Tuesday, July 01, 2008

Why Should Private Equity Invest In US Commercial Banks?

There has been a lot of ink spilled recently on how the Fed and other related US bank regulators need to adapt various rules so that "private equity" can rescue crippled commercial banks by supplying new capital, but without the onerous current restrictions.

The Wall Street Journal devoted a front page piece to the topic on Friday, and gave space to two Carlyle group directors to opine on the same topic Thursday.

I think this concern over how to allow private equity to invest in commercial banks is misplaced. It's entirely the wrong solution.

Let's understand what the current situation among large commercial- BofA, Citi, Wachovia, Chase- and three of the four large public investment banks- Merrill, Morgan Stanley and Lehman- really mean.

These financial institutions committed grave and expensive errors of risk management and timing of investments and trades, resulting in very large and continuing losses. These operating losses, realized in ever-more regular fashion, have depleted capital among these eight large publicly-held US financial institutions.

Don't such losses imply excess capacity in the sector, which led to injudicious, risky behavior on the part of the competitors?

Isn't the obvious solution to consolidate the sector's participants? How much loan origination, underwriting and trading capacity do we really need? Surely not so much that it goes off in search of bad deals and blows holes in the balance sheets of the sector's competitors.

In fact, if/once you fence off simple deposit-taking activities, which are federally insured, all other banking businesses are quite competitive and, thus, subject to cyclical losses.

What we're seeing now is not really anything new, but, rather, a confluence of several bad financial bets by these large banks at once. Combining overly-aggressive mortgage financing with securitization resulted in them messing up both a real economic sector- housing- and the entire financial sector with it.

The result has been material losses of shareholder capital from these boneheaded moves on the part of the eight large firms mentioned above, plus, of course, the now-dead Bear Stearns.

But that's no reason to lament the availability of capital for publicly-held financial institutions.

You can bet your bottom dollar that private equity shops only want in because they think there will be a feast as economic and financial conditions recover, and probably a few regulatory sweeteners tossed in for good measure.

But why worry about the temporarily shrinking capacity of US commercial and investment banks? If private capital can buy into these institutions, to filter their capital into loans, etc., why can't they just enter the businesses directly?

Private equity shops could, if they chose, hire commercial and personal loan employees from publicly-held banks and go forward with their own fresh capital, replacing the questionable business practices and judgments of the commercial and investment banks.

Why throw good money after bad, and into the hands of inept CEOs and senior managements at the existing eight large commercial and investment banks?

I don't see a crisis here at all. In fact, I don't see a need for any regulatory intervention whatsoever. What I see is a need for mergers of weak commercial and investment banks. Or maybe just the death of the worst-performers.

There's nothing wrong with the financial sector that segregating deposit-taking and then allowing mergers of weak institutions won't fix. With less taxpayer 'help' and modification of regulations.

But letting private equity into the picture is just mistaken. Those guys are smart enough to just take on the businesses and do it themselves. They don't need to be buying into the management of inept commercial and investment banks.

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