Barbarians back at bank gates

FDIC chief Sheila Bair rolled out new rules for private investors buying failed banks.

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NEW YORK (Fortune) -- Regulators cleaning up after bank failures showed Wednesday how far they're willing to reach out for help.

The Federal Deposit Insurance Corp.'s board voted 4-1 to set new rules governing the terms under which private investors such as buyout firms may invest in failed banks.

The rules call for private buyers of failed banks to hold more capital than existing banks are required to, and to hold onto their investments for at least three years.

Chairman Sheila Bair said at the agency's board meeting in Washington that she views the rules -- which aim to lure in private equity money while minimizing risks to the federal deposit insurance fund -- as a workable solution to a "tough issue."

So far in 2009, 81 banks have failed, and dozens more are expected to close over the next year as the banking industry digests losses tied to the real estate bubble.

"I think the compromise we struck is a good and balanced one," Bair said. Of private equity investors, she said, "I think they will continue to bid with these criteria."

The FDIC typically sells failed banks to other banking institutions, which are already subject to strict federal rules on leverage and dealings with affiliates.

Just last Friday, the FDIC sold four failed banks to other institutions -- including the sale of Texas thrift Guaranty Bank to a Southern regional bank owned by a Spain's BBVA (BBV).

But the scale of the cleanup ahead has policymakers considering every source of capital available, including buyout firms and others outside the heavily regulated banking industry.

The FDIC has already sold a few big failed banks -- including IndyMac, the third-biggest failure in history -- to private equity firms. It also sold failed Florida lender BankUnited in May to a group led by buyout specialist Wilbur Ross.

The agency proposed new rules last month in a bid to make such deals more routine. Because the July proposal was tough and fuzzy on some details, private equity interest in failed bank acquisitions cooled for a time.

"We were having an enthusiastic response until the policy statement came out," said Manual Mehos, chairman of closely held Green Bank in Houston, a bank that's raising private equity funds to invest in failed bank deals. "Since then, it hasn't exactly frozen but it has been sort of on hold."

But Mehos said the revised rules appear at first blush to be considerably more favorable for private investors.

Under the new rules, private investors buying a failed bank will have to hold so-called tier 1 common equity equivalent to 10% of the bank's assets.

That's below the FDIC's original proposal, which would have required buyers to maintain a 15% tier 1 leverage ratio, but well above the 5% tier 1 leverage ratio required of well capitalized existing banks and the 8% tier 1 leverage ratio demanded of new banks.

The FDIC held firm on a requirement that investors keep the banks for three years, in the name of attracting bids only from firms that Bair characterized as being serious about the banking business for the long term.

"We want people who are serious about running banks understanding ... they need to be operated profitably but also prudently," Bair said.

The moves come as policymakers are under pressure in Congress not to hand failed-bank buyers any gifts at a time when bailout rage is still fresh.

Along those lines, the private equity investors who took over the remains of the failed IndyMac bank in January are already sitting pretty.

The bank's failure last July is estimated to have cost the FDIC insurance fund $10.7 billion. But OneWest, as the resurrected IndyMac is known, turned a $182 million profit in the second quarter ended in June. The buyers include hedge fund billionaire John Paulson and buyout specialist Chris Flowers.

"You can see where the FDIC might be looking over its shoulder about people making huge money," said Hal Reichwald, a lawyer at Manatt Phelps & Phillips in Los Angeles who represents investors.

Reichwald said that while the lower capital requirements will be more attractive to potential failed-bank bidders, he questioned whether the new rules will be enough to draw in the flood of private equity funding the FDIC desires.

For instance, the rules adopted Wednesday include a statement encouraging private equity investors to join with existing bank holding companies in bidding for failed banks.

Though that policy may makes sense for regulators trying to manage a huge flow of failed banks, "that's the last thing private equity wants to do," said Reichwald.

He said private equity investors see themselves as "master of their own fate," and that going through existing holding companies wouldn't appeal to their desire for control.

"This is adding more process to a difficult situation," Reichwald said.