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Wall Street’s Next Big Trade…

Posted by Larry Doyle on January 4, 2009 7:45 AM |

Secretary of the Treasury Henry Paulson has become a household name over the course of 2008. Paulson has been roundly criticized for his mixed messages and inconsistent use of funds from the $700 billion TARP (Troubled Asset Repurchase Program).

While most of us have seen more of Henry than we would have ever cared, allow me to introduce you to another Paulson. John Paulson (no relation to Henry) is one of the most highly acclaimed and profitable hedge fund managers on Wall Street. While investment banks, hedge fund managers, and most asset managers were investing in and promoting sub-prime mortgages and the like, John Paulson was “going the other way.” In 2006, he started shorting sub-prime originators, the ABX (the CDS index that tracked the sub-prime market) and the investment banks that most heavily trafficked in this sector. He personally and the investors in his fund made tidy fortunes in the process.

The reason for my introducing you to John Paulson at this juncture is because he wants to enter the world of community banking. One may wonder why a titan from Wall Street would want to enter into the world of regional and community banking.

This past summer, the first large bank to fail was Indymac Bank located in Pasadena, CA. Since then there have been another 24 banks that have failed with another 200 on the FDIC “watch list.”

Enter John Paulson, along with J.C Flowers of private equity shop J.C Flowers and Co., and Steve Mnuchin from hedge fund Dune Capital. Paulson, Flowers, and Mnuchin are about to purchase Indymac. Flowers already took a controlling stake in a small community bank in Missouri. By the end of Friday, none other than George Soros and Michael Dell were also part of the consortium purchasing Indymac. With a group as high profile and diverse as this, do you think they are getting a fabulous deal?

What do these transactions give them? Well, what does any hedge fund or private equity shop want? Cheap funding, a strong backer that will absorb losses, a bigger balance sheet, and a source of cheap assets. Indymac Bank provides cheap funding from the consumer deposit base (savings and checking accounts paying very little and CDs paying 2-3%). Indymac Bank has a strong backer in the form of the U.S. government that will agree to underwrite a significant percentage of non-performing assets. This loss sharing technique was widely utilized in the S&L meltdown in the late ’80s and will very likely be used again. Indymac Bank has cheap assets currently on its books but also can utilize its balance sheet to buy more cheap assets as it lays off unwanted assets onto ………the U.S. government!!

What do these hedge fund and private equity fund managers bring to the equation? Capital and an expanded balance sheet, both of which are desperately needed by our banking system currently.

Why have banking regulators, the FDIC and the Office of the Comptroller of the Currency, been reluctant to engage these companies and others like them in the purchase of failed institutions? I mean, this is the essence of capitalism and risk taking, correct? Shouldn’t these purchases be promoted? Even our highly respected analyst Meredith Whitney has been recommending that federal funds be directed toward smaller regional and community banks. Won’t these transactions help accomplish that? Not necessarily!! My concern, and it has been shared by the regulators to this point, is that these hedge fund and private equity managers will not promote the core mission of community lending at these banks.

Hedge fund managers and private equity investors are primarily focused on return on capital without the obligations of traditional banking. How do they most effectively achieve that? Cut expenses and overhead as aggressively as possible. In my estimation, they would just as soon have an online bank with little to no infrastructure. Utilize adverse selection in terms of assets at these banks that they will retain. Adverse selection is simply the process of cherry-picking the existing portfolio. The government will certainly end up with the dregs. Grow the portfolio not through lending but via the purchase of illiquid assets already in the marketplace which have expected returns higher than those on traditional lending.

Another concern is the potential conflict of interest in the bank activities versus the ongoing investment activities at the hedge fund and private equity fund. If there is ever a situation screaming out for aggressive regulatory oversight it is the entry of these buyers into the banking business.

Again, I am a strong and steady proponent of free and open markets in which private capital has an opportunity to take risk to generate returns. I welcome and applaud the government for the willingness to deal with “new money” but I hope that strong and demanding regulators are reviewing this operation regularly. We need to make sure these new buyers know how to “play nice in the local sandbox.”

Read more about this deal and how the rough and tumble world of hedge funds and private equity wants to “come to a town near you” in the WSJ article: Soros, Dell Join Flowers in Purchase of IndyMac.

I thought it may also be helpful to provide a link which highlights all of the banks in our country. This list comes from the FDIC and ranks, in descending order, the risk embedded in these banks as measured by their troubled credits utilizing the Texas Ratio, which is determined as follows:

100 * ((non-performing assets – U.S. gtd loans) + other REO (real estate owned)) / (equity + loss reserves)

The 95 banks with a ratio higher than 100 are considered to be in very serious danger of collapse. Well worth a look!! Additionally those banks with very low ratios may be a great place to start for those looking to make equity investments. Check it out at: LewRockwell.com

I have to believe that Messrs. Paulson, Flowers, Mnuchin, Soros, and other hedge fund and private equity managers are already booking travel plans!!!

LD






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