We’ve mentioned from time to time the Fed’s fantasy that banks could recapitalize in short order. John Dizard of the Financial Times has been the most blunt in describing the disconnect between the central bank’s wishes and reality:
It is not fair to say the Fed does not have a plan. It does. The plan is for the banking system to recapitalise for a new on-balance sheet world by raising a minimum of $200bn in a short period of time, not longer than two quarters. That way, there is no credit crunch, according to the model. A credit crunch, in Fed chairman Ben Bernanke’s own language, is: “A significant leftward shift in the supply curve for bank loans, holding constant both the safe real interest rate and the quality of potential borrowers.” (The Credit Crunch , Brookings Institution, 1991) That means you can have a decline in the demand for credit as part of a business cycle without a “crunch”.
Let us put the Fed’s plan in the context of the world of the capital markets. Consider Washington Mutual’s $7bn recapitalisation of last week. We would have to have a Washington Mutual recap a week for the next six months to get the Fed’s plan done. All the uncommitted capital available to the private equity funds could be dedicated to this purpose.
All of it? I do not think so. The private equity people have other ideas. To raise anything like the bank capital the Fed and the other authorities such as the Treasury want, it would be necessary to have a series of road shows for the investing public that would be the size of theme parks. That could be done with difficulty and with great dilution for shareholders and, more seriously, career damage for senior management.
While the fact that Qatar stumped up for the recent Barclay’s fundraising was a relief, it was the exception that proves the rule that sovereign wealth funds have become decidedly cool on financial firm investments, having been badly burned in their first round of fundraising.
The Fed seems to be coming to the realization that it needs a Plan B, but (from what we see in public), its ideas still appear to be in the realm of wishful thinking. The central bank is considering relaxing rules on bank ownership so as to facilitate private equity investment. That sounds well and good, but the reason that most PR firms steer clear isn’t simply the investment rules, but the fact that they are also wary of investing in regulated entities, since those pesky rules can change unfavorably at short notice.
From the Wall Street Journal:
In a move that could facilitate the flow of capital to cash-strapped banks, the Federal Reserve is considering steps to make it easier for private-equity firms and others to invest in banks, according to regulators and other people familiar with the matter…
Until now, tough federal rules have often served as an obstacle that prevented private-equity firms from pumping much cash into struggling lenders. The Fed and other banking regulators are wary of unregulated entities exerting control over banks. The result is that, with a small handful of recent exceptions, buyout firms have steered clear of bank investments…..
Fed officials recently have met with big buyout firms – including J.C. Flowers & Co., Carlyle Group, Kohlberg Kravis Roberts & Co. and Warburg Pincus – and banking lawyers to discuss the obstacles, according to people familiar with the matter. Among other things, the Fed has been trying to determine if private-equity firms are seeking more board representation than is currently permitted in bank deals, one person said.
The Fed isn’t expected to take a completely hands-off approach that some private equity firms might prefer. Still, even tangential changes could be significant, potentially opening the door to an influx of private-equity capital, industry experts say.
Under federal law, to own more than 24.9% of a bank, an entity must register as a bank holding company, which is subject to heavy regulation and can be forced to serve as a “source of strength” for the bank. Ownership of more than 9.9% of a bank also subjects the entity to regulatory scrutiny to ensure that it isn’t controlling – or even influencing – the bank’s operations.
The Fed can’t change those laws, but it has wiggle room in how it interprets them.
Even if the some PE firms do have signs of interest (the Warburg Pincus investment in MBIA illustrates that optimism can outweigh common sense), those players have aggressive return on equity targets. Yet this is a time when, due to a drive for more regulation and stronger equity bases at financial firms, that ROEs going forward are certain to be lower than their pre-bust levels. Yes, an investor can get in cheap and benefit from buying at the bottom of a cycle, but the broader point is that industry trends are moving against equity investors in banks. You have to have a good deal of confidence and skill to sail into such strong headwinds.
5 comments
Comments are closed.
I could see people with cash interested in forming new banks with zero exposure to SIVs, CDSs, and so on, to compete with the current banks and cherry pick their best businesses. But capitalizing them seems pretty darned risky.
Yves,
I’m not so sure that private equity wouldn’t be interested. Indeed, many private equity firms like regulated entities (e.g. telecom), or entities that are very dependent on government contracts (e.g. military contractors), because many private equity firms specialize in having the lobbying power to tilt the government in its favor.
Indeed, the dirty little secret of the success of some of these firms has little to do with superior business management and more to do with superior government lobbying to change the rules of the game. For example, the Carlyle Group counts as its advisers (both former and current) G.W.H. Bush, G.W. Bush, James Baker, Arthur Levitt, John Major, and numerous other highly placed former political figures.
Such people weren’t hired for their business acumen. But they serve the firm well when it comes to lobbying for changes in rules or awarding of contracts to the businesses they own.
Indeed, the fact that the Fed is basically begging them to step up and buy our banks means they will have extraordinary bargaining power, even before brandishing their political firepower. That bargaining power ensures that there will be favorable changes in the regulatory environment that will allow them to meet their ROI objectives, even at the cost of the fundamental health of the banks or the American financial system in general.
This rule change may have more to do with buying failed institutions from FDIC than with recapitalizing failing banks. The number of banks able to absorb the assets and deposits of a $10-$50B failed regional bank is rather small. But PE shops would love to pick up these institutions once FDIC has taken the bad assets.
Lune,
I still have to differ somewhat, although I probably should have been more precise. KKR did look at Bear, but most forget that Kohlberg, Kravis and Roberts all came out of Bear.
Military contractors are money coining machines. It’s brutally difficult and costly to win contracts, but once you have them, the contracts have very long lives and are generally hugely profitable. They have a product monopoly granted by the government.
The PE interest in telecom (the regulated part, not equipment suppliers) is recent and due to looser regulations.
Banking in many ways is now the worst of both worlds: regulated but with very few areas that are de facto oligopolies. Credit cards have via consolidation become an oligopoly, but look at the mess they made of that. When the business was more fragmented (by issuer) back in the 1980s, everyone charged annual fees, so there was no incentive to find (create) the chronically indebted customer. But they started offering no-fee cards and moving the profit model towards greater dependence on credit.
I don’t see the direction of re-regulation doing much to reduce the competitiveness within product lines (ie, no one seems to be contemplating restoring Glass Steagall). So we’ll have a competitive industry subject to tougher capital requirements and possibly more regulatory scrutiny of complex products. I don’t see that as a great profit formula.
Yes, you can buy low and sell high, but that means you have to be pretty confident we’ve hit bottom and the profit improvement will be on a timetable that works for the PE firm. But look how long it took Japan’s banks to get back on their feet.
Finally, most PE players come out of the M&A side of Wall Street or industry. They don’t understand managing a treasury operation or trading risk and they know it. Yes, in theory you can hire management, but given that pretty much everyone senior is associated with failing entities, talent is scarce and hard to vet.
Aside from the FDIC idea (some local banks can have very good franchises, and well run, can outperform big banks), I don’t anticipate much appetite.
This is merely a means of obfuscating sovereign investment in the banks. Note TPG raised $2B I belive last week or so from China. THe single biggest commitment. Ironic that China will be using its devalued dollars to buy a devalued bank. Which is depreciaiting faster?
If the PE shops are getting involved it will be at a substantial risk to the taxpayer. The two pieces of information these guys have are not on view for the public are: (1) the actual assets in the inventory and associated marks and (2) the inside deal they are getting at taxpayer expense.
Yet another sign of the sheer desperation. Bernanke is a stone loser in this anyway you cut it. The only thing I am waiting for is the headline “we had to destroy it to save it.”