To hear them talk, central bankers and regulators believe we can continue to have, at the same time, accelerating asset write downs, stricter capital ratios, and flatter yield and credit curves. That is, without having the real economies shut down from lack of liquidity. The only way the banks can reconstruct their balance sheets, or at least their cash flow statements, is from years of steep yield curves caused by artificially low policy rates. Is there an inflation risk to that? Yes, of course. But, given our inability to travel in time, there is no way to go back and undo what Alan Greenspan and the others did starting a decade ago.

John Dizard
Financial Times
July 8, 2008

In this issue of The IRA, we consider a question we've been asked a lot lately, namely how smaller and medium size commercial banks will be able to raise capital in the next year or more. How banks can raise new capital when they are being compelled to limit dividends on existing common and preferred equity remains to be seen, but we see at least some signs of ferment.

With a number of financial insolvencies impending due to the subprime meltdown, including talk about a "bridge bank" for IndyMac Bancorp (NYSE:IMB), the issue of recapitalizing the US banking system is "Topic A" for both regulators and investors. Our suggestion: FDIC needs to set up an auction facility with legal counsel and perhaps, gasp, investment banking advice on call to help in triaging and selling failed commercial banks.

Subscribers to The IRA Bank Monitor click here to see the profile for IndyMac Bank FSB.

Dawn Kopecki at Blomberg reports that Zions Bancorporation (NASDAQ:ZION) was forced to offer a dividend yield of 9.5% on a preferred stock deal and even then only a third of the $150 million deal got done. This confirms earlier observations we've made of 30-40% discounts to previous day's close for other bank equity deals.

Subscribers to The IRA Bank Monitor login and click here to view the profile for ZION.

Notice that nearly 80% of the Economic Capital allocation for ZION in The IRA Bank Monitor comes from securities exposure, not loan risk. Notice too that the nosebleed 95% Loss Given Default or LGD for ZION in Q1 2008, once a level of loss reserved for subprime credit card lenders, is now just ahead of the peer average of the more than three dozen similar sized institutions.

The apparent need by small and medium sized banks to raise capital has led to speculation as to whether the federal regulators responsible for supervising the ownership of banks are willing to be more flexible to facilitate such investments. In a July 1, 2008 comment in SeekingAlpha, for example, former Commerce Bancorp CEO Vernon Hill argues that change in how the feds regulate investment in commercial banks is long overdue.

To get a perspective on the current thinking by federal regulations regarding investments in US banks and bank holding companies, The IRA spoke to Ernest T. Patrikis, partner at Pillsbury Winthrop Shaw Pittman LLP. Before joining the Pillsbury firm, Patrikis worked in and eventually led the legal department of the Federal Reserve Bank of New York and then spent eight years as general counsel of AIG (NYSE:AIG).

The IRA: There is a lot of speculation in the banking industry and in the press about whether the Fed should change its rules regarding the ownership of banks. This speculation is driven by the fact that smaller and medium size banks need to raise capital, but have limited avenues to access new funds - especially with the market for preferred issues now closed. What's going on here - or not - and what should large investors pondering bank investments know?

Patrikis: There are two basic pieces of legislation which govern bank ownership in the US, the Change in Bank Control Act and the Bank Holding Company Act. The former statute is applicable to the Fed (state member banks), FDIC (state insured, nonmember banks, including ILCs) and OCC (national banks), and the latter for companies which control banks. The OTS has a similar regime for thrift ownership.

The IRA: So what is the current threshold for determining control?

Patrikis: In terms of the Change in Bank Control, individuals and firms generally have been sticking to below 9.9% ownership to avoid being subject to the applications process and the potential for the imposition of conditions. One of these is a "fit and proper" test, similar to what is used in the UK and EU, where the regulator looks at the shareholders to make sure that they are reputable people. The regulator will also take a look at their financial background to see the source of funds for the purchase. Then more recently the FDIC and then the OCC, in cases of where a company has gone over the 10 percent threshold, have come up with what I describe as a modified "source of strength" requirement.

