By Shah Gilani
Contributing Editor
Money Morning
The financial Barbarians are at the gates of the U.S. banking sector.
“Regulatory arbitrage” – sometimes called “regulatory shopping” – has emerged as the favorite strategy for these Barbarians, otherwise known as private equity firms, to get around the federal rules that kept them from owning banks.
Why the sudden interest in banks? Like legendary bank robber Willie Sutton is famously (and probably falsely) remembered for saying: “That’s where the money is.”
Like so many of the businesses in the financial sector, the private equity business is right now reeling – and littered with its own bankrupt leveraged buyout deals. So now these LBO firms are shrewdly targeting failed banks, playing regulatory arbitrage, and shopping around as they search for ways around the regulations that were designed to keep companies with their motives out of the U.S. banking industry’s venerable vaults.
The new twist on acquisition leverage is to have taxpayers, through the Federal Deposit Insurance Corp. (FDIC), backstop losses on acquired banks if the economy continues to falter. And as soon as they can leverage depositors and the FDIC as a source of funds, these private equity firms will go back to buying leveraged-up targeted companies with cheap borrowed money – to which they’ll have easy access, since they’ll actually own the banks.
The Background on Banking Regs
Banks are regulated at the federal level by a number of agencies. The regulators include the Federal Reserve Board (FRB), which oversees national banks chartered by the government, the Office of Thrift Supervision (OTS), a U.S. Treasury Department office that oversees thrift institutions, savings and loans and credit unions, the Office of the Comptroller of the Currency (OCC), and the FDIC, not to mention various state banking regulatory bodies.
Lately, approval actions by the OTS and FDIC are at odds with the U.S. Federal Reserve, which has not authorized the acquisition of controlling interests in any banks by any private equity players. The FDIC has expressed its acquiescence as a way of more-quickly offloading insolvent banks in the hope that doing so might help limit its exposure to depositor claims. And the OTS, after being somewhat hesitant – and with its future as a regulator now in jeopardy – seems to be doing what it can while it still has the power to grease the wheels for private equity interests.
For a case in point, consider billionaire investor Wilbur L. Ross Jr., an expert purchaser of so-called “distressed” assets who is known by some as “The King of Bankruptcy.”
Using his recently acquired American Home Mortgage Servicing Inc. – one of the nation’s largest mortgage servicing companies, with about $100 billion on its books – as his investment vehicle, Ross sought to buy bankrupt American Home Bank – at one time a would-be Countrywide Financial Corp. emulator.
The OTS denied the sale on the grounds that Ross’ firm wasn’t already a bank, and AHB was subsequently sold to The Bancorp Inc. (Nasdaq: TBBK), a federally chartered online bank based in Wilmington. But in a classic example of “if-at-first-you-don’t-succeed” strategic resolve, the Ross-led WL Ross & Co. LLC-headed a consortium of private equity giants and investors that included including Blackstone Capital Partners (NYSE: BX), Carlyle Investment Management, Centerbridge Capital Partners LP, LeFrak Organization Inc., The Wellcome Trust, Greenaap Investments and East Rock Endowment Fund – and with the full blessing of the OTS and FDIC just acquired BankUnited Financial Corp. (OTC: BKUNQ), a Coral Gables, Fla.-based savings and loan that had been shuttered by federal banking regulators.
The “Silo” Sidestep
The vehicle that was used to acquire BankUnited is called a “silo.” In a neat little end-around the bank-holding-company laws separating bank owners from controlling other commercial businesses – and control of multiple businesses is one of the keys to success for a private-equity player – the so-called silo arrangement theoretically establishes a walled-off vehicle to acquire and manage the bank separately from the firms’ other investments. Who knew it was that simple? The Fed has said that it has yet to determine the validity of the silo-structure vehicle approach.
The silo structure was first tested and approved back in January, when the OTS approved New York-based MatlinPatterson Global Advisers LLC’s purchase of Flagstar Bancorp Inc. (NYSE: FBC) in Troy, Mich. But as a precaution – and to address the early OTS denial of Ross’ attempt to buy American Home Bank (based on the fact that he didn’t already own a bank), Ross that same month personally bought a controlling stake in tiny Indiantown, Fla.’s First Bank and Trust Co.
At the time, Miami Banking expert Ken Thomas told the Palm Beach Daily News that Ross “[isn’t] buying a bank as much as he's buying a bank charter. Once you have a bank charter, you can go statewide, region-wide, or nationwide. That may be just the beginning of his endeavors. It could be Bank of Indiantown or Bank of America (NYSE: BAC) – it doesn’t matter.”
As for why Ross bought the stake personally, Mark Tenhundfeld, director of regulatory policy at the American Bankers Association, a Washington-based trade association, told Bloomberg News that “an individual cannot be a bank holding company. If the OCC approves a change in bank control proposal by an individual, then that person may avoid bank-holding-company regulations.”
