Billions in Bank Rescue Funds are Fueling Buyouts, Instead of Lending

While the Treasury Department’s investment of more than $250 billion in U.S. financial institutions has been billed as a strategy that will bolster the health of the banking system and also jump-start lending, buyout deals such as these three show that the recapitalization plan has actually had a much different result – one that’s left whipsawed U.S. investors and lawmakers alike feeling burned.

Bank of American Corp. (BAC), which is getting $15 billion from the U.S. government as part of the Treasury Department’s $250 billion "recapitalization" effort, is doubling its stake in state-owned China Construction Bank Corp., and will hold a 20% stake worth $24 billion in China’s second-largest lender when that deal is finalized.

PNC Financial Services Group Inc. (PNC), which will get $7.7 billion from 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. (NCC).

And U.S. Bancorp (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. (DSL), and PFF Bank & Trust, a subsidiary of PFF Bancorp Inc. (OTC: PFFB). U.S. Bank 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.

While the Treasury Department’s investment of more than $250 billion in U.S. financial institutions has been billed as a strategy that will bolster the health of the banking system and also jump-start lending, buyout deals such as these three show that the recapitalization plan has actually had a much different result – one that’s left whipsawed U.S. investors and lawmakers alike feeling burned.

Those billions have touched off a high-level game of "Let’s Make a Deal," in which the biggest U.S. banks are using government money to get even bigger – admittedly removing the smaller, weaker banks from the market. And it’s also reduced the competition that’s benefited consumers and kept the explosion in banking fees from being far worse than it already is.

This all happens without any of the economic benefits that an actual increase in lending would have had. And it does nothing to address the billions worth of illiquid securities that remain on (or off) banks’ balance sheets – as this week’s Citigroup Inc. (C) imbroglio demonstrates.

In fact, 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, while causing investor confidence to do the same.

One could even argue that since this first bailout wasn’t really designed to fuel takeovers and not to free up credit, the government had to roll out the $800 billion plan announced Tuesday – a move that adds still more debt to the already-sagging U.S. 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 expert on the U.S. credit crisis who is the editor of the Trigger Event Strategist, which identifies trading opportunities emanating from financial-crisis "aftershocks."

"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 asked. "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 to that question would be … nothing."

In launching TARP, U.S. Treasury Secretary Henry M. "Hank" Paulson Jr. said the government’s goal was to restore public confidence in the U.S. financial services sector – especially banks – so private investors would be willing to advance money to banks and banks, in turn, would 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. "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 in order to remain competitive."

Indeed, they’ve been quite open about it during conference calls related to quarterly earnings, or in media interviews.

Take BB&T Corp. (BBT). During a conference call that dealt with the bank’s third-quarter results, Chief Executive Officer John A. Allison IV 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 the bank would likely accept the money in order to finance its expansion plans, The Wall Street Journal said.

"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]," Allison said during the conference call.

And BB&T is hardly alone. Zions Bancorporation (ZION), a Salt Lake City-based bank that’s been squeezed by some bad real-estate loans, recently said it would be getting $1.4 billion in federal money. CEO Harris H. 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 Chief Financial Officer Doyle L. Arnold said any lending increase wouldn’t be dramatic. Besides, Arnold said, Zions will also 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."

With all the liquidity 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, although it took about three months longer for that to happen this year than it did a year ago.

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 Sept. 1, liquidity from the U.S. and U.K. governments has ignited record levels of financial-sector deal making.

According to Dealogic, government investments in financial institutions has reached $76 billion this year – eight times as much as in 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 (JPM) buyouts of The Bear Stearns Cos. and Washington Mutual Inc. (WAMUQ), for instance.

When it comes to identifying possible buyout targets, M&A experts such as 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 climes – and bring their assets along for the trip. Plus, the Southeast is largely un-penetrated by large national banks. An acquisition of a regional bank like SunTrust Banks Inc. (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 U.S. Tax Code actually gives big U.S. banks a potential windfall of as much as $140 billion, says Gilani, the credit crisis expert and Trigger Event Strategist editor. 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 $1billion 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 U.S.-based banks will be the main hunters. But The Takeover Trader’s Basenese says that even foreign banks will be on the prowl for cheap U.S. banking assets.

