While the Treasury Department’s noble investment of more than $250 billion in US financial institutions has been billed as a strategy that will bolster the health of the banking system, the real story shows that the ‘recapitalisation’ has actually had a very different result.
And it’s one that has left whipsawed US investors and lawmakers alike feeling burned.
For example, the US government dished out $15 billion to Bank of America (NYSE:BAC), which is using the money to double its stake in state-owned China Construction Bank Corp. When the deal is finalised, it will hold a 20% stake, worth $24 billion, in China’s second-largest lender.
Another example… PNC Financial Services Group Inc. (NYSE:PNC), which will get $7.7 billion from the Treasury’s Troubled Assets Relief Program (TARP), is using that cash infusion to help finance its $5.2 billion buyout of embattled National City Corp. (NYSE:NCC).
And yet another example… US Bancorp (NYSE:USB), which received a $6.6 billion capital infusion from that same rescue package, has acquired two California lenders – Downey Savings & Loan Association, F.A., a subsidiary of Downey Financial Corp. (NYSE:DSL), and PFF Bank & Trust, a subsidiary of PFF Bancorp Inc. (OTC:PFFB). US Bancorp agreed to assume the first $1.6 billion in losses from the two, but says anything beyond that amount is subject to a loss-sharing deal it struck with the Federal Deposit Insurance Corp. (FDIC).
Those billions have touched off a banking-sector version of “Let’s Make a Deal,” in which the biggest US banks are using government money to get even bigger. While that’s admittedly removing the smaller, weaker banks from the market – a possible benefit to consumers and taxpayers alike – this trend is also having a detrimental effect: It’s reducing the competition that has benefited consumers and kept the explosion in banking fees from being far worse than it already is.
And this all happens without any of the economic benefits that an actual increase in lending would have had. Plus, it does nothing to address the billions worth of illiquid securities that remain on (or off) banks’ balance sheets – as the recent Citigroup Inc. (NYSE:C) imbroglio demonstrates.
The treasury triggers an unintentional buyout binge
In fact, the Treasury’s TARP program has even managed to create a potentially illegal tax loophole that grants banks a tax-break windfall of as much as $140 billion. Lawmakers are furious – but possibly powerless, afraid that a full-scale assault on the tax change could cause already-done deals to unravel, which would cause investor confidence to do the same.
One could even argue that since this first bailout (the $700 billion TARP initiative) has fueled takeovers – and not lending – the government had no choice but to roll out the more-recent $800 billion stimulus plan, aimed at helping consumers and small businesses. It’s a move that may spur lending and spending, but still adds more debt to the already-sagging federal government balance sheet.
At the end of the day, these buyout deals are bad ones no matter how you evaluate them, says R. Shah Gilani, a retired hedge fund manager and editor of the Trigger Event Strategist, which identifies trading opportunities emanating from such financial-crisis “aftershocks” as this buyout binge.
“Why in the name of capitalism are taxpayers being fleeced by banks that are being given our money to grow their businesses with the further backstop of more of our money having to be thrown to the FDIC when they fail?” Gilani asks.
“Consolidation does not mean that bad loans and illiquid securities are somehow merged out of existence. It means that they are being acquired under the premise that a larger, more consolidated depositor base will better be able to bear the weight of those bad assets. What in heaven’s name prevents depositors from exiting when the merged banks continue to experience massive losses and write-downs? The answer is… nothing.”
With consolidation poised to accelerate, banks are lining up for deal money
In launching TARP, US Treasury Secretary Henry Paulson said the government’s goal was to restore public confidence in the US financial services sector – especially banks. In turn, private investors would be willing to advance money to banks, which would then be willing to lend.
“Our purpose is to increase the confidence of our banks, so that they will deploy, not hoard, the capital,” Paulson said.
Whatever Treasury’s actual intent, the reality is that banks are already sniffing out buyout targets, while snuffing out lending – and the TARP money is the reason for both.
Fueled by this taxpayer-supplied capital, the wave of consolidation deals is “absolutely” going to accelerate, says Louis Basenese, a mergers-and-acquisitions expert, who is also the editor of The Takeover Trader newsletter. He says, “When it comes to M&A, there’s always a pronounced domino effect.’ Consolidation breeds more consolidation, as industry leaders conclude they have to keep acquiring to remain competitive.”
Indeed, banking executives have been quite open about their expansionist plans during media interviews, or during conference calls related to quarterly earnings.