The IRA: Now that's an old fashioned notion. We always like to remind generalists that bank ownership can sometimes involve significant financial burdens. Can you give an example?

Patrikis: In the case of a private equity fund look at the Blackstone Group transaction with respect to Alliance Data Systems (NYSE:ADS).

The IRA: Or the Cerberus transaction with GMAC?

Patrikis: Yes. The requirement from the FDIC has been that, when the bank's capital has dropped to a certain level, a stated amount of capital need be injected. That's not a full "source of strength" type requirement such as the Fed imposes on the controlling shareholders of a bank holding company. This is clearly going to be an issue for a company desiring to invest between 10-25 percent in a bank, but may not want to commit to putting in more beyond that investment. I don't recall any cases where the Fed imposed this requirement. This has been done by the FDIC and with respect to ILCs. The OCC apparently was prepared to impose a similar requirement on the ADS transaction.

The IRA: There's reportedly an application pending with the FDIC by Cerberus asking permission to continue to hold GMAC Bank, a UT-based ILC with $30 billion in assets at the end of Q1 2008. Some 62% of total assets are in real estate loans.

Subscribers to The IRA Bank Monitor click here to view the QuickSheet for GMAC Bank.

Patrikis: This goes to the ILC issue, does it not, that the activities of the owner must be generally financial in nature? This is not the law, by the way. It is an FDIC policy.

The IRA: So this is the FDIC's interpretation of the Change in Bank Control statute?

Patrikis: No! It's just a requirement by the FDIC. It is not a requirement in law. If a proposed investment by a company will be 10 percent or more of the shares of the bank then the FDIC applies the requirement. What do potential purchasers want as a threshold? Presumably they don't want hit the 25% threshold and have to apply to become bank holding companies subject to Fed qualitative supervision and activity regulation.

The IRA: This is why we wanted to talk to you. What is the likelihood of change in these regimes? There is a lot of discussion lately about an issue that is normally quite obscure.

Patrikis: Mostly dilatory. During the FDIC's standstill on ILC applications from applicants not generally engaged in financial activities, Congress proposed legislation somewhat similar to these proposals. The FDIC continues to impose the financial nature limitation. That's not the law. This is a matter best addressed by the Congress.

The IRA: Right, the FDIC made that rule up out of whole cloth, as in the case of Wal-Mart (NYSE:WMT).

Patrikis: Let me go a step further on this point. What is the rational for the Bank Holding Company Act and thereby making it more difficult for companies to acquire control of banks? I'll give you two rationales. First is the Fed continues to believe in the separation between backing and commerce, something for which I do not have a lot of respect. Citicorp's becoming a one-bank holding company and thereby gaining the ability to engage in all sorts of non-bank services was one prime motivation for amendments to the Bank Holding Company Act in 1968.

The IRA: Well, aren't we done with the 19th Century? Isn't Glass-Steagall over and done with?

Patrikis: No, not really. We still have the Bank Holding Company Act. While Gramm-Leach-Bliley greatly broadened the activities permissible for bank holding companies, it has not been entirely eliminated. Few countries in the world have limitations like that, maybe Japan. Most countries do not impose activity limitations on companies controlling banks. With limitations on transactions between banks and controlling persons, is that limitation necessary?

The IRA: Correct.

Patrikis: The second rationale for the Bank Holding Company Act may well have come about as a result of Saul Steinberg's Reliance Insurance Company taking a run at Chemical Bank. The banking industry now has a poison pill called the Federal Reserve Board.

The IRA: In terms of models of corporate governance and accountability? Yes. How does the Fed govern control issues for BHCs?