Basenese also believes that Goldman Sachs Group Inc. (GS) and Morgan Stanley (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 the best way to do that is to buy other banks, Basenese says.

"One thing [the wave of deals] does is to restore confidence in the sector," Basenese said. "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."


William Patalon III
November 26, 2008

"Until today or tomorrow, the typical turkey enjoyed a fairly decent life," commented our friend Nassim Taleb, in Zurich yesterday.

Yesterday, the stock market was quiet. The Dow ended up 36 points.

Oil held at $50. Gold too…it stayed right where it was, at $820 an ounce.

But the slaughterhouses and gold mints worked overtime.

"You can understand how fraudulent most economic analysis is," Nassim explained, "just by looking the life of the turkey. The animal is fed for 1000 days…and then it is killed. So, if you plotted out the turkey’s life on a chart, it would look great for 1,000 days…each day, the food arrived reliably, and each day, the turkey gained weight. The turkeys would look around and say they were enjoying growth and a bull market. Momentum investors would see it as an opportunity. The quants would run linear regressions on the data and prove that the risk was minimal. "

Ben Bernanke would describe the turkey’s life – with no setbacks – as the product of a "great moderation." Turkey stockbrokers would assure their clients that nothing had ever gone wrong in the turkey’s life. Turkey econometricians and theorists would come up with explanations for why the turkeys’ growth would continue forever and they’d pat each other on the back for having finally mastered the "turkey cycle." Turkey politicians would run for re-election on the grounds that they had helped create a better world. And turkey economists would project further weight gains…until the turkey was the size of a hippopotamus

Then, come Thanksgiving, and all of a sudden, something goes wrong. Alas, all the turkeys’ theories, models, and conceits were for the birds.

"Rare events can’t be modeled," Nassim continued. "Because they are too rare. You can’t get a statistically reliable sample. Alan Greenspan recently explained that he ‘had never seen anything like this before.’ Well, of course he had never seen it before. It never happened before.

"Because these events are so rare, they are also completely unpredictable…and usually much worse than you can expect. Like Thanksgiving Day for the turkey."

The turkeys are getting the axe…but they’re having some revenge: Americans are getting the axe too.

Unemployment is rising sharply…and tomorrow, when Americans sit down to their turkey dinners, they will be dining in houses worth about 18% less than they were worth a year ago. Not only are their houses worth less…their values are falling faster and faster.

There’s no sign of a bottom to the housing market. In some areas – Los Angeles, Miami, San Diego, and San Francisco – the loss in housing wealth already exceeds 26% from a year earlier.

But don’t worry, dear reader. Houses are not dot.coms. And they’re not turkeys. They won’t go to zero. And they won’t disappear.

Besides, they were never financial assets in the first place. They’re just places to live. If you’re happy with your house…you don’t care what its price is.

On the other hand, if you’re not happy with your house, this is the time to start looking around. Our guess is that house prices will go down another 20-30%. Then, you will be able to get houses at very reasonable prices.. Unless you want to live in Detroit – where you’ll be able to get a house at a remarkable price.

Meanwhile, the economy itself is sinking too. GDP faded in the 3rd quarter – down 0.5%. Most likely, the U.S. economy will begin walking backwards faster too. Which means…more businesses will fail…more people will be out of work…and those people with any money in their pockets will be very careful about how they spend it…

…which will, of course, make things worse.

All this is a natural, normal response to a credit bubble. It gets bigger and bigger – and then it blows up. Loans are made…and then they are collected. Mistakes are made…and then they are corrected. People do stupid things…and then they pay for them. People go mad on the way up…then, they go mad again on the way down. What could be simpler?

But if you think the feds are going to stand still and let something natural happen, you have not been reading the papers. They’re "pulling out all the stops" to try to prevent the correction. More below…

*** So far, the feds’ efforts have been futile. But we have little doubt that they will get the hang of it eventually. If there is one thing the feds can do it is inflate the money supply. Ben Bernanke stakes his reputation on it.

