naked capitalism

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.