Sec. 382 after the bailout.

• Author: Friske, Karyn Bybee

EXECUTIVE SUMMARY

* In an effort to ameliorate the current economic crisis, the federal government has created a number of programs, such as the Troubled Asset Relief Program (TARP), in which the government provides cash infusions to ailing corporations in return for equity interests in or debt instruments of the corporations.

* Without rules exempting its application, Sec. 382, which limits the use of a corporation's existing net operating losses and net unrealized built-in losses against future income following an ownership change, would apply to many corporations receiving funds in these programs, thereby reducing their effectiveness.

* In order to prevent Sec. 382 from interfering with the various relief programs, Congress has passed legislation and the IRS has issued regulations and notices that provide exemptions from the application of Sec. 382 for qualifying corporations.

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The current economic crisis has spawned a massive government effort to stabilize the economy. The administration's initial efforts to rescue the economy from distress included a bailout of Fannie Mae and Freddie Mac under the Housing and Economic Recovery Act of 2008 (HERA) (1) and the Troubled Asset Relief Program (TARP) under the Emergency Economic Stabilization Act (EESA). (2)

Treasury issued several notices as part of the government's response to the crisis. The notices allow relief from Sec. 382 for loss corporations acquired under TARP. They also provide relief for obligations and other securities issued by Fannie Mae and Freddie Mac in the recent bailout. The American Recovery and Reinvestment Act of 2009 (ARRA) (3) contained further changes affecting these notices and provided rules for transactions after February 16, 2009. The exhibit on p. 378 shows a timeline of these events.

Treasury continues to develop and implement programs under TARP in an attempt to restore stability and liquidity to the U.S. financial system. Some of the programs established under EESA are the Capital Purchase Programs (CPPs) for public issuers, private issuers, and S corporations; the Targeted Investment Program (TARP TIP); and the Automotive Industry Financing Program (TARP Auto).

This article examines the effects of these recent notices and new Sec. 382(n).

Fannie Mae and Freddie Mac Bailout

The Federal National Mortgage Association (FNMA), commonly known as Fannie Mae, was established as a federal agency in 1938 during the Depression and in 1968 became a stockholder-owned corporation chartered by Congress as a government-sponsored enterprise (GSE). Fannie Mae operates in the secondary market, buying mortgages, pooling them, and selling them to investors as mortgage-backed securities. (4) Fannie Mae does not make home loans directly to consumers but rather functions as an intermediary in the U.S. secondary mortgage market. By purchasing and securitizing mortgages, Fannie Mae facilitates liquidity in the primary mortgage market by ensuring that funds are consistently available to the institutions that do lend money to homebuyers. (5) The Federal Home Loan Mortgage Corporation (FHLMC), another GSE commonly known as Freddie Mac, was created in 1970 to expand the secondary market for mortgages in the United States. (6)

HERA created the Federal Housing Finance Agency (FHFA) to regulate the secondary mortgage markets. On September 7, 2008, James Lockhart, director of the FHFA, announced that Fannie Mae and Freddie Mac were being placed into conservatorship of the FHFA. As of 2008, Fannie Mae and Freddie Mac owned or guaranteed about half of the $12 trillion mortgage market in the United States. (7) Conservatorship is a statutory process designed to stabilize troubled institutions with the objective of returning the entities to normal business operations. The FHFA will act as the conservator to operate the enterprises until they are stabilized.

In order to encourage market stability, ensure that each GSE maintains a positive net worth, and support GSE debt- and mortgage-backed security holders, Treasury entered into several agreements with the GSEs in conjunction with the conservatorship. The original agreements Treasury made with both GSEs specify that there will be an upfront issuance to Treasury of $1 billion of senior preferred stock with a 10% coupon from each GSE in exchange for future support and capital investments of up to $100 billion in each GSE. In addition, each GSE will immediately issue to Treasury warrants for the purchase of common stock representing an ownership stake of 79.9%, at an exercise price of one-thousandth of one U.S. cent per share and with a warrant duration of 20 years. Beginning in 2010, each GSE will pay a quarterly fee to Treasury. Other conditions of the agreements require that each GSE's retained mortgage and mortgage-backed securities portfolio shall not exceed $850 billion as of December 31, 2009, and shall decline by 10% per year until it reaches $250 billion. (8)

On February 18, 2009, Treasury announced amendments to its previous agreements with the GSEs. The amount of future support and capital investments will increase from $100 billion to $200 billion in each GSE. In addition, each GSE's retained mortgage and mortgage-backed securities portfolio shall not exceed $900 billion rather than the $850 billion original limit. (9)

Troubled Asset Relief Program

EESA gave Treasury broad powers to stabilize the financial system in the form of TARP. Treasury has implemented several programs under TARP to restore stability and liquidity to the U.S. financial system. In addition to the CPP, discussed below, Treasury has used TARP to stem failures in the automotive industry and has initiated the TARP TIP in which investments are made on a case-by-case basis to stabilize financial institutions.

Capital Purchase Program

The goal of the CPP is to unfreeze the credit markets and allow banks to lend and also attract additional private capital. The original plan was to purchase illiquid assets from troubled banks. However, with the worsening of the economy, the plan changed to the purchase of preferred stock from regulated banks and thrifts. (10) Treasury's announcement on October 14, 2008, included the details.

Under the program, Treasury will inject up to $250 billion in equity capital to banks in the form of senior preferred stock. The program will be available to qualifying U.S.-controlled banks, savings associations, and certain bank and savings and loan holding companies engaged only in financial activities that elected to participate before 5 p.m. (EDT) on November 14, 2008. The minimum subscription amount available to a participating institution is 1% of risk-weighted assets. The maximum subscription amount is the lesser of $25 billion or 3% of risk-weighted assets.

In conjunction with the purchase of senior preferred shares, Treasury will receive warrants to purchase common stock with an aggregate market price equal to 15% of the senior preferred investment. Treasury will fund the senior preferred shares purchased under the program by year end 2008. In addition...