There remains an issue about what to do with troubled banks, and the regulations over who can own banks and at what percentages only add more questions rather than answers.  FDIC Chairman Sheila Bair and other regulators are still trying to craft a formal policy on how to deal with private equity and the ownership of banks.  Depending upon what is ultimately decided, it might even allow the “brokers gone bankers” of Goldman Sachs Group Inc. (NYSE: GS) and Morgan Stanley (NYSE: MS) to  become bank owners rather than just being classified as bank holding companies but not being bankers because that was convenient during the financial meltdown.  It will also allow private equity firms such as The Blackstone Group LP (NYSE: BX), Carlyle, and others to get more proactive in deciding which troubled banks they are interested in even before it is known that these troubled banks are formally up for grabs.

BankUnited (NASDAQ: BKUNA) was the runner-up in the race for the most expensive seizure in recent years, and it was a private equity consortium including Wilbur Ross, Carlyle, and others which won the bid for the remaining assets in the bank.  IndyMac was also taken over by J.C. Flowers. What is interesting is that regulation over control and ownership allowances by private equity firms remain cloudy when you consider the hundreds of troubled banks, the jurisdictions and regions in which they operate, and which agencies are in charge of them.  A recent report from the FDIC noted that more than 300 banks could still fail in the near-term and the FDIC has a board meeting today on certain regulations that prevent banks from past practices in aiding to their own destruction at the expense of the FDIC.

From all the data we have seen, there are many overlaps and contradictions among guidelines from the FDIC, the Federal Reserve, and the Office of Thrift Supervision.  This makes a nightmare scenario for doing research and due diligence for private equity and local investor groups which might be interested in acquiring troubled local banks.  Throw in the Comptroller of Currency guidelines and local laws and local taxation districts, and suddenly you need a team of lawyers specializing in the laws of each body to determine what rules and regulations exist for private equity ownership and private equity investment into troubled banks.  Consolidation of regulatory bodies may help, but how long does it take to consolidate and then integrate branches and agencies under the Federal Government?  And what about each state and local government?

It seems that Sheila Bair has a goal of getting some unified rules that could become generic throughout each agency, but banks differ wildly on a case by case basis when you consider the national footprint of some versus a single-state chartered bank and then simple community banks.  Does this mean that the goal can be reached?

Private equity firms and buyout groups from vulture funds to local wealthy investor groups have a unique ability to remedy some of the banking troubles that exist today.  Not all, but some.  Troubled local banks can be taken over by local businessmen that are well respected and are well entrenched.  But they might not invest only passively or for a smaller stake where there is no control.  If they want that sort of investment, they could just invest in regional bank funds.

Additional changes and exceptions to the current 25% ownership cap that is currently allowed is a start.  Kicking out management or jettisoning bad assets may be too difficult if each decision has to be run by committees.  Private equity investors have enjoyed being able to act quickly, decisively, and without endless meetings and lines of red tape.  It seems a stretch that the 25% hurdle will be changed any time soon as it would require changes to law.  But certain “exemptions” and “exceptions” could be granted.  This will run up against the rules of “precedent” for case law, so don’t expect a sweeping change here.

Investors and acquirers have little incentive to buy these troubled banks before they go into receivership.  After the FDIC takes control, there becomes a loss-sharing model that in a sense subsidizes losses for the new investors.  And the FDIC, the Fed, the Treasury and others are probably not going to protect existing investors if the notion of systematic risk is not present.

Unless there are some new private equity exceptions, then this list of 300+ troubled banks is likely to see many more failures and FDIC-seizures followed by acquisitions by private equity groups and investor consortiums.  Wilbur Ross and other private equity players would probably like to be sole-owners of some of these banks.  That does not seem possible under the existing rules.  Changing those very rules could also bring about additional risks down the road.

Those big investment banking firms also have private equity arms of their own, and they may finally get in on the action despite being poor acquirers so far.  They might not.  For now, we think private equity groups will continue banding together to make banking acquisitions.

Jon C. Ogg
May 29, 2009

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