On Wall Street: Banks no longer so lucrative - Private equity unable to find much else to buy

On Wall Street: Banks no longer so lucrative - Private equity unable to find much else to buy
By Henny Sender
Copyright The Financial Times Limited 2009
Published: July 3 2009 19:52 | Last updated: July 3 2009 19:52
http://www.ft.com/cms/s/0/8fe706f4-67fa-11de-848a-00144feabdc0.html


The planned merger of two Japanese banks is the latest unhappy chapter in the 10-year saga of foreign private equity capital’s adventure in Tokyo finance.

The two banks, Shinsei and Aozora fell into the hands of Ripplewood and Chris Flowers and Cerberus Capital Management respectively at what appeared to be close to the end of the country’s lost decade. The two purchases came after the Ministry of Finance was unable to find any domestic buyers for the two ailing institutions. Ten years on, the two are still not healthy. Both got into trouble like many of their US peers by straying into investments that promised high yields with seemingly low risk, whether junk bonds that proved worthless for Shinsei or a piece of GMAC in the case of Aozora. It has been easy for both banks to stray from the banking business in Japan in recent years because they lacked a broad base of cheap funding from deposits and they never became the go-to source of loans for corporate Japan.

Now private equity is an eager if frustrated buyer of troubled banks in the US and one of the few sources of fresh equity for a sector that desperately needs capital. US authorities are as paranoid as their Japanese peers of these would be owners’ intentions and intend to impose onerous requirements, (which may or may not prove very burdensome) on private equity. At the same time, regulators also intend to impose all sorts of constraint on the banks and limit the degree of leverage all banks are allowed, which will likely lead to lower profitability.

Given all the new shackles, why would anybody want to own a bank these days?

Partly because, in spite of the new constraints, banking ought to be the most simple, guaranteed profitable business under the sun. Moreover, during hard times, the Fed tries to help banks support the economy by providing cheap funds that the owners then turn round and lend at a guaranteed spread over what they paid for the funds. Owners essentially get to control the profit level by deciding how much money to tuck away for a rainy day in the form of loan loss reserves.

Also, for private equity, these days owning a bank is particularly attractive because there isn’t much else to buy, for the simple reason that there isn’t much debt around. Banks are innately leveraged, making it possible to make decent returns even if the private equity firms have to put down a lot of their own money.

The desire to buy banks assumes a normal environment. But these days aren’t exactly normal economic times and there isn’t much new net lending. The authorities have been leaning on the banks to turn on the credit tap, but they are resisting. Why make a loan today when any signs of recovery are still fragile and a good loan today can turn bad tomorrow? And even if they wished to lend, there is little demand.

That is what happened in Japan. Merging Aozora and Shinsei will allow the two banks to cut some costs. Aozora’s strong capital base will help support Shinsei. But the combination will do little to address the underlying problems. That’s why rating agency Moody’s issued a sceptical report on the prospects of the latest incarnation of the two banks. “Moody’s notes that in light of each entity’s weak franchise and management, as well as their relatively weak financial fundamentals, there is a low probability of a prompt improvement in the merged bank’s competitive position and franchise,” the report stated.

In the last cycle in the US, 20 years ago, private capital made massive profits from the savings and loans crisis partly because the government took on the losses and partly because the buyers were able to ride the powerful upward momentum of a recovering economy. But this time, the recovery is likely to be far less robust. Demand can no longer be built on the sand of over-borrowing. Consumers, 70 per cent of the US economy, will have to finance purchases with their own money, not their bankers’. Private equity in the US, as in Tokyo, may end up with far less lucrative investments than they anticipate in any banks that they do succeed in acquiring.

henny.sender@ft.com