And here is Thomas L. Friedman explaining what is needed:

"…a massive stimulus program to improve infrastructure and create jobs, a broad-based homeowner initiative to limit foreclosures and stabilize housing prices, and therefore mortgage assets, more capital for bank balance sheets, and most importantly, a huge injection of optimism and confidence…"

Friedman is the voice of the masses. But the intellectuals agree. Bloomberg reports:

"’You want to do everything you can when you’re facing the threat of a deflationary breakdown of the economy,’ says Michael Feroli, a former Fed official who is now an economist at JPMorgan Chase & Co. in New York. He sees the central bank cutting the overnight lending rate to zero in January and holding it there throughout the year."

"Fed Chairman Ben S. Bernanke and Treasury Secretary Henry Paulson are being forced to pull out the stops because the extraordinary actions they’ve taken so far have failed to gain much traction. Credit markets are collapsing, stock prices are plunging and the world economy is sinking into a recession."

"The biggest mistake Obama could make," says Yale economist Jeffrey Garten, "is thinking this problem is smaller than it is. On the other hand, there is far less danger in over-estimating what will be necessary to solve it."

Yeah…go ahead and err on this side now…. Why not? You erred on the other side. That is about the depth and breadth of thinking on the issue – at least from the people who never understood what the problem was…and now offer to solve it.

And it was to one of these same hacks whom Obama has turned for his Secretary of the Treasury – Timothy Geithner. Here is another Hank Paulson. Unlike Hank, he did not work on Wall Street. Instead, he was supposed to be keeping an eye on Wall Street – as head of the New York Fed. "He was in the room," when all the bailouts and busts happened, said one Wall Street pro. AIG, Bear, Lehman, Citigroup – he was in on them all. And he was at least peeping through a keyhole when Wall Street was enjoying its wild party. He saw the deals go down…the leveraged debt…the private equity buyouts…the subprime razzle-dazzle…the quants…the bonuses.

We don’t recall a single word of warning. But then, he’s a young guy…maybe he’s learned something.

But we have a pretty strong hunch he’ll be at the Treasury Department not to further his education…but to play his role in the developing tragedy. He’s meant to try to stop the correction. Rather than examine his lines carefully to see if they really make sense…he’ll speak the speech given him. "Stimulus," he will say. "Protect jobs…save homes…avoid financial meltdown." he has heard them before. He will say them again. And why not? Almost everyone wants to hear them. They all want bailout. Almost everyone wants to be saved. Almost everyone wants to duck the bill collector…and stop the hangman.

We all have to play our roles, dear reader. We are all turkeys…waiting for the axe.

*** The way, for now, to avoid getting flattened by the Big Bang Bailout, soon to be ignited by Mr. Obama, is to buy gold. But how? This week, we got word that that Perth Mint has had to shut it doors.

This, from the Australian:

"FEARS of the unknown long-term effects from the global financial crisis have sparked a new gold rush.

"With retail and wholesale clients around the world stocking up on the precious metal, the Perth Mint has been forced to suspend orders.

"As the World Gold Council reported that the dollar demand for gold reached a quarterly record of $US32 billion ($50.73 billion) in the third quarter, industry insiders said the race to secure physical gold had reached an intensity that had never been witnessed before.

"Perth Mint sales and marketing director Ron Currie said the unprecedented demand had

forced the Mint to cease orders until January, with staff working seven days a week, 24-hour days, over three shifts to meet orders.

"He said Europe was leading the demand, with Russia, Ukraine, Middle East and US all buying — making up 80 per cent of its sales. One European client purchased 30,000 ounces for $33 million.

"We have never seen this before and are working right at capacity. And we are seeing it from clients in the shop buying one ounce, right up to 30,000 ounces from overseas clients," Mr Currie said.

"Robert Jaggard, manager of bullion and rare coins dealer Jaggards, said business had picked up strongly and he expected it to increase further.

"All around the world there has been a heavy run on physical gold and there is a shortage of supply," he said.

Until tomorrow,

Bill Bonner
The Daily Reckoning