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Should Hedge Funds Be Able to Take Over Failed Banks?

Hedge funds and other private investor groups are rarely allowed to buy troubled banks, mainly out of fear that they would try to turn the bank around and sell it for a quick profit.

But, as the financial crisis causes more banks to fail, the cash-strapped FDIC may be forced to back away from that longstanding policy as it scrambles to find buyers.

Last week, during a symposium, Federal Deposite Insurance Corp. Chairman Sheila Bair hinted at that possibility, saying, "We want to get a little more innovative."

But such a change poses a difficult challenge for Bair and other regulators—as well as elected officials—worried about the potential public backlash.

"Though they will allow people from outside the banking world into the bidding process if they are willing to conform to the rules, they don't want to particularly see hedge funds involved, " says William Isaac, a former FDIC chairman.

Distressed loan and investment adviser Bill Bartmann, CEO of Bartmann Enterprises, thinks it's slightly more political than that. "The FDIC is reluctant to incur political exposure during a time when the Senate is proposing rules on who will be in charge of future bank regulation and bank liquidation."

Up to now, IndyMac,the mortgage lender that collapsed in 2008, is the only failed bank sold by the Federal Deposit Insurance Corporation to an investment group resembling a hedge fund.

OneWest Bank Group, a privately-held thrift holding company led by hedge-fund manager and former Goldman Sachs executive vice president Steve Mnuchin, bought the assets of IndyMac for a reported $1.55 billion. A year later, the consortium of heavy-hitters, which includes investors George Soros and John Paulson, reported $1.6 billion in profits from the acquisition, according to the Office of Thrift Supervision.

But others haven't been able to crack the barrier.

Jason Ader, former Bear Stearns executive and Managing Principal at hedge fund Hayground Cove Asset Management, tried to acquire branches of Las Vegas-based Colonial Bank and 1st Commerce Bank last year.

But a tentative deal for sale of Colonial's Nevada operations to Ader's company, GlobalConsumer Acquisition Corp.,fell through. State and federal regulators seized Colonial Bank and, after nullifying the agreement with Global Consumer, the FDIC sold the deposits and loans to BB&T of Winston-Salem, N.C.

While Ader declined to comment, Bartmann says: "Public sentiment is anti-Wall Street (which translates to hedge funds—albeit they are remarkably different) and this has led to the FDIC telling some hedge funds 'not to bother' to apply for the opportunity to purchase a failed bank."

Isaac says: "If hedge funds come in to take over these banks and in two years flip it for a huge profit, that could be incredibly embarrassing for the FDIC. The FDIC is not interested in day traders—they are interested in long-term investors."

Though the FDIC may prefer to keep the assets and operations of failed banks all in the community, that policy may become an unrealistic expectation. Post-crisis, many big banks are still struggling to regain their footing and are in no position to buy up distressed assets.

Adding urgency to the situation is the FDIC's precarious financial position. In response to industry outcry against new fees approved by the agency, FDIC Chairman Sheila Bair admitted last year the insurance fund could dry up amid a surge in bank failures.

Bartmann says, "The FDIC is broke! The Deposit Insurance Fund has essentially $0—we are looking at perhaps $100 billion more losses over the next 3 to 4 years."

The FDIC soon plans to auction more than $1 billion in assets seized from failed banks and is eagerly trying to speed up efforts to unload assets of seized financial institutions.

With more than 700 banks on the FDIC "Troubled Bank List" and the possibility many of them could fail in the next 12 to 18 months, the FDIC may need additional help finding new owners.

The agency seems to be making more aggressive moves toward securing new bidders. Senior officials of the FDIC met with a wide variety of interested parties including pension funds, private investors and investment managers on March 23. They discussed possible revisions to the FDIC's current policy on the acquisition of failed banks (published September 2, 2009).

Among those in attendance were Allen Puwalski, Senior Vice President at Paulson and Co.; Robert Steel, former Wachovia CEO and Treasury Under Secretary for Domestic Finance; and Randal Quarles from Carlyle Group.

Randall Kroszner, former Federal Reserve Board Governor and Professor of Finance at the University of Chicago's Booth School of Business, thinks it isn't necessarily a bad idea to get the private sector more involved.

"Increasing capital at troubled depository institutions promotes financial stability and allows them to restart their lending," says Kroszner. "With appropriate safeguards, inflows of private capital can be part of this process."

After the event, FDIC Chairman Sheila Bair said, "Bringing responsible new investors into the banking system is an important step towards a strengthened banking system. In doing so, we must also make sure that new investment supports strong banking institutions for the long term."

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