As Investors Circle Ailing Banks, Fed Sets Limits

No one seems to want to own a business in this dusty, windswept corner of rural America, population 370, with its crumbling sidewalks and boarded-up storefronts.

Except, that is, for J. Christopher Flowers, a media-shy New York billionaire who last year bought the First National Bank of Cainesville, one of the United States’ smallest national banks.

Mr. Flowers, a private equity manager, has no particular love for rural Missouri; in fact, he has never set foot in Cainsville. Rather, he wants to use the national bank charter he picked up in this farm town to go on a nationwide buying spree.

With that charter in hand, Mr. Flowers plans to take over a handful of large struggling banks, casualties of the economic crisis. In some cases, he hopes, the federal government will help.

But Mr. Flowers, whose investments in banks overseas have made him one of the richest men in America, has run into a major obstacle in the United States: the Federal Reserve, and its very notion of what a bank should be.

The Fed does not mind if private equity firms have a minority interest in banks — the Obama administration even wants them to invest. But the Fed will not let them take control, a stance the firms are lobbying regulators mightily to change, especially given that stress test results to be released Thursday are expected to show a glaring need for capital in the banking system.

It’s not personal, Fed officials say. It’s just that as the nation recovers from one of the worst banking crises in history, the Federal Reserve wants to make sure that it does not set the stage for the next financial implosion by turning banks over to private equity firms, some of the riskiest players in the business world.

So while Mr. Flowers was able to buy the bank here with his own money, he cannot tap into the billions his firm, J. C. Flowers & Company, has raised.

How this battle — and others being fought in the aftermath of the economic crisis — plays out will help determine the future shape of the financial industry.

For all the talk of the banking crisis, Mr. Flowers and other giant private equity players are circling distressed banks around the country, competing to buy into the industry. Bidding wars are now breaking out among private equity firms, including the Carlyle Group, which is going up against Mr. Flowers’s firm for a stake in BankUnited of Florida.

They and other investors see banks as the recession’s biggest prize: potential money machines that could one day generate fabulous returns, particularly after the federal government eats the losses of failed banks, then heavily subsidizes their sale. But like Mr. Flowers, some of them would prefer to take over the banks completely, replace their managements and take all the profit.

“I don’t think the Republic is going to be brought to its knees if private equity owns banks, personally,” Mr. Flowers said from his Midtown Manhattan office with its expansive views of Central Park. “We invest around the world — Japan, Germany, England, no problem.”

The Fed is resisting this pitch, for several reasons. Current law prohibits mixing banking and commerce, based on a fear that if industrialists own banks, they will dominate — and try to manipulate — the economy, as they did during the early-20th-century heyday of John Pierpont Morgan.

The government also wants the ability to stabilize a teetering bank by drawing on the funds of its parent company. That is hard to do with private equity firms, which have numerous businesses owned by funds, each of which is walled off to protect investors.

For these reasons, banks generally cannot be owned by nonfinancial companies like the Carlyle Group, whose assets are as varied as an interest in Dunkin’ Donuts and United Defense Industries, a maker of combat vehicles and missile launchers.

The equity firms counter that banking desperately needs cash if the economy is going to recover, and that they are the only big sources of money around. An executive at the Carlyle Group said the industry had an estimated $400 billion in “dry powder,” or ready-to-invest reserves.

To push their case at the White House, the Treasury and the Fed, Mr. Flowers and others in his industry have enlisted an all-star cast of advisers, lobbyists and lawyers. They include H. Rodgin Cohen, chairman of the Sullivan & Cromwell law firm and Wall Street éminence grise, and Randal K. Quarles, a managing director of the Carlyle Group and a Treasury under secretary in the administration of President George W. Bush. Part of their strategy, Mr. Flowers said, is to persuade the Treasury secretary, Timothy F. Geithner, to pressure the Fed to back down.

“Chris is obviously a get-it-done type of person — and he wants to get this done,” said Mr. Cohen, who represents Mr. Flowers. “He believes, as I do, that it is unfortunate to deprive the banking system in the United States of this key source of capital.”

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While they press their case, the firms have found some ways around the rules.

They have formed so-called club deals, in which teams of private equity firms and other investors each buy up to the legal limit of a bank — about a quarter or a third, depending on the type of bank — with their individual pieces adding up to 100 percent control. IndyMac, the failed California bank, was sold by the Federal Deposit Insurance Corporation last fall to one such club, which includes funds controlled by Mr. Flowers; the hedge fund billionaires George Soros and John Paulson; and Michael S. Dell, founder of the Dell computer company. The investors are barred from acting in concert to, in effect, take control of the bank — an unwieldy arrangement but one that regulators insist they can enforce.

CONTINUED : "Grave dancers" can make a fortune.

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