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Story Retrieval Date: 11/20/2014 4:49:03 PM CST

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Benjamin Miraski/MEDILL

Washington Mutual and National City Bank have received capital from private equity, an idea endorsed in part by the Federal Reserve. However, the pool of funds may not be as deep as the Fed may hope.

Private equity pool dry for banks seeking capital

by Benjamin Miraski
Aug 07, 2008

The battered bank sector is looking for ways to shore up its shaky balance sheet in the wake of the financial crisis brought on by the collapse of investments in mortgage-backed securities. One solution that has been proposed by both Federal Reserve Chairman Ben Bernanke and Treasury Secretary Henry Paulson is private equity investment in the banking sector.

Despite backing for the idea, it appears that the pool of available funds from private equity, plus the regulatory hurdles the funds must clear, make this an unlikely solution, or at best only a drop in the bucket for capital-hungry banks.

The need for capital has become an urgent issue as the credit crisis stretches into its second year and estimates now reach $1 trillion for the amount of mortgage write-downs banks will ultimately have to take, according to Bill Gross, managing director of bond fund giant Pacific Investment Management Co.

“So far there hasn’t been a serious capital problem,” said Bert Ely, president of Ely and Co., a firm that specializes in consulting for the financial industry. “The concern is what is coming down the road. There is a growing concern that outside capital has been tapped out to an extent.”

The outside capital traditionally comes in the form of additional stock offerings by the bank. However, banks that have sought new capital through stock offerings haven’t seen the benefits, and the additional shares have been dilutive to their stock prices.

“Many of the capital injections that have been made into large banking companies over the last year are at this point under water, meaning the stock has continued to decline in price,” Ely said.

Enter private equity, pools of money from wealthy investors put together for the purpose of taking a controlling interest in a company, often when the company is not performing well.

“Private equity firms get paid to be contrarians and invest where others won’t tread,” said Tom Bagley, founder and senior managing director for Pfingsten Partners LLC, a private equity firm in Deerfield, Ill.

However, Bagley’s firm does not invest in financial firms, and is specifically forbidden to do so by its charter.

Bagley’s firm isn’t alone. Representatives from a number of private equity firms said they do not touch the sector, which calls into question whether vast pools of private money are even available for troubled banks.

Only about one percent of private equity firms have the necessary expertise, or staff who previously worked in the financial sector, according to Don Edwards, a partner with private equity firm Flexpoint Partners LLC.

Flexpoint is one of the few firms that does have the expertise, recently closing a $225 million fund designed to invest in the healthcare and financial services industries. The key to the fund is the inclusion of partner Gerald Ford, an investor who has run banking businesses for over 30 years, including a stint as the CEO and chairman of Golden State Bancorp.

But the $225 million in Flexpoint’s fund is pocket change compared to the combined multimillion dollar write-downs that many banks have taken as a result of falling asset values in the wake of the sub-prime mortgage collapse.

The mortgage crisis, the collapse of Bear Stearns and the resulting chain reaction that has resulted in the seizing of at least five regional banks, has pushed forward a great deal of conversation on the regulatory environment in banking and also the actions of banks themselves.

“I think this crisis will be calling into question the entire structure of our financial framework,” Edwards said.

Heavy regulation of ownership in the banking sector is one reason that Edwards said many private equity firms don’t invest in banks. The private equity firms traditionally like to have strong control of their investments.

Current regulations are designed to limit control of banks from outside interests. Holdings in banks greater than 9.9 percent are subject to greater regulatory scrutiny to make sure that no undue control is pressed on banking operations.

Holdings of more than 24.9 percent require the investor to register as a bank holding company and it restricts the investor’s ability to make investments outside of the banking industry. The restrictions are all part of the 1956 Bank Holding Company Act.

“We can’t possibly have our fund classified as a bank holding company,” Edwards said. He added that there are ways that private equity firms can participate, but a simple infusion of capital is not the usual way.

“I personally feel the Bank Holding Company Act is outdated,” Edwards said. “The act was designed and legislated before private equity existed.”

However, regulatory reform proposals such as Paulson’s “Blueprint for Reform,” unveiled in April, and a report released this week by former New York Federal Reserve Bank President E. Gerald Corrigan as part of the Counterparty Risk Management Policy Group, do not specifically address changes to the act.

Ely said the situation has not deteriorated to a point that would prompt a major Congressional review of the law, now several decades old.

“Congress has not deemed fit to change this,” he said. “It’s not something that’s even been talked about up there. I just have not heard it reach that level.”

“I believe what the Fed is trying to do is to offer more existing flexibility within the context of the existing law,” Ely added.

This is likely interpreting the law so that the requirements which are currently placed at one level might be observed at the next highest level, therefore lessening the restrictions on the owners.

Still, the lack of expertise in the private equity sector for these types of transactions would make even the lessened restrictions unlikely to provide the impetus for the needed influx of capital.

Even so, there have been two big private equity investments recently in the banking sector. Corsair Capital was part of a group that invested more than $6 billion in National City and now controls almost 70 percent of the bank. Washington Mutual was also propped up with $7 billion from TPG, although Washington Mutual is a savings and loan institution and so doesn’t fall under the same restrictions as a commercial bank.

Bernanke and Paulson recognize the value in allowing increased access to private equity investment in banks to shore them up, according to Edwards, but they lack the ability to change the laws.

“Unfortunately, these things take three to four years and the need for capital is now,” he said. “There is a need for capital in our banks and there is capital availability in our private equity funds. The hurdles in terms of core competencies and the hurdles in the Bank Holding Company Act make it hard for those things to come together.”

In the absence of changes to banking laws, many banking companies may be left with asset sales, such as Citigroup's $12 billion in leveraged loan assets in April. The last resort, of course, is closure.

So far, eight banks have failed this year and their insured deposits have been taken over by other banking institutions, the biggest being California-based IndyMac Bancorp.