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Hedge Funds, Big Money Circle TARP's Weakest Banks

As Treasury moves to offload the majority of its remaining financial crisis-era bank bailout investments, it's fielding heavy interest from yield-starved money managers eyeing slices of some 200 of the program's weaker banks, according to people familiar with the matter.

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The scale of likely investors ranges from small, specialized hedge funds like Arlington, Va.-based EJF Capital and Sandler O'Neill Asset Management; to investing behemoths like PIMCO, Alliance Bernstein, and Wellington Management, these people said.

(Read More: Another Hedge Fund Veteran Throws in Towel)

The firms are looking at an obscure, but potentially lucrative, pool of some $2 billion in investments made through Treasury's Capital Purchase Program, a critical component of the Troubled Asset Relief Program (TARP) the government launched in 2008 to prop up faltering institutions during the financial crisis.

Auctions for groups of these 200 bank stakes are set to kick off in the upcoming months. A deadline for the crop's stronger banks to submit plans to "opt out" of the auction process passed earlier in the month, with roughly 80 institutions filing paperwork to do so, according to a person familiar with the matter. On Monday, Treasury began auctions on 11 of those "opt out" institutions.

At present, Treasury and its advisors continue to sift through those applications, which require banks either to submit plans to repurchase the stake itself, or designate a third-party buyer for the assets.

(Read More: Inside America's Economic Crisis)

Many, however, remain too small or too weak to repay on their own. Treasury will pool these companies and give investors an opportunity to bid on a package deal, which could incentivize buyers to shore up the smaller banks if they are coupled with and offset by stronger banks in the same pool.

Key to investors' interest: a hefty preferred stock dividend that skyrockets next year. Additionally, Treasury could sell investments at a discount, meaning investors could reap the difference if banks redeem in full.

Investments in these bailed-out banks would carry a yield of at least 5 percent annually, a rate that ticks up to 9 percent for a large number of these securities late next year if they remain unable to buy out the original loans. Thus, banks have an incentive before that happens to redeem the stake from third-party investors at par — which will be anywhere from 10 to 20 percent higher than Treasury's auction price, based on previous discounts.

As one source put it: "For investors who win these auctions, all roads lead to a premium."

Since the pool is comprised mostly of small, private, and in some cases troubled institutions, some investors worry that the collection of assets could carry inordinately high risks. Others worry Treasury could wind down the program too hastily, which could pose great harm to institutions already struggling to repay investments. While banks are not obligated to stay current on their dividend payments, for instance, any specter of a missed payment could cause the value of the investment to plummet, possibly incite reputational damage or, in the worst case scenario, a collapse, according to some advisers.

Former Treasury official Jim Millstein, now CEO at Millstein & Co., rebuffs those concerns, saying Treasury's exit plan is "thoughtful and deliberate" amid large profits from the big banks and, more important, intangible economic gains. "The losses associated with some of these investments are more than outpaced by the gains of restoring normalcy to the banking system," Millstein told CNBC.

While the slate of potential bidders may appear wide-ranging and arbitrary, some share a common characteristic: links to former Treasury officials.

Though PIMCO, the California-based investment firm with $1.8 trillion in assets under management, would likely be eyeing a potential investment as part of a fund specialized toward high-risk and high-return assets, the firm does have under its wing eel Kashkari — PIMCO's head of global equities, who ran TARP from 2008-2009. A PIMCO spokesperson did not respond to a request for comment nor to questions about Kashkari's role in the process.

(Read More: Few Bright Spots Among Stocks - PIMCO's Kashkari)

Spokespeople from Alliance Bernstein and Wellington declined to comment.

Sandler O'Neill Asset Management, a hedge fund with roughly $1 billion under management, has been an active participant in prior Treasury auctions. Sandler O'Neill's investment banking arm is currently a lead advisor on private placements of Treasury bank stakes, according to regulatory filings. While some of its investment banking partners do have an economic interest in the asset management unit, the two businesses remain siloed — with Treasury raising no red flags when potential conflicts of interest were addressed, people familiar have said.

A Sandler O'Neill spokesperson declined to comment.

All of Treasury's auctions are conducted publicly, and according to people familiar with the process, it does not pre-screen buyers.

While the giant money managers pose formidable competition, it appears that EJF Capital, though relatively unknown, could be in pole position to snap up many of these stakes. Its namesake is founder Emmanuel "Manny" J. Friedman, the father of Friedman, Billings, Ramsey. Friedman is cited in many Wall Street circles as having a keen eye for bank investments, but carries the dubious distinction of having been barred from brokerage firm supervision back in 2006 after being fingered in an SEC insider trading case.

Despite that reputational blow, Friedman's resurfaced as an éminence grise in the financial sector. In the years since the financial crisis, EJF's assets under management have swelled to $1.6 billion from $700 million, according to people familiar with the firm. Friedman has participated in multiple Treasury bank auctions in the past year, but is eyeing one-off negotiations with a "handful" of banks as an alternative to the more competitive auction process, people have said. (Read More: Ex-TARP Watchdog Unleashes on 'Monster' Banks)

Friedman's also getting good advice: People familiar with the matter say he's being advised by former Treasury official Sloan Deerin, now a senior banker at Compass Point Research & Trading. Deerin spearheaded the creation of Treasury's CPP (Capital Purchase Program) and, earlier this year, helped lay the groundwork for this round of asset sales.

Compass Point declined to comment about its role in the process. EJF's head of investor relations, when reached by phone, declined to comment, citing a no-engagement policy with members of the media.

For its part, Treasury has been widely credited as running an otherwise successful CPP program since its creation in 2008. The government has already lined up a tidy profit on its original $250 billion investment.

The process would help Treasury near the end of its bank investment program. Though some 90 banks will still have Treasury stakes, people familiar with the matter say the process even for those banks could be completely exited in the next 12 to 18 months.

-By CNBC's Kayla Tausche and Jesse Bergman
@KaylaTausche nd @JBergmanCNBC

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