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7.1 Prohibition Against Federal Government Bailouts of Swaps Entities (the "Swap Push-out Rule")

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7.1 Prohibition Against Federal Government Bailouts of Swaps Entities (the "Swap Push-out Rule")

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            7.1.       Prohibition Against Federal Government Bailouts of Swaps Entities (the "Swap Push-out Rule").  The initial version of the Swap Push-out Rule, as proposed by Senator Blanche Lincoln (D-AR), generally prohibited banks active in the swaps markets from receiving various forms of "Federal assistance," including Federal deposit insurance and access to the Fed discount window or any Fed credit facility.  After considerable debate the scope of the compromised version of the Swap Push-out Rule has been significantly narrowed.  The final legislative text of the Swap Push-out Rule prohibits providing "Federal assistance" only to depository institutions that constitute "swaps entities" and also contains several important exemptions for qualifying insured depository institutions.[§716]

                        7.1.1.  What Depository Institutions are Affected by the Swap Push-out Rule?  Under the rule, Federal assistance may not be provided to any "swaps entity with respect to any swap, security-based swap, or other activity of the swaps entity."  Federal assistance is defined as the use of any advances from any Federal Reserve credit facility or discount window (that is not part of a facility with broad-based eligibility under Section 13 of the Federal Reserve Act), or FDIC insurance or guarantees for the purpose of (i) making any loan to, or purchasing any stock, equity interest, or debt obligation of, any swaps entity; (ii) purchasing the assets of any swaps entity; (iii) guaranteeing any loan or debt issuance of any swaps entity; or (iv) entering into any assistance arrangement, loss sharing, or profit sharing with the swap entity.         

            A "swaps entity" is any swap dealer or major swap participant that is registered with the CFTC or SEC, but does not include any major swap participant that is also an insured depository institution.

            A "swap dealer" is a newly created category under the Act defined as an entity that (i) holds itself out as a dealer in swaps; (ii) makes a market in swaps; (iii) regularly enters into swaps with counterparties as an ordinary course of business for its own account; or (iv) engages in any activity causing the person to be commonly known in the trade as a dealer or market maker in swaps.  The swap dealer definition contains a proviso, however, that states that in no event shall an insured depository institution be considered to be a swap dealer to the extent it offers to enter into a swap with a customer in connection with originating a loan with that customer.  Taken as a whole, the swap dealer definition would appear to permit a depository institution that operates a traditional lending business, together with limited and related swap activities, to continue these functions without being affected by the Swap Push-out Rules.

            A "major swap participant" is another newly created category under the Act defined as a person: (i)  who maintains a "substantial position" in swap transactions, excluding positions held for hedging or mitigating the participant's commercial risk (commonly referred to as "commercial end users") and positions held by employee benefit plans; (ii) whose outstanding swaps create "substantial counterparty" exposure that could have serious adverse effects on the financial stability of the United States banking system or financial markets; or (iii) who is a financial entity that (A) is "highly leveraged relative to the amount of capital it holds, and that is not subject to capital requirements established by an appropriate Federal banking agency" and (B) maintains a substantial position in outstanding swaps transactions.

            As noted above, the term "swaps entity" does not include any major swap participant that is an insured depository institution.  Accordingly, an FDIC-insured depository institution would only be a "swaps entity" if it were a swap dealer.

However, the reach of section 716 could also impact insured depository institutions by preventing them from using depository institution funds to do any of the enumerated activities that qualify as "Federal assistance", such as purchasing a debt obligation of a "swaps entity," or guaranteeing a loan or debt issuance of a "swaps entity."

                        7.1.2.    What other Exemptions are Available from the Swap Push-out Rule?  An FDIC-insured depository institution will not be subject to the prohibition on Federal assistance if its swap activities are limited to (i) hedging and other similar risk mitigating activities directly related to the insured depository institution's activities; (ii) acting as a swaps entity for swaps involving rates or reference assets permissible for investment by a national bank under 12 U.S.C. 24; and (iii) acting as a swaps entity for credit default swaps that are cleared by a derivatives clearing organization or a clearing agency.

            In addition, the term "swaps entity" does not include any insured depository institution under the FDI Act or a covered financial company under Title II which is in conservatorship, receivership or a bridge bank operated by the FDIC.

                        7.1.3.    Can a Depository Institution Permissibly Establish an Affiliate to Operate as a Swaps Entity?  Yes, Title VII's prohibition on Federal assistance does not apply to, and does not prevent an FDIC-insured depository institution from establishing and maintaining, an affiliate that is a swaps entity, provided that the following conditions are satisfied:  (1) the depository institution is part of a BHC or SLHC that is supervised by the Fed, and (2) the affiliated swaps entity complies with Sections 23A and 23B of the Federal Reserve Act and any other requirements that the CFTC, SEC and the Fed may determine necessary.

                        7.1.4.    Prohibition on Use of Taxpayer Funds to Prevent Receivership of Swaps Entities.  The Act prohibits the use of taxpayer funds for preventing (i) the receivership of any insured depository institution swaps entity; (ii) the receivership of any Significant Nonbank swaps entity; or (iii) the orderly liquidation of non-FDIC insured, non-systemically significant institutions.  However, if a swaps entity constituting (a) an insured depository institution or (b) a Significant Nonbank is placed in receivership, its swap activity will be subject to termination or transfer in accordance with applicable law.  All funds used in the termination or transfer or swap activity of any swaps entity are to be recovered through the disposition of assets or through assessments, including assessments on "the financial sector."

            7.1.5.    What Additional Rulemaking is Required Under the Swap Push-out Rule?  The prudential regulators are charged with prescribing rules and setting standards to permit swaps entities to conduct their swap activities in a safe and sound manner and to mitigate systemic risk.  Banks and BHCs may not become swaps entities unless they conduct their business in compliance with such rules and minimum standards.

In prescribing these rules, the prudential regulators are required to consider: (i) the expertise and managerial strength of the swaps entity, including systems for effective oversight; (ii) the financial strength of the swaps entity; and (iii) systems for identifying, measuring and controlling risks arising from the swaps entity's operations, the swaps entity's participation in existing markets and participation and entry into new markets and products.

            7.1.6.    When Does the Swap Push-out Rule Go Into Effect?  Generally, two years after the effective date of these provisions of Title VII, which is 360 days after the date of enactment of the Act.  In addition, if an insured depository institution qualifies as a "swaps entity" and therefore is ineligible for Federal assistance, the applicable Federal bank regulator with jurisdiction over the institution will give the institution up to a 24-month transition period to divest the swaps entity or cease the activities that require registration as a swaps entity, plus the possibility of a one-year extension.  In establishing the appropriate transition period for any such divestiture or cessation of derivatives-related activities, the applicable Federal bank regulatory agency will take into account the potential impact on the bank's (i) mortgage lending, (ii) small business lending, (ii) job creation and (iv) capital formation versus the potential negative impact on insured depositors and the FDIC's Deposit Insurance Fund.

                        7.1.7.    How Does the Swap Push-out Rule Address Existing Swaps a Bank Entered Into Before Enactment of the Act?  Insured depository institutions that have entered into swaps before the expiration of the transition period in which the institution must divest itself of the swaps entity (two years, plus a possible additional one year), do not have to unwind the existing swaps to continue to receive Federal assistance.  Swaps entered into before the expiration of the bank's transition period are not affected by the prohibitions in Section 716.