Take BB&T Corp. (NYSE:BBT). During its third quarter conference call, CEO John Allison said the Winston-Salem, N.C.-based bank “will probably participate” in the government program. Allison didn’t say whether the federal money would induce BB&T to boost its lending. But he did say, “We think that there are going to be some acquisition opportunities – either now or in the near future – and this is a relatively inexpensive way to raise capital [to pay the buyout bill].” The Wall Street Journal says BBT willlikely accept the money in order to finance its expansion plans.
And BB&T is hardly alone.
Zions Bancorporation (Nasdaq:ZION), a Salt Lake City-based bank squeezed by some bad real-estate loans, recently said it would be getting $1.4 billion in federal money. CEO Harris Simmons said the infusion would enable Zions to boost “prudent” lending and keep paying its dividend – albeit at a reduced rate.
Sounds good, right? Not so fast. During a conference call about earnings, Zions CFO Doyle Arnold said any lending increase wouldn’t be dramatic. He also said Zions will use the money “to take advantage of what we would expect will be some acquisition opportunities, including some very low risk FDIC-assisted transactions in the next several quarters.”
Worldwide deal-making already in the fast lane
With all the liquidity that the world’s governments and central banks have injected into the global financial system, the pace of worldwide deal making is already accelerating. Global deal volume for the year has already passed the $3 trillion level – only the fifth time that’s happened.
At a time when the global financial crisis – and the accompanying drop-off in available deal capital (either equity or credit) – has caused about $150 billion in already-announced deals to be yanked off the table since September 1, liquidity from the US and UK governments has ignited record levels of financial-sector deal-making.
According to Dealogic, government investments in financial institutions have reached $76 billion this year – eight times as much as all of 2007, which was the previous record year. And that total doesn’t include the $250 billion in TARP money, or other deals that Paulson & Co. are helping engineer – JPMorgan Chase & Co.’s (NYSE:JPM) buyouts of The Bear Stearns Cos. and Washington Mutual Inc., for instance.
If you can’t beat ’em… buy ’em?
When it comes to identifying possible buyout targets, M&A experts like Louis Basenese say there are some very clear frontrunners.
“I’d put regional banks with solid footprints in the Southeast high on the list, and for two reasons,” Basenese said. “First, demographics point to stronger growth [in this region] as retirees migrate to warmer climates – and bring their assets along for the trip. Second, the Southeast is largely un-penetrated by large national banks. An acquisition of a regional bank like SunTrust Banks Inc. (NYSE:STI) would provide a distinct competitive advantage.”
There’s a very good reason that smaller players may be next: Big banks and small banks have the easiest times – relatively speaking, of course – of raising capital. It’s toughest for the regional players. Big banks can tap into the global financial markets for cash, while the very small – and typically, highly local – banks can raise money from local investors.
The afore-mentioned stealthy shift in the US Tax Code actually gives big US banks a potential windfall of as much as $140 billion, says Gilani. What does this tax-change do? By acquiring a failed bank whose only real value is the losses on its books, the successful suitor would basically then be able to use the acquired bank’s losses to offset its own gains and thus avoid paying taxes.
“While everyone was panicking, the Treasury Department slipped through a ruling that allows banks who acquire other banks to fully write-off all the acquired bank’s bad debts,” Gilani says. “For 22 years, the law was such that if you were to buy a company that had losses, say, of$1 billion, you couldn’t just take that loss against your own $1 billion profit and tell Uncle Sam, Gee, now my loss offsets my profit, so I don’t have any profit, and I don’t owe you any tax.’ It was a recipe for tax evasion that demanded an appropriate law that only allows limited write-offs over an extended period of years.”
Given these incentives, who will be doing the buying? Clearly, the biggest US-based banks will be the main hunters. But Basenese says that even foreign banks will be on the prowl for cheap US banking assets.
Basenese also believes that Goldman Sachs Group Inc. (NYSE:GS) and Morgan Stanley (NYSE:MS) will be “big spenders.” Each will use TARP funds to help accelerate its transformation from an investment bank into a bank holding company. The changeover will require each company to build up a big base of deposits. And Basenese says the best way to do that is to buy other banks: “One thing [the wave of deals] does is to restore confidence in the sector. It will go a long way in convincing CEOs that it’s safe to use excess capital to fund acquisitions, and to grow, instead of using it to defend against a proverbial run on the bank.”
Not everyone agrees with that assessment. Investors who play the merger game correctly will do well. But the game itself won’t necessarily whip the industry into championship form, Gilani says.
“While consolidation, instead of outright collapses, in the banking industry may serve to relieve the FDIC of its burden to make good on failed banks, it in no way guarantees fewer failures,” he said. “In fact, it may only serve to guarantee, in some cases, even larger failures.”
• This article was written by William Patalon III for the Smart Profits Report.