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As More Banks Fail, Private Investors Gaining Favor

With the toll of bank failures surging, regulators are expected Wednesday to ease rules they proposed only last month for private investors seeking to buy failed institutions.

Private equity funds have been targets of criticism in recent years for their risk-taking and outsized pay for managers. But the depth of the banking crisis appears to have softened the Federal Deposit Insurance Corp.'s resistance. In part, that's because fewer banks are now willing to buy other, ailing institutions.

In July, when bondholders rescued commercial lender CIT Group, it marked the first time since the crisis erupted last fall that private investors had saved a big financial firm without federal aid or oversight.

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Rising loan defaults, fed by tumbling home prices and worsening unemployment, have hammered banks. Eighty-one have failed so far this year. The closings have drained billions from the FDIC deposit insurance fund, which insures regular bank accounts up to $250,000 and is financed with fees paid by U.S. banks.

The FDIC estimates bank failures will cost the fund around $70 billion through 2013. The fund stood at $13 billion -its lowest level since 1993 -at the end of March. It's slipped to 0.27 percent of insured deposits, below a congressionally mandated minimum of 1.15 percent.

The FDIC seizes failed banks and seeks buyers for their branches, deposits and soured loans. Under the crush of failures, the agency says private equity can inject vitally needed capital into the system, especially with fewer healthy banks looking to acquire failed institutions.

"There's an enormous need for private money to do this," said Josh Lerner, a professor of finance at Harvard Business School. "There's the sense that you have a lot of money which is currently sitting on the sidelines."

A potential "sweet spot" for private equity buyers are banks with $5 billion to $20 billion in assets, said Chip MacDonald, an attorney at Jones Day in Atlanta. Falling within that range was BankUnited FSB, a Florida thrift with $12.8 billion in assets that closed in May. BankUnited was sold for $900 million to a group of private equity investors that included billionaire Wilbur Ross' firm, without the new FDIC policy being in effect.

Private equity firms tend to buy distressed companies, slash costs and then resell them a few years later. They invest their own capital to buy a company and pump it up with money from other investors.

Such "leveraging" to buy companies amounts to, on average, three-to-one for private equity firms: They invest $3 in outside capital for each $1 they put up themselves. The roughly 2,000 private equity firms in the U.S. have around $450 billion in capital to invest, according to the Private Equity Council, the industry's 2-year-old advocacy group.

Investors in private equity funds include pension funds, university endowments and charitable foundations. Organized labor still denounces private equity as vultures and job-killers. Unions got a sympathetic ear from many Democrats in Congress in 2007, when several key lawmakers pushed to raise taxes for managers of private equity firms as well as hedge funds. That tax campaign stalled.

The private equity industry is exploiting the economic crisis to enrich itself, said Stephen Lerner, director of the private equity project at the Service Employees International Union. "They are trying to use their political and financial sway to get into what they see as bargain basement prices for very little risk."

But with the financial crisis and recession causing banks to fail at the fastest pace since the height of the savings-and-loan crisis in 1992, support is building among regulators to use private equity money to bolster the industry.

"We want nontraditional investors," FDIC Chairman Sheila Bair said in early July, when the agency proposed its rules. "There is a significant need for capital, and there is capital out there."

When the FDIC board meets in a public session Wednesday, it's expected to ease restrictions, people familiar with the issue say. They spoke on condition of anonymity because the rules haven't been made public in final form yet.

Regulators also have begun to reach overseas. On Friday, the FDIC seized Guaranty Bank, a big Texas lender, and sold most of its operations to the U.S. division of Banco Bilbao Vizcaya Argentaria SA , Spain's second-largest bank. Guaranty was the second-biggest U.S. bank to fail this year, with about $13 billion in assets. Its sale marked the first time during the crisis that a foreign bank had bought a failed U.S. institution.

In the FDIC policy as proposed, the most important requirement is for private equity investors to maintain enough cash in the banks they acquire, as measured by its capital leverage ratio. The ratio is a measure of health, reflecting a bank's capital divided by its assets.

Investors would have to maintain a ratio of at least 15 percent for three years. Most banks have ratios lower than that. Citigroup , for example, had a reported ratio of around 9 percent as of June 30. The mandate could be reduced to 10 percent or lower in the final rules, the people familiar with the issue say.

A private equity role in the FDIC's resolution of failed banks would be in addition to private investors' participation in a Treasury program to buy banks' bad mortgage-backed assets. That program is intended to relieve banks of up to $40 billion of these assets, whose value plummeted with real estate prices.

But some analysts question whether this program will provide much benefit. Rising unemployment and loan defaults appear to have surpassed soured bank securities as threats to the financial sector.

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