Monday, July 6, 2009

More (?!) Bank Closings and New Rules for Private Equity Buyers

Is this a visual alarm bell, or just an economic system purging itself? As of Thursday, the total number of banks closed since Fall 2008 is greater than 75. At the end of Q109, the FDIC had 305 banks with $200 billion in assets on its list of "problem institutions." Interestingly, in concert with Thursday's seizures, the FDIC proposed new rules for private equity groups purchasing the banks. The online discussion since has been pretty robust.

The FDIC is juggling conflicting goals here: trying to entice the deep pocket liquidity of private equity buyers, while structuring the purchase and performance of the newly acquired banks so that future systemic problems are avoided. Critics charge that the move will deter the very private equity the FDIC is courting. Among the requirements generating the most discussion is the proposal that buyers maintain a 15% leverage ratio after they purchase the bank.
Briefly, leverage ratios are useful in understanding how a bank uses its assets, as well as predicting whether that bank can meet its financial obligations. The concept is straight-forward enough: you have $10,000 of your own money at 5% anticipated gain. Your profit is $500. But if you fully leverage yourself and borrow someone else's $9,999 against your own $10,000, your profit doubles to $1,000 (presuming the same 5% anticipated gain). The profit to be gained from more and more leverage - all on the back of your original $10,000 investment - is understandably attractive. The problem is when losses occur and downside risk has not been provided for. Plenty of commentators have identified leverage as a key factor contributing to the ongoing economic snap. The FDIC proposed leverage ratio and the subsequent pushback illustrates the indecision of what to do with this issue moving forward ...

Other proposed requirements for private equity buyers include: owning the purchased bank for at least three years; not lending to affiliates, including buyers' own portfolio companies; and disclosing buyer details, such as ownership. The proposal is subject to a 30-day comment period. This is a really intriguing matter for me, so although this post strikes more of an FYI tone, I will continue to follow the issue and update the blawg as the next several weeks unfold.

Hat tip: Kevin LaCroix at The D & O Diary.

Photo courtesy of Wikimedia Commons).

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  1. I think the regulations are wise in their intent. US financial institutions are some of the most undercapitalized in the world, and this was a major contributor to the recent economic collapse. It's great, on the one hand, to attract buyers of failed institutions to try to save what we can and give them new life, but it would be foolish to let the pattern of excessive speculation repeat itself (costing taxpayers money either in the form of FDIC insurance funds or bailouts). When I say "excessive" speculation - I refer to speculation of the kind where the potential lossise fatal to the risk-taking institution. Sure, no risk, no reward, but if we learned anything from the recent economic crisis it is that in today's global economy, when bets that are too risky (institutionally fatal) fail, the snowball effect has worldwide economic and political significance. In fact, the CIA has recently decided to start recruiting ex-Wall street guys to monitor global financial conditions, recongnizing that an unstable economy is directly tied to major political upheavals (read: global security threat). (Heard the CIA bit on NPR:) So, the proposed policy is a good idea in my view.

  2. Hey Bolga!

    Thanks for the comment. I agree, the leverage ratio seems a practical provision in light of the last several months' events. Having said that, I'm really interested in what has the private equity guys so up in arms >> is it just the reduced profit in light of a lower leverage ratio? Do they think this is not the appropriate manner to handle the leverage issue in the new governance structure the Obama Administration is building? How much potential profit is loss? Is there an alternative means of capturing that loss profit without the low ratio (new vehicles?)? Cynics will say the private equity guys just don't care about stability, but that doesn't shake either: they lose money, too, when risks come to fruition.

    So there's a lot more here to investigate >> *yeah*: more posts!

    Have a good one, Beaut - we'll speak soon,


  3. The private equtiy buyers are complaining because they want to stake out as much freedom and flexibility as possible to do as they please. no one likes being told how to handle their money, especially by the government! Also, private investors don't have that much to lose because they are only out to the extent of their investment and because of the limited liability doctrine they are not liable for personal bad debts incurred as a result of reckless business practices. regulation is necessary to counter this incentive to over-gamble with other people's money.


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