the Financial Crisis: A Panel Discussion with Senior Leaders; Wednesday, 8 October 11:00 a.m.–Noon (Eastern)

• Learning and Development during the Financial Crisis: A Panel Discussion; Wednesday, 8 October 11:00 a.m.–Noon (Eastern)

• Responding to the Financial Crisis: An IT Leadership Perspective; Wednesday, 8 October 11:00 a.m.–Noon (Eastern)

Appendix 1. Additional Information About the U.S. Emergency Economic Stabilization Act of 2008 2. Recent Additions to the Draft Act 3. Glossary

1. Additional Information About the Draft U.S. Emergency Economic Stabilization Act of 2008 1. What TARP Encompasses • Section 101 of the Act empowers the Treasury Secretary to purchase Troubled Assets (any residential or commercial mortgage-related assets) held by financial institutions originated on or before 14 March 2008, or others as determined the Secretary after consultation with the Fed Chairman. • Instead of purchasing those assets, Section 102 allows the Treasury Secretary to issues guarantees for the interest and principal of Troubled Assets (not to exceed 100%) held by financial institutions in return for a premium paid by those institutions; the premiums must at a “level necessary to create reserves sufficient to meet anticipated claims, based on an actuarial analysis, and to ensure that taxpayers are fully protected”; the premiums are managed in the Troubled Assets Insurance Financing Fund. • The Treasury Secretary has authority immediately to tap up to $250 billion, which the President can increase to $350 billion; the Treasury Secretary can increase that authorization up to $750 billion upon sending a notice and plan to Congress, so long as Congress doesn’t disapprove of the plan through a joint resolution within 15 days of receiving the plan. • The Act encourages the Treasury Secretary to place special emphasis on supporting institutions that lend to lower-income borrows as well as small financial institutions that were well capitalized prior to the government placing Fannie Mae and Freddie Mac into conservatorship. • The Treasury Secretary has broad power to manage the purchased Troubled Assets, including sell them and create securities based on them. • Note also that there are a number of provisions throughout the act designed to assist financial institutions negatively affected when the government placed Fannie Mae and Freddie Mac into conservatorship (e.g., treatment of gains/losses of preferred stock in those institutions as ordinary income) and to prevent incidental penalties to companies like J.P. Morgan Chase who purchased financial institutions and assets as part of broader efforts to shore up the financial markets. 2. Efforts to Reduce Foreclosures • The Treasury Secretary must create a plan designed to reduce the number of foreclosures; to that end, the Secretary can change the terms of residential mortgages in purchased Troubled Assets. • Fannie Mae and Freddie Mac must issue plans designed to encourage lenders to participate in the HOPE program (the July 2008 law aimed at stemming the U.S. foreclosure rate), although it remains voluntary and its efficacy to date in shoring up the housing market is questionable. Source: Corporate Executive Board research. IRR1AL8UQ1 © 2008 Corporate Executive Board. All Rights Reserved.

1. Additional Information About the Draft U.S. Emergency Economic Stabilization Act of 2008 (Continued) 3. Protection of Taxpayers • The Act directs the Treasury Secretary to establish policies and otherwise act to prohibit participants in TARP from unjust enrichment, which means that the Secretary shouldn’t pay more for Troubled Assets than they cost the person from whom they are purchased; there are potentially important exceptions for current owners and conservators of Fannie Mae, Freddie Mac, Bear Stearns, Lehman Brothers, and Washington Mutual. • The Treasury Secretary takes a warrant in publicly traded companies for non-voting common stock or preferred stock in those companies who sell Troubled Assets under the program; non-publicly traded companies must provide senior debt instruments instead; the Treasury Secretary determines the terms and conditions and will include anti-dilution provisions; the Treasury Secretary can establish “de minimis” exceptions where the aggregate purchase from the institution is under $100 million. • Costs of purchased and guaranteed Troubled Assets will be determined in accordance with the Federal Credit Reform Act of 1990 (2 USC 661 et. seq.). 4. Oversight • The Act creates an Office of Financial Stability, headed by an Assistant Secretary of the Treasury. • The Treasury Secretary must consult with the Board of Governors of the Federal Reserve, the FDIC, the Comptroller of the Currency, the Director of the Office of Thrift Supervision, and the Secretary of Housing and Urban Development; note, though, that consultation typically doesn’t have a lot of teeth. • The Act also creates a Financial Stability Oversight Board consisting of the Fed Chairman, the Treasury Secretary, the Director of the Federal Home Finance Agency, the SEC Chairman, and the Secretary of Housing and Urban Development; the Chair of the Board is selected by its members, but it can’t be the Treasury Secretary; it meets monthly and has the power to create a Credit Review Committee to evaluate the Treasury Secretary’s exercise of purchase authority. • The Comptroller General has oversight of TARP, basically to evaluate the efficacy of the program and its implementation as well as to monitor controls; it can only report and recommend changes; the Comptroller General also is charged with creating a big “what happened, who is responsible, and what should we do about it” report by 1 June 2009. • The Act creates a Special Inspector General also to oversee TARP. • The Act also creates a Congressional Oversight Panel. Note: For the Congressional Budget Office’s initial view: http://cboblog.cbo.gov/p=173

Source: Corporate Executive Board research.

For a section by section breakdown of the Act: http://www.msnbc.msn.com/id/269332651/

2. Recent Additions to the Draft Act Raise in Limit on Federal Deposit Insurance 1. The Senate agreed to vote on the legislation along with the measure temporarily raising the limit on federal deposit insurance to $250,000 from $100,000. That increase was proposed by Republicans critical of the plan authorizing Treasury Secretary Henry Paulson to buy troubled debt from lenders, which was rejected by the House two days ago. Additional Tax Breaks 2. Also linked to the legislation is a two-year extension of tax breaks that will save individuals and corporations about $149 billion over the next decade, another move popular among House Republicans. Two-thirds of House Republicans and 40 percent of Democrats defeated the bailout plan on a 228-205 vote. President George W. Bush and Senate leaders vowed to revive the legislation.

Source: Bloomberg; Corporate Executive Board research.

3. Glossary Commercial Paper Commercial Paper is a form of short-term debt (less than 270 days) that some companies sell to investors. Commercial paper can be thought of as a (typically less expensive) alternative to borrowing from banks through a credit line. That said, most companies issuing commercial paper also have “back-up” lines of bank credit to ensure they can meet their commercial paper obligations when they come due. Companies typically require a high credit rating to issue commercial paper. Credit Default Swap A credit default swap (CDS) is a credit derivative contract between two counterparties, whereby the “buyer” or “fixed rate payer” pays periodic payments to the “seller” or “floating rate payer” in exchange for the right to a payoff if there is a default or “credit event” in respect of a third party or “reference entity.” LIBOR The London Interbank Offered Rate (or LIBOR) is a daily reference rate based on the interest rates at which banks offer to lend unsecured funds to other banks in the London wholesale money market (or interbank market). SIVs A structured investment vehicle (SIV) is a fund which borrows money by issuing short-term securities at low interest and then lends that money by buying long-term securities at higher interest, making a profit for investors from the difference. SIVs are a type of structured credit product; they are usually from $1 B to $30 B in size and invest in a range of asset-backed securities, as well as some financial corporate bonds. A SIV has an open-ended (or evergreen) structure; it plans to stay in business indefinitely by buying new assets as the old ones mature, and the SIV manager is allowed to exchange investments without providing investors transparency/the ability to look through to the structure. TED Spread The TED spread is the difference between the interest rates on inter-bank loans and short-term U.S. government debt (“T-bills”). The TED spread is an indicator of perceived credit risk in the general economy.

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