The Flowering Inferno
Being the cautious type, however, Ross wasn’t the first to personally buy a bank. That distinction goes to billionaire investor J. Christopher Flowers, who personally bought tiny First National Bank of Cainesville in Missouri in order to keep his own private-equity shop from becoming a bank holding company. It seems that both Ross and Flowers are determined to “backdoor” their way into owning and controlling banks, while at the same time limiting the larger exposure of their principal investment vehicles. How that turns out for the banks, or for their depositors, remains to be seen.
J.C. Flowers & Co. LLC. is no stranger to banking, at least not outside the United States. J.C. Flowers bought a 24% stake in Hypo Real Estate Holdings AG, Germany’s second-biggest commercial property lender and a company that’s in such deep trouble that it’s 90% owned by Germany’s national stabilization fund – which wants to “squeeze out” Flowers, according to news reports.
Flowers & Co. also owns a third of Shinsei Bank Ltd., a Japanese bank in which it has invested hundreds of millions of dollars. Too bad Shinsei is in dire straits and has had to be supported by the Bank of Japan.
But in another “if-at-first-you-don’t-succeed,” Flowers is looking to merge Shinsei with another failing Japanese bank, Aozora Bank Ltd., which itself happens to be majority controlled by none other than the three-headed dog from Hell, Cerberus Capital Management LP – the same Cerberus that wouldn’t support its Chrysler LLC investment with any additional capital. One of the reasons Aozora isn’t doing so well is that it invested its depositors’ money in its master’s LBO deals, and in the case of lending to Cerberus’ 51%-owned, struggling and technically insolvent GMAC LLC (NYSE: GMA), has lost hundreds of millions of dollars.
The two failures are now telling Japanese regulators they intend to merge the two banks. The deal is actually being orchestrated by Japan’s banking regulator, the Financial Services Agency, and according to a recent Wall Street Journal article, is the second time that the government has aided the two banks.
Back here in the United States, J.C. Flowers – along with hedge fund Paulson & Co. and others – also bought defunct IndyMac Bancorp Inc. (OTC: IDMCQ) bank out of receivership from the FDIC.
Allowing private equity players to replicate the failures of their recent history and leverage going concerns with layers of debt by now granting them access to FDIC-insured depositor funds to do more of the same is a mistake of massive proportions. In a recent letter to U.S. Treasury Secretary Timothy F. Geithner, U.S. Sen. Jack Reed, D-R.I., expressed “serious concerns” about this potential problem, stating that “private equity firms are not transparent. There are potential conflicts with their other holdings, investors, management and sources of funding, much of which is not disclosed.”
Desperate times don’t always require desperate measures. While it’s true that banks need to be recapitalized and that private-equity firms have plenty of dry powder at the ready, we should welcome banking-sector investments from these private-equity players only if it’s passive in nature. After all, why should we give the quick brown financial fox access to our already-plucked-to-death hen house?
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To read a related story on how the long-term dismantling of U.S. banking regulations set the stage for the U.S. financial crisis, which appears elsewhere in today’s issue of Money Morning, please click here. The story is available free of charge.]
News and Related Story Links:
- The Truth About Mortgages.com:
Ross Wins American Home Mortgage Servicing Bid. - PhillyBusiness.com:
Bancorp Inc. to buy Chicago-based bank. - Wikipedia:
The Wellcome Trust. - CNN.com:
Florida bank collapses - firms swoop in. - CNN.com:
Investors to buy IndyMac - $13.9B. - Wikipedia:
Wilbur L. Ross Jr. - BusinessWeek.com:
Private Equity's Banking Problem. - Wikipedia:
John Paulson. - CNN.com:
Barbarians at the banking gates. - Wikipedia:
Willie Sutton. - Bloomberg News:
Flowers, LBO Investor, Approved to Buy Missouri Bank. - Wikipedia:
J. Christopher Flowers. - MSN News:
German fund says it may squeeze out HRE bank investors. - MSNMoneyCentral.com:
Report: Shinsei and Aozora Banks to merge.
About the Author
Shah Gilani boasts a financial pedigree unlike any other. He ran his first hedge fund in 1982 from his seat on the floor of the Chicago Board of Options Exchange. When options on the Standard & Poor's 100 began trading on March 11, 1983, Shah worked in "the pit" as a market maker.
The work he did laid the foundation for what would later become the VIX - to this day one of the most widely used indicators worldwide. After leaving Chicago to run the futures and options division of the British banking giant Lloyd's TSB, Shah moved up to Roosevelt & Cross Inc., an old-line New York boutique firm. There he originated and ran a packaged fixed-income trading desk, and established that company's "listed" and OTC trading desks.
Shah founded a second hedge fund in 1999, which he ran until 2003.
Shah's vast network of contacts includes the biggest players on Wall Street and in international finance. These contacts give him the real story - when others only get what the investment banks want them to see.
Today, as editor of Hyperdrive Portfolio, Shah presents his legion of subscribers with massive profit opportunities that result from paradigm shifts in the way we work, play, and live.
Shah is a frequent guest on CNBC, Forbes, and MarketWatch, and you can catch him every week on Fox Business's Varney & Co.