FDIC Prodding Pensions to Invest in Failed Banks

In my last post on pension black holes, I discussed how Irish trade unionists has accused the Government of plundering the National Pension Reserve Fund to appease zombie banks.

On Monday, BusinessWeek published an article from Bloomberg's Dakin Campbell, Failed Banks May Get Pension-Fund Backing as FDIC Seeks Cash:

The Federal Deposit Insurance Corp. is trying to encourage public retirement funds that control more than $2 trillion to buy all or part of failed lenders, taking a more direct role in propping up the banking system, said people briefed on the matter.

Direct investments may allow funds such as those in Oregon, New Jersey and California to cut fees for private-equity managers, and the agency to get better prices for distressed assets, the people said. They declined to be identified because talks with regulators are confidential.

Oregon’s retirement fund may contribute $100 million as regulators seek “the support of state pension funds to solve the crisis surrounding ongoing bank failures,” Jay Fewel, a senior investment officer at the Oregon State Treasury, said in a presentation at the fund’s Feb. 24 meeting. New Jersey’s fund may also participate, said Orin Kramer, chairman of New Jersey’s State Investment Council.

The FDIC shuttered 140 lenders last year and expects the tally may be higher in 2010. Regulators have avoided signing up private-equity firms as rescuers on concern that they might take too much risk. Pension funds, whose 100 largest members manage $2.4 trillion, could provide capital to acquire deposits and outstanding loans from collapsed banks, according to the people.

Welcome Mat

“The FDIC is constantly looking at structures where we can get the greatest opportunity to tap into capital that we have not had the success reaching through previous disposition methods,” FDIC spokeswoman Michele Heller said in an e-mailed statement. “We welcome and work with all investors.”

Current rules don’t prohibit pension funds from buying failed banks. Until now, they have typically chosen to invest through private-equity firms using limited partnerships, which gives pension funds little to no control over the day-to-day management of the investments. They also pay management fees levied on the amount of money committed as well as a percentage of any profit.

“We’ve been examining a broad range of alternatives to take advantage of what I believe are attractive transactions coming out of the FDIC,” said New Jersey’s Kramer. The state pension system faced a shortfall of about $46 billion as of last year because of investment declines and a failure to make full contributions, according to annual financial reports.

Oregon State Fund

Oregon would invest in Community Bancorp LLC, a bank being formed by Sageview Capital LLC, according to the Oregon presentation. Sageview was founded by former Kohlberg Kravis Roberts & Co. executives Scott Stuart and Ned Gilhuly. Sageview is looking to raise about $1 billion from pension funds and similar investors, the presentation said.

While the structure makes sense, pension funds would be better off investing in existing banks, said Chris Whalen, managing director of Institutional Risk Analytics of Torrance, California. At those lenders, management will oversee details of buying failed lenders and save pension funds the time and effort needed to launch a new bank, he said.

“If they are really interested in playing this area, they should put their money into a larger bank that’s already playing here,” Whalen said. “If you look at the risk-reward and the distraction involved, it’s not worth it” to back a new bank, he said.

Investing in distressed banks doesn’t always pay off, as the U.S. Treasury Department learned with the Troubled Asset Relief Program. At least 60 lenders skipped some of their promised dividends to the TARP fund, according to SNL Financial, and a $2.33 billion stake in CIT Group Inc. was wiped out last year when the lender went bankrupt.

Amegy’s Paul Murphy

Sageview, based in Greenwich, Connecticut, and Palo Alto, California, would get yearly fees as an adviser and would also invest about $100 million of its own. Ruth Pachman, a spokeswoman for Community Bancorp, declined to comment.

Community Bancorp will look to buy three or four banks in the next three years and will be run by Paul Murphy, the presentation said. Murphy built Houston-based Amegy Bank into a $12.3 billion-asset lender over more than a decade, and it’s now owned by Salt Lake City-based Zions Bancorporation.

“We’re pleased with the Oregon decision,” Murphy said in an interview. He declined to comment further as the group is still raising capital and in a “quiet period.”

Spokesman James Sinks at Oregon’s Treasury said the state is still negotiating its commitment, and declined elaborate.