Patrikis: When you are buying between 10 and 25 percent of a BHC, the Fed's Board of Governors puts in place passivity conditions, which limit the ability of a company to elect directors and of other limitations so that a company cannot exercise a controlling influence over the bank. A controlling influence to me is not absolute control, but rather an influence that is very strong. And the Fed has made sure that you as a significant investor have virtually no influence. One of the questions that now faces the Fed is that investors may want to put in 10-20 percent new money to recapitalize a bank, but they also may want representation on the bank's board of directors and other items to protect their investment.

The IRA: There is that position, the active investor, but you will also often see institutional advisers declaim beneficial ownership or control of shares. That is almost always the case for large investors in publicly listed shares.

Patrikis: They can do that, and the Fed will not object. If an investor wants to take on passivity conditions in connection with an investment, then the Fed is not going to resist, other factors being equal. But there are other investors who may not take that view. They do not want to say they have control, but they may want representation on the board of directors. That's not control. So what we are seeing now is a ripening of an issue that has been simmering quite a while. This debate about the issue of control did not just start in the past several months. To its credit, the Fed's legal division has been studying this issue for a while. They know that this approach needs to be brought up to date in light of many year's experience.

The IRA: If we put this issue in historical context and go back to the 1930s, when the states eliminated double liability for bank shareholders…

Patrikis: And they eliminated bank shareholders too.

The IRA: That's right. You had to be a wealthy individual to survive the calls for new capital by the few banks which passed the solvency test. But over the years, most members of the public and especially investors have forgotten the safety and soundness criteria used to limit ownership in banks. They need to engage counsel just to consider such an investment above 10 percent.

Patrikis: Correct and most of these non-individual investors have no interest in going near much less over the 25 percent voting share requirement, which is the ownership threshold for the rebuttable presumption of control. They don't want to be under the Bank Holding Company Act, and they don't want all of the reporting, supervision, and activity limitations that go along with control. While banking organizations have broker/dealer subsidiaries, broker/dealers do not acquire banks. Why? The Bank Holding Company Act. We are really talking about the greater than 10 percent but below 25 percent group of potential purchasers. These are investors who are putting in a major stake, but don't want to be absolutely passive. They want to be able to protect their investment by voicing their concerns and making recommendations to management.

The IRA: The Fed should welcome such activism. Do you think that the Fed would look favorably on "club deals" where a group of funds each came in for 10 percent or so but committed not to coordinate investment strategy or act in concert? The banks may need to raise significant amounts of new capital.

Patrikis: Right and as long as the investors are not acting in concert that should not be a problem.

The IRA: Well, in a club deal one fund usually does the diligence and sits on the board of the portfolio company while the others act as passives. In this case, each participating firm would have to actively manage its stake under the rules prescribed by the Fed.

Patrikis: Theoretically, a dealer firm could raise capital for banks via a fund vehicle whereby each investor declaimed control and cut their own deal for their capital infusion and the advisor and general partner also declaimed control.

The IRA: Is there possibly a transaction template that passes the regulatory sniff test, but also has some safety and soundness backup? Could these funds agree to put in money today but also have a backup commitment to satisfy "source of strength" concerns?

Patrikis: It is not clear to me that funds are going to want to commit to put in additional capital or put in the amount of capital sought by the supervisor in the future.

The IRA: So, going back to square one, is it accurate to say that the Fed and other regulators have the leeway to adjust the rules regarding investments in banks?

Patrikis: Yes. The point we're at now is discovering how much wiggle room exists in current practice and regulation. The longer it takes for the Fed's staff in Washington to promulgate new rules and clarify some of these issues, the more difficult it is going to be for investors to navigate these issues.

The IRA: But surely, with the FDIC preparing itself for a large increase in the number of bank insolvencies, the Fed staff must be gearing up to process and approve a large number of control applications. When you see articles about the Fed's bank control rules in newspapers, does not this suggest that the issue is ripe?

Patrikis: I think that the pressure is already on the Fed to act.

The IRA: On the issue of a BHC being a "source of strength" to its subsidiary banks, can the Fed actually compel the shareholders of a BHC to put more money into an undercapitalized institution?

