The Fed Is Banking on Hedge Funds, But Merrill Lynch Can't

The Wall Street Journal's “Fed May Give Private Equity More Leeway to Help Banks” reports that Federal Reserve officials have met with J.C. Flowers, Carlyle Group, Kohlberg Kravis Roberts and Warburg Pincus. Not unknown to panic, Bernanke’s Fed now wants to encourage private equity to play a bigger role in funding bank recapitalization. Private equity does not want the oversight incurred with a 10% or greater investment.

Former Fed Chairman Greenspan fought hard to keep Congress and the SEC off the backs of private equity and hedge funds. Now Bernanke has to go one step further to get them to play ball. Under current law, a stake greater than 9.9% incurs regulatory oversight to insure the stake holder is not exerting control. Equity holders above a 24.9% stake must register as bank holding companies. The current compromise is that the Fed determines control by the number of Board seats, generally limiting a 10% plus stakeholder to one seat.

The funds have generally acted in concert with other large investors to ease the regulator burden. Now the Fed is concerned that the other investment pools are drying up, and wants to know what would be needed to motivate greater private equity participations. The Journal says the funds want total control without government supervision into their other affairs. It looks like Bernanke will continue Greenspan’s policies and be as accommodating as possible.

TPG led an investment group putting $7B into Washington Mutual (WM) and Corsair Capital led an investment group putting $7B into National City (NCC).

The related Journal article “Merrill's Hard Decisions” reports that Merrill Lynch (MER) must make its prior investors whole if it sells common stock at a lower price, or sells preferreds that convert to common at a lower price. Participants in the most recent $12B capital raising round would be entitled to cash or stock compensation. Given the recent collapse in Merrill share price, this provision would be quite dilutive. I believe that WaMu and National City face the same provision. These price protection provisions last 12 to 24 months, depending on the deals and participants.

The Journal implies that each bank’s round two will have to rely on asset sales. UBS (UBS) was first up, selling a $22B block of mortgages for $15B. Unfortunately, they also had to finance most of the deal. Merrill is better positioned with a 20% stake in Bloomberg and a 49% stake in BlackRock (BLK) available. Those two could be worth up to $18B. Lehman (LEH) announced asset sales during its conference call, and Citigroup (C) is also shrinking its balance sheet.

The Fed might be more concerned with the smaller regional banks that have not yet hit the trough. How can BankUnited (BKUNA) raise $400M without giving up control, when its stock price is hovering around a dollar?

Disclosure: Author is long BKUNA, C, NCC, UBS and WM. (All the junk!)

Comments

[Richard Wendling]

These are all good points but don't forget to think about the destreuctive force that the specialists who run each of these issues can put upon the stocks listed above. For more information on how they apply this pressure and also my thoughts about some of the issues listed above click on my website and read the free reports and corresponding specialist system information. It will cost you nothing except the amount of time it takes you to read the articles.

Thank you

Richard

[PrudentMan, CFA]

Sooner rather than later, the investment community, Wall Street, the Banking Industry, Congress and the Fed better understand we are in the 21st Century and the brokerage/investment banking model is dead and should be buried. Who needs them in the cyberworld?

[PrudentMan, CFA]

Forgot to add: The NYSE Specialists are petitioning for a five cent spread. Talk about chutzpah! These Neanderthals should get a real job. Their argument is they can't make orderly markets as if they ever did. The fact is they want take a bigger piece of the risk-less pie.

[mythoughts]

I thought most stock trades were electronic matching: who has what to sell and who wants to buy over the internet. My brockerage firm acts this way. They get instant stock prices without going through specialist.

[johnhaskell]

Of the stocks listed above the worst performing is easily BKUNA. And who is the specialist for BKUNA? That's right, it's NASDAQ and doesn't have a specialist. I'm sure the NYSE listed names above would like to be down 95% over the past 12 months like BKUNA. Darn specialists!

What's even more interesting than the stock performance of C, NCC, WM, BKUNA etc is the frenzied excuse making and conspiracy theorizing that so much of the investment community indulges in rather than acknowledge that they backed incompetent management.