Calpers Presentation

After the credit crisis ate into private-equity returns, pension managers started looking for ways to trim fees and boost returns. The California Public Employees’ Retirement System, the largest U.S. public pension fund, said in a Feb. 16 presentation that one of its goals is to increase its “co-investments” in transactions alongside money managers. That kind of structure could give the pension fund an actual stake in firms purchased, rather than the private-equity firm’s buyout fund, according to the people.

Known as Calpers, the pension fund plans to “explore unique structures with select general partners,” according to the presentation. The fund’s investment portfolio was valued at $203.3 billion as of Dec. 31, according to the Calpers Web site. Spokesman Brad Pacheco didn’t respond to a request for comment.

Regulators have been debating how much leeway to give private buyers of failed banks on concern that they’re more likely to put federally insured deposits at risk, or will look to flip the bank for a quick profit.

Longer Horizon

Private-equity managed funds typically promise they’ll return funds to their investors in about 10 years. Pension funds are aiming to fund retirements that are decades away and thus can hold on to investments longer, which would help ease the FDIC’s concern, said one of the people.

FDIC guarantees may soften the risk of investing public pension money in distressed banks, Whalen said. When the FDIC sells a failed bank, it typically shares a portion of the loan losses.

“Financially sophisticated people do not assume that banks have recognized all of their real estate losses,” Kramer said, adding that it can still be a bad deal if a buyer overpays for a deposit franchise or if loans perform worse than expected. “We are in the early innings for commercial real estate.”

My thoughts on public pension funds investing in failed banks? I think any way they do it, it's a recipe for disaster. I can just see the private equity sharks raising funds to bid on failed banks. And even if pension funds take direct control of these failed banks, do they really know what's lurking on their books and how to operate a bank? I shudder to think at what will happen to these investments if we enter a protracted period of weakness in commercial real estate.

Finally, Richard Suttmeier was interviewed on Tech Ticker on Monday explaining Why Banks Can't Lend: U.S. Financial System "Not as Good as Wall Street Says":

Forget the unemployment rate, durable goods orders or the Baltic Freight Index. Veteran market watcher Richard Suttmeier says the FDIC quarterly banking profile is "the single most important leading indicator for the U.S. economy."

Released about 55 days after the end of each quarter, the FDIC report offers a bird's eye view of lending activity in America, especially among smaller Main Street lenders and small businesses. "It's a balance sheet of our economy," says Suttmeier, chief market strategist at Niagara International Capital and ValueEngine.com.

Based on the latest quarterly profile, for fourth-quarter 2009, the state of the banking system is "not as good as Wall Street is saying. Particularly when you get beyond the 'too big to fail' banks," Suttmeier tells Aaron in the accompanying clip.

Bad Banks Can't Lend As was widely reported, the most recent report showed the number of "problem" banks rose 27% in 2009 to 702 -- the highest level since 1993.

Less widely discussed is Suttmeier's concern that more than half of the nation's roughly 8,000 banks "can't lend anymore" because of rising levels of bad loans on their books. The problems are especially acute in construction & development and commercial real estate loans, he says, citing the FDIC quarterly report. Because so many of these loans are delinquent, banks don't have the capital coming in to lend out and thus are content to mostly sit on deposits, he explains.

"We can't sustain positive GDP growth without the construction market turning around [and] banks getting rid of these bad loans so that they can lend again," Suttmeier says. "When you have light demand for loans and loans on the books deteriorating while the economy's going up -- something's not right."

FDIC under strain. Meanwhile, the Federal Deposit Insurance Corp.'s fund has been dwindling, hitting a $20.9 billion deficit as of Dec. 31, as the AP reports. Suttmeier says TARP funds repaid by bailed out banks should be used to shore up the FDIC's fund, rather than raising fees for banks, which will leave them with less capital to lend.

To be clear, the FDIC has a $500 billion line of credit with the U.S. Treasury, and Suttmeier doesn't see much risk of the FDIC changing (or being unable to cover) its $250,000 guarantee for individual deposits. Suttmeier isn't an alarmist and doesn't see run on the banks as started to occur in late 2008 in the depths of the global credit crisis. However, one trend is clear: "We have to find funding for the smaller banks," he says.

Nothing less than positive GDP growth and a sustainable U.S. recovery are at stake.

Watch the interview below and relay it back to why the FDIC is prodding US public pension funds to invest in failed banks. Will this be the next huge financial blunder? Sure looks like it.