IN FEBRUARY A video put out by an eight-man viral marketing firm for mortgage loan officers ThingBigWorkSmall caused such an uproar that the US’s Federal Deposit Insurance Corporation had to issue a rebuttal. In the four-minute video, which ended up on YouTube, TBWS employees Frank Garay and Brian Stevens laid out reasons why the sale of failed bank IndyMac to private equity firms can be considered a "sweetheart deal".
The low-budget video speculatives about how the private equity deal is making money for its new owner, OneWest Bank, and attempts to associate hedge fund manager and IndyMac co-investor John Paulson with Treasury secretary Hank Paulson to bolster its assertions that Goldman Sachs was behind the whole thing, but it is nonetheless just what FDIC chief Sheila Bair does not need.
US bank failures are on the rise. This year, 20 US banks had failed by February 20. And the FDIC has forecast that 2010 will have the most bank failures since the financial crisis began. Last year was bad enough: 140 US banks fell. Sub-prime loans are no longer an issue. Commercial real estate is the ticking time bomb. On average, US banks with less than $10 billion in deposits have 37% of their entire assets in commercial real estate, while equity is between only 5% and 8% of assets. Commercial real estate values are already down 40%.
"A small decline in the value of real estate loans would wipe out equity," says investor Wilbur Ross. "Most of the smaller banks on a mark-to-market basis are insolvent right now." Ross estimates that a further 500 banks will fail before the cycle draws to a close.
The high bank failure rate is costing the FDIC heavily. The FDIC insurance fund, which had $45 billion in its coffers in 2007 to protect consumer bank deposits when banks fail, went negative in the third quarter of 2009. Based on future estimates of bank failures, Bair is predicting that the fund will be in the red through 2012.
Turning to the Federal Reserve for a hand-out will not be a popular political move. Rather, what Bair needs are buyers for failed banks. She has them. Beyond the medium-sized US banks and foreign bank buyers that will help alleviate some of the FDIC’s woes, there lie in wait tens of private equity firms and private investors, with, sources say, billions of dollars ready to buy failed banks. They include investors such as Wilbur Ross, who see the investment opportunity posed by failed banks and who are willing to outbid bank acquirers to snare such opportunities. The problem is that Joe Public does not really want to see Wall Street make large profits out of US bank failures – a sentiment that drove the rapid circulation of ThinkBigWorkSmall’s video to over 1 million hits on its own website alone.
The topic is highly sensitive. Nearly all the buyers contacted refused to comment, and advisers insisted on anonymity. "No one wants to be seen talking about bank acquisitions," said one. "It’s politically too sensitive, and anyone seen talking about it fears they will be struck off the acquirer list, and there is too much investment opportunity to risk that."
In a move some observers claim is driven by political pressure, the FDIC has already adapted its rules governing bank acquisitions to alienate some private equity players, Ross included. But can Bair afford to turn down buyers?
Emergency money
To date, only two sales of US banks since 2008 have been traditional private equity deals. IndyMac, the US’s fourth-largest bank, collapsed in July 2008 and was bought by Goldman Sachs alumni-owned Dune Capital Management, JC Flowers, John Paulson, George Soros and Michael Dell. The deal completed in March 2009.
The second was Bank United, which was bought by John Kanas’s group of Wilbur Ross, Blackstone, Carlyle and Centerbridge Capital Partners in May.
The two deals were expected to be the first in a long line of private equity bank acquisitions, and private equity groups lined up their lawyers in preparation for the onslaught. In August, however, the FDIC seemed to do a U-turn. New rules for acquisitions of failed banks effectively put traditional private equity players out of the picture. Capital requirements increased for non-bank holding companies. Ownership above 9.9% results in resale limitations, and private equity firms must retain their shares for at least three years.
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"Those who should be embarrassed are the banks that did not bid high enough and missed out on the profits"
Wilbur Ross |
Just why the rules were altered is a moot point. Sources say that the deals were simply "emergencies", so there were no rules at that time. "The deals were necessities and they were new territory for the FDIC," says a former FDIC employee. "When the dust settled, however, rules had to be put in place. Added to that you couldn’t have Wall Street firms being allowed to hoover up failed US banks at a profit. If the trend continued it could have become politically unpopular."
So just how profitable were these deals? The exact returns are unknown; indeed it’s too soon to say for sure but one source familiar with the buyers says the IndyMac deal "made the buyers stinking rich". The group paid $13.9 billion for $6.4 billion in deposits and $23.5 billion in assets. The investor group also negotiated a generous loss-sharing agreement whereby they absorb the first 20% of IndyMac’s losses, with the FDIC taking the remaining hit. Co-investor Chris Flowers conceded in an interview with the New York Times: "The government has all the downside and we have all the upside." The consortium of private equity investors that bought Bank United paid $900 million for $12.7 billion in assets and $8.3 billion in brokered deposits. The FDIC agreed to share in the losses on approximately $10.7 billion of assets. An analyst says buyers get two to three times their money back over time and returns that would be around 25% for a normal deal, and these deals probably offer more. "When you do an FDIC deal you are buying a bank at 1x book value. Historically banks trade at 2x or 3x book value. And you are getting an insurance policy on the future loss of assets. You are essentially buying the cleanest bank in the US."
As generous as these deals might appear to be, it is important to remember that there were other bidders that could have won. They were banks that would have reaped the same profits as the successful private equity players. In the case of Bank United, TD Bank also bid, but was topped by Kanas’s consortium. Ross says: "Perhaps the regulators fear they will be blamed for having made too good of a deal, but they put out an auction. They took the highest bid. There is nothing to be ashamed about for that. Those who should be embarrassed are the banks that did not bid high enough and missed out on the profits."
