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Banking

US banking: Private equity smells too strong for FDIC

Twenty US banks have failed this year and 720 more are on the troubled bank list. Private equity buyers have been snubbed but there not enough strategic buyers for the FDIC to be so fussy. Helen Avery reports.

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.

Wilbur Ross

"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."

It is a difficult position for the FDIC. On the one hand, they are required to sell to the highest bidder in order to keep taxpayer losses to a minimum; on the other, they face criticism for selling to a non-bank entity.

Ross says the current conditions deter large private equity firms, and therefore prevent the FDIC raising as much money as possible in failed bank sales. A commercial bank that wants to bid for a failed bank requires capital to be 5% of assets; for private equity investors it is 10%. "That means if I am bidding in competition with a bank, I will get half the rate of return that he will, as I have 5% more that is not earning returns," says Ross. "That’s a big disadvantage." He says that had these rules been in effect at the time of the Bank United failure, the group of private equity investors would have bid much less than they did to compensate for the extra 5% of capital that would have to be held. In all likelihood, the second bidder, TD Bank, would have won the bid, and the FDIC would have received less money. Ross also points out that the regulations require a private individual to put up only 8% of capital to start a bank from scratch.

The scorpion and the frog

A New York-based investor looking to buy banks says that the FDIC’s reluctance to encourage private equity buyers is not simply political. "Fears of public backlash about profits ending up on Wall Street have some impact," he says. "But there is also a valid concern that private equity players would take their profits and run. Then the FDIC would land up with another failed bank in a few years." He says it is the classic story of the scorpion and the frog: the frog agrees to carry a scorpion across a river only to have the scorpion sting him and they both drown. "It’s hard to fight natural instincts," claims the investor. "Private equity firms promise they will not simply flip the banks they buy to make a buck, but that they will look after the banks to prevent them ending up back in the FDIC’s failed bank list in two or three years’ time and writing themselves out of any future possibilities. But the nature of the private equity firm is to make money. In the end, the concern for the FDIC is whether they will really be able to stop themselves."

Ross retorts by pointing to examples outside the US. He cites the success of private equity players in turning around banks in Japan and Korea. Ross’s firm bought Kofuku Bank, a regional bank in Osaka that failed in May 1999. "We renamed Kofuku as Kansai Sawayaka Bank and installed a new management that brought the return on equity up to 17%. After a few years, we merged KSB into the Kansai affiliate of Sumitomo Mitsui Bank for twice our cost."

To prevent flips, the FDIC has enforced resale limitations on larger investors. In banking, if a buyer trips the 25% mark, it must become a bank holding company and adhere to those regulations, so private equity firms would avoid hitting that level in any case, but stakes would ideally be between 10% and 25%. Ross says the rules are logically inconsistent. "The FDIC is prohibiting private equity firms from having control and yet restricting their ability to resell their share at the same time. Why should it matter if a non-controlling shareholder sells out?" He says ownership is unimportant. The management is the key. "The point is that if private equity sold out, the management would likely remain and the capital would not change just because the name on the stock certificate did."

The shelf charter

The new rules are having consequences. While traditional private equity players are wondering if it is worth the effort to buy US banks, other investors are getting on board in the form of shelf charters. Shelf charters are similar to blank-cheque companies in that an individual or group (normally former bank management teams) can apply for a new bank charter (essentially a shell bank). Once approved as a holding company, the firm is ready to acquire banks within a certain time frame. Bond Street Holdings is an example. Approved for a shelf charter in October 2009, the firm has already bought two US failed banks this year. The group consists of several types of investors, each of which have a controlling stake of less than 10%.

One investor says: "What the FDIC has done by allowing shelf charters and not the straightforward private equity deals is to say: ‘We want the capital of private money, but we want something that does not look or smell like private equity’." Sources report more than 10 bank management groups backed by private investors in New York alone that are looking to buy banks through the shelf-charter route.

A spokesman for the FDIC says there have been several shelf-charter deals, and that in many sales of failed US banks there have been bids from shelf-chartered investors that ultimately have lost the bid to banks. He describes them as private equity deals and says that the shelf charters prove that the FDIC is still open to private equity.

That’s not really accurate. End investors tend not to be private equity firms. As one source involved in advising on shelf-charter deals says: "The FDIC is confusing private capital with private equity. Private equity investors have not been end investors in the shelf charters our firm has put together. Less than 10% ownership with no board seats? It’s just not a private equity play. We have hedge funds, mutual funds and institutional type investors as owners."

Ross also points to the distinction between private equity and shelf charters. He says the dynamics are entirely different and warns that shelf charters do not necessarily mean a better future for the bank that is acquired than it would have with a traditional private equity deal.

"There is a time pressure to find a suitable target once the shelf charter is set up," he says. "It is dangerous to have that pressure to spend money quickly." He also points out that many of those involved in shelf charters are former bank senior executives who want to get back in the game. The management teams then get private investors to back them and apply for shelf charters. "At least private equity firms are not looking for a job for themselves," he says. "There is a different set of dynamics and I am concerned about the outcome of these blank-cheque companies."

Despite the relatively warm reception for shelf charters, they have been few and far between. According to one source, Bond Street has $400 million available but as yet has spent just $75 million. One adviser to bank buyers says: "The FDIC just prefers banks as acquirers, so shelf charters are taking time to really be accepted. That said, it’s a step closer to accepting private equity back in."

Joshua Laterman, special counsel for global private wealth managers Nuverse Advisors, which is considering multiple bank investment opportunities, believes it will take time. "Perhaps once the agencies achieve greater synchronicity of policy and acceptable investment standards, private equity might become more of a patriotic option and save taxpayer dollars."

Ross is confident that the FDIC and the Fed will warm to the idea of private equity investors. "As the bank failures increase and hundreds of billions of assets are under threat, and as the regulators come to understand better how to deal with private equity, there will come a point at which a comfort level will kick in."

On an optimistic note, some observers argue that perhaps the fact that the FDIC is keeping traditional private equity players at bay indicates that they are not forecasting any more large failures like IndyMac or Bank United. Let’s hope the FDIC is right. "If there was another large failure, the rules would change again," says an adviser on bank deals. "The problem is that the private equity players who would step in have now moved on. They are fed up with the confused message coming out from Washington."

Hang-ups

Ross for one has moved on. While the US remains so opposed to the sort of deals he is involved in, he is looking abroad. "The message from the US is too inconsistent," he says. "The UK government, so long as the buyers are responsible, does not seem to have such hang-ups about private equity ownership of banks. We are quite interested in RBS and Northern Rock. One way or another we will back a UK group or organize a group to try to participate in those events."

If other US private equity investors follow suit and turn their backs on the US, Bair might find herself in a tight squeeze. In late February, the FDIC announced that there were 720 banks on its troubled banks list – up from 600. Although the FDIC is right to quash accusations of sweetheart deals, it needs to stand firm against a US public backlash and put politics aside. Bank buyers are needed. Joseph Vitale, partner at law firm Schulte, Roth and Zabel, says that the magnitude of the problem is likely to force the FDIC to become more amenable to private equity. "There are not enough strategic buyers out there to take those on the 720 banks on the troubled bank list," he says. "Private capital will be needed."

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