Patrikis: The "source of strength" doctrine applies to BHCs, and it is law, and it has been litigated extensively. It only applies to those companies who have "control."

The IRA: So does this mean that the Fed can actually raise cash or simply threaten to take over the bank units of the BHC?

Patrikis: The Fed cannot takeover a bank subsidiary of a bank holding company. The Fed can compel control parties to inject additional capital into the bank. That's why what the FDIC has required with respect to ILCs is like a "mini" source of strength doctrine, but not full blown.

The IRA: So the Fed has the power to compel control parties to recapitalize a BHC?

Patrikis: Yes, compel here means cease and desist order from the Fed.

The IRA: This may be the real gating item for investors. No fund manager wants to be forced to raise cash at a time not of their choosing. That could be very ugly for them and their investors.

Patrikis: But that is precisely what the Fed wants from control parties.

The IRA: How do you view the progress made by banks to raise funds?

Patrikis: I have been impressed by the ability of firm's such as Merrill Lynch (NYSE:MER), Citigroup (NYSE:C) and others to raise large amounts of funds over the past few months. That suggests that there are investors out there who see value in commercial and investment banking. Maybe after we come out of all of this trouble, there will be a better pricing of risk, and banks will become more profitable. One of the things I learned working at AIG in the property and casualty business is that, when competition increases substantially and premiums dropped too low to cover potential claims, we stopped writing business. We were willing to let our competitors take those losses.

The IRA: Right, that's how you correct the market; you just say no.

Patrikis: But will banks do that? Have they learned the lesson that at some point when the risk is not priced correctly that you just stop? The question now is what happens if the investors in a bank or BHC just walk away. This is something that the FDIC is likely very concerned about, especially with small banks. If large banks fail, the FDIC can create a bridge bank and come up with a solution. If I recall correctly, the government ultimately made money on Continental Illinois. I hope that the New York Fed makes a sizable return on its Bear Stearns' credit. FDIC Chair Shelia Bair and Treasury Secretary Paulson seem to be raising the prospect of a bridge-bank-type mechanism for a systemic situation involving an investment bank.

The IRA: Well, we think the existing mechanisms for broker-dealer insolvency are more than adequate. The Bear rescue was and is political and opaque. One of our former Fed colleagues noted last week that the collateral backing the $30 billion loan by the FRBNY to the Maiden Lane LLC rescue vehicle set up to fund the Bear rescue is still carried at the last mark by Bear in March, hardly "fair value" under today's accounting rules. But the good news is that there are piles of cash sitting on the sidelines. We constantly hear from people who want to know if it is "time" to get back into financials. We are all of us conditioned to expect a medium-term bounce.

Patrikis: As long as people writing down are not writing off, then there is value remaining and the situation can turn for the better over time.

The IRA: Correct. If you have the capital to sit with the position, then life is good.

Patrikis: I assume that is why a number of companies have raised major amounts of capital. These firms may believe that these assets or transactions will be in the money over the long haul. It is just like LTCM. If I recall correctly, the firm's transactions were in the money over the long term. They just didn't have the capital to meet margin calls.

The IRA: But isn't that issue of capital precisely the point, namely that in an OTC market environment players like BHCs, banks, an LTCM, Bear Stearns, or even an AIG must have far more capital than in the past? Such a general rule suggests that the real ROE of these businesses is far lower than current Street estimates would leave observers to believe. Thus, yes, LTCM would have made money, but with a far lower ROE and RAROC than the players might have anticipated.

Patrikis: That is a question for directors of organizations and supervisors. And that is the question to me over the long haul, namely how does this industry make sufficient profit with how much required capital? What will be bank profitability over the long haul? Historically, banks have not been the greatest investments.

The IRA: No, indeed. Our work on bank profitability (See The IRA, "Talking About RAROC: Is Financial Innovation Good for Bank Profitability?").

Patrikis: The issue is how do we get bank profitability up? What is the game plan?

The IRA: Good questions. We'll leave it there Ernie. Thanks.

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