Wednesday, September 24, 2008



The previous rules concerning what constitutes a “bank holding company” for regulatory purposes understandably discouraged private equity firms from buying big stakes in banks; being classified as a “bank holding company” would preclude most private equity firms’ major activity: buying large, usually controlling, interests in other companies. Any investments by private equity firms in banks (e.g., TPG’s taking a stake in Washington Mutual early this year) were thus carefully structured to avoid the bank holding company rules and, of necessity, limited. Desperate to find potential investors in troubled banks, and realizing that the private equity industry has plenty of money looking for a home, the Fed earlier this week loosened its rules concerning what constitutes a “bank holding company” for regulatory purposes. Until these rule changes, any investor that was deemed to control a bank was considered a bank holding company and thus subject to relatively stringent regulation. While the threshold for control for this purpose was 25% ownership, control could be construed with ownership of as little as 10% of a bank. Under the newly issued rules, an investor can now own as much as 33% of a bank, of which 15% can be voting common, without being considered a bank holding company and thus subject to regulation as such by the Fed.

The hope is that, freed from the risks of being considered a bank holding company and thus effectively being put out of business, private equity firms will now invest heavily in the banking sector, thus becoming a large element in the rescue of this critical sector of the economy. The dangers of this hope’s being realized are not inconsiderable. The most salient of these perils is that a private equity firm that owned a large share in a commercial bank could force the bank to lend money to other companies that its private equity owner controls, thus putting the FDIC (and thus the taxpayers) on the hook for investments that are not necessarily good for the bank but are instead designed to enrich its private equity owners. (Given the size of the bailout currently being jammed down the taxpayers’ gullets (er, sorry, being carefully considered) in Washington, this concern sounds almost laughable, but it’s in no one’s interests to let them get away with small ones by diverting us with big ones. But I digress.) Another fear is that, since private equity firms by their nature employ plenty of financial leverage in their acquisitions, allowing aggressive purchases of banks by private equity holders amounts to putting leverage on top of (or beneath, I suppose, technically) leverage.

Another less obvious danger of allowing greater private equity investment in banks can be discerned by taking a look at AIG. Recall that, in the case of AIG, which seemingly “required” an investment of roughly $85 billion of more or less public funds, it was the holding company that was in trouble. The insurance units of AIG were well, or at least adequately, capitalized and thus no policyholders were in danger of losing their insurance. However, the holding company, which had metamorphosized into an enormous hedge fund, had gotten into trouble primarily through its amateurish dabbling in credit default swaps (“CDS”s) and, to a lesser extent, various mortgage related securities. The Fed felt compelled to bail out AIG partly out of the general public’s, and thus the politicians’, misplaced concern that the insurance policies of John Q. Public were in jeopardy, mostly because of the political class’s pathological readiness to use other people’s (i.e., your) money to alleviate even the slightest hint of discomfort to a major, cash paying constituency, and partly due to fear of the ramifications for the CDS market of a failure of AIG.

Now consider the case in which a private equity firm (admittedly a different animal from a hedge fund, which is what parent AIG had become) owns a big stake in a bank, or several banks. Imagine that the private equity fund gets into trouble through the failure of one or several of its non-bank investments. Such a scenario indeed does not take much imagination. Consider Cerberus and an industry with which I have more than passing familiarity. Cerberus’s automotive investments, GMAC and Chrysler are, if shaky is not a completely appropriate adjective, shall we say not robust and/or not working out according to plan at the moment. Furthermore, Dave Tepper at Appaloosa (Though I knew Dave a long, long time ago, we have not seen each other for at least twenty years and would not know each other if we passed on the street. Thus I have absolutely no more information than you do regarding what Dave is thinking, but I still feel comfortable with this sentence.) is probably (or at least ought to be) grateful that his deal to purchase Delphi fell apart before it could do serious damage to Appaloosa and thus to his personal fortune. The fact is that private equity firms do make bad investments and those investments have the potential to put such firms in precarious financial positions. It is no stretch to imagine such things happening with greater frequency in the near future.

So suppose a private equity firm gets into trouble with its non-bank investments. Will the Fed feel compelled to bail out, a’la AIG, that private equity firm due to a perhaps ill-considered run on its banks triggered by news of their parents’ financial travails or just a generalized fear that “XYZ Private Equity Firm is in trouble and, now that it controls several banks, who knows what ramifications such trouble will have for our financial system?” This is something to consider, and seems to have gotten little or no consideration, perhaps because of the understandable focus on RTC II or because of the relatively arcane nature of the problem.

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