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While the TARP CPP program has returned a financial profit, as the Treasury has recovered 103% of its investment in the form of dividends, repayments and gains on sale of warrants, about 350 banks remain in the TARP CPP program.  In this election year, it appears increasingly likely to us that Treasury is seeking means to eliminate the government’s continuing investment (and resulting entanglement) in financial institutions.

According to multiple sources, Treasury is looking to exit from the TARP CPP program in the “near-term” or by mid-year 2012.  As we’ve previously noted, Treasury has hired Houlihan Lokey to advise it on exit strategies, paying Houlihan Lokey $375,000 a month for advice.  We understand that Houlihan Lokey has now talked with about a third of the remaining banks, and is expected to talk to the remainder over the next several weeks.  These discussions have generally been cordial, and equal parts information sharing and information gathering.

We expect Houlihan Lokey to present Treasury with multiple options, including: individual auctions, pool sales, and potential restructurings.

Under the terms of the preferred stock investments, Treasury can’t require repayment, and institutions will still need regulatory approval to make a payment.  We’ve separately heard that the FDIC has inquired about repayment of TARP in reviewing a bank’s strategic plan, suggesting that the bank regulators may “force” repayment in connection with approving changes to business plans, etc.  Treasury has initiated off-site examination of TARP compliance programs of the remaining TARP participants, but we understand that this function is at least nominally separate from Treasury’s investment decision and not intended to motivate banks to repay the TARP funds.

If the TARP CPP investments are sold by Treasury, the general terms of the security will remain the same; the instruments will still generally have a 5% dividend rate (increasing five years after the initial investment) and will still be callable by the institution (subject to regulatory non-objection).  However, the purchaser would stand in the shoes of the Treasury in having the right to select two directors after six missed dividend payments (and Treasury would lose the right and any TARP directors would automatically cease to be directors upon action by the new owner).

Certain provisions applicable to TARP CPP recipients contained in the Securities Purchase Agreement are only effective while Treasury retains its investment.  Specifically, the limitations on increasing dividends on common stock or repurchasing common stock would be eliminated if the Treasury no longer owns the investment.

Under existing Treasury guidance, the executive compensation restrictions would also be lifted.  This is consistent with the terms of the Securities Purchase Agreement, but the under the American Recovery and Reinvestment Act of 2009, the TARP executive compensation restrictions are required by law to remain in place so long as the TARP investments “remain outstanding.” Treasury is taking the position that for purposes of the definition of “TARP period” in §30.1 (Q-1), an obligation is treated as no longer outstanding upon Treasury’s transferring the obligation to a third party that is not a federal government entity (nor an entity organized by Treasury or another federal government entity to hold interests formerly held by Treasury).

To facilitate banks’ ability and interest in repurchasing TARP CPP investments, we understand that Treasury has approved a reduction in the minimum amount that a bank may repurchase from Treasury (with regulatory approval).  Previously, Treasury would only approve redemptions of at least 25% of the institution’s TARP preferred stock, but under the reduction, Treasury will accept repurchases of amounts equal to the greater of 5% of the institution’s TARP investment or $100,000.  (See the updated FAQ from the Treasury Department, question number 4.)

We understand Treasury has no current plans to extend the 5% rate beyond its original five year term, and no plans to offer another program like SBLF to provide a means to refinance the investment.  (A new program like SBLF would further require legislative action to provide additional funding, and there appears to be no appetite in Congress for such legislation.  The Treasury has also consistently indicated that it will not accept a repurchase offer at less than 100% of par value.

However, we believe the Treasury remains open to potential restructurings whereby new investors are only willing to invest if Treasury takes a discount. In analyzing such options, we believe the Treasury considers a number of factors, including: the condition of the bank, the risk of receivership, whether the new investment will be sufficient to bring the bank back to health, and whether all parties (Treasury, existing investors and the new investors) are being treated equitably. As a general matter, proposed terms for a restructuring need to be proposed to Treasury, as Treasury is reluctant to suggest structures or engage in hypotheticals.

If Treasury sells in individual auctions (which I would expect it to do only for the largest investments), the bank (and the bank’s other investors) will likely be allowed to participate in the auction (or given an opportunity to match the winning bidder).   If Treasury sells in pools, it is more difficult to see how Treasury could offer bank’s an opportunity to match for their own portion of the pool.  In choosing between individual auctions and pools, we would expect Treasury to consider a number of factors, including: size of the bank and the Treasury’s investment, geography, market conditions, and credit quality. I would envision only the largest remaining TARP investments being sold in individual auctions, but could see a variety of means for the Treasury to select participants in various pools.  For example, I could envision pools consisting of only performing investments, only investments in dividend deferral, pools of certain states, or different regions and sizes.

Based on the time frames involved, we understand that Treasury and Houlihan Lokey are recommending that any bank looking at trying to negotiate a restructuring with Treasury should be in contact with Treasury ASAP.