On July 9, 2009, FDIC issued a notice of proposed Statement of Policy. The public comment period ends August 10, 2009 (go to http://www.FDIC.gov/regulations/laws/federal/notices.html if you want to file a public comment). The private equity firms have submitted their comments and obviously they don't like the FDIC proposal.

Our banking system is in dire need of new capital. Consider this: FDIC is forecasting as many as 500 bank failures in the near future. Pretty bad situation.

Private equity firms are just chopping at the bit to jump in to rescue the banking system - for the good of the country - hell no. These are potentially good deals - low distressed prices with huge FDIC subsidies. FDIC sold IndyMac Bank to a group of private equity investors back in January. Part of the deal included a Loss Share Agreement whereby FDIC would assume some the loses on a pool of risky loans.

FDIC and other regulators (except Office of Thrift Supervision) are rightfully suspicious about investments from private equity firms. But, the situation is so bad in the banking system FDIC has to do something. Private equity firms have already made some purchases of banks but structures of the deals have been such that more than one private equity firm is involved in the deal (as in the case of IndyMac Bank).

FDIC is reluctant to allow one private equity firm to acquire a controlling interest in a bank. Private equity firms by nature/structure are institutions that thrive on risk and high leverage. These are characteristics that are not well suited for a battered banking system. There are concerns about private equity firms using banks as their own ATM and leaving a mess for FDIC to clean up later if deals start tanking for the private equity firm.

JC Flowers & Co. is an example of a private equity firm that is hungry for government assisted bank deals. They lost out on the IndyMac Bank deal but that has not deterred them. J. Christopher Flowers runs JC Flowers & Co. Mr. Flowers bought a small Missouri bank in with his own money in September 2008.

But what makes JC Flowers & Co. interesting case is that this private equity firm owns a stake in a German bank called Hypo Real Estate. Hypo was declared insolvent earlier this year. The German government now owns 90% of this real estate bank after injecting more than 100 billion Euros into it.

JC Flowers & Co. fought this government takeover hard. The strategy for JC Flowers & Co. and other private equity firms is to buy banks at distressed prices, restructure the banks and sell the for a profit and obviously taking advantage of the government subsidies. But the strategy didn't work for JC Flowers in Germany. And there is big question whether this will work in the U.S.

FDIC is rightfully concerned about private equity capital. This from FDIC's public notice:

The FDIC has reviewed various elements of private capital investment structures and considers that some of these investment structures raise potential safety and soundness considerations and risks to the Deposit Insurance Fund (DIF) as well as important issues with respect to their compliance with the requirements applied by the FDIC in its decision on the granting of deposit insurance. The concerns center on the need for fully adequate capital, a source of financial and managerial strength for the depository institution, and the potential adverse effects of extensions of credit to affiliates.

FDIC's proposal includes the following:

1) Prohibition of "silo" structured funds to bid on distresses assets and liabilities. Private equity firms create and manage equity funds (Bank Buying Fund I, LP), which typically are limited partnerships or limited liability companies. "Silo" structure is referring to these funds that are typically closed funds - limited number of investors - and may not have any requirement for additional capital from investors. So, if there are problems and a bank is need of more capital but its owners are a "silo" equity fund theoretically this fund can simply walk away from the bank.

2) Required capital measured by Tier 1 leverage ratio - ratio of bank capital to its assets - of 15% and be held at this level for three years.

3) A three year holding period.

4) Full disclosure of ownership structure.

5) Required "Source of Strength" commitment from the private equity firm which is basically a guarantee that the private equity firm will not just walk away from the bank.

The private equity industry has submitted its formal comments to FDIC's proposal. The biggest sticking point (although they object to most of the proposal) for the private equity firms is the tier 1 leverage ratio requirement and the holding period. The Private Equity Council, an industry group, argued for a reformulate the capital requirement on a "Tier 1 common ratio" and a holding period of 18 months.

BTW, there are differences, not surprisingly, between how the Fed, OTS and FDIC are approaching private equity investments. Is this a potential problem? OTS has indicated that the door is wide open for private equity investors. The OTS, the primary regulator of federal savings associations, and the main regulator of the former Washington Mutual (WaMu).