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How Private Equity Firms Can Profitably Invest in Troubled Banks

Expert Witness: Don Coker
Private Equity firms can profitably invest in banks by injecting reasonable capital, engaging experienced, professional bank management, and prudently investing the bank’s funds in loans and other investments that make economic sense.

News Bulletin: The old banking model still works, if given a chance.

It is quite encouraging that I recently have received numerous calls from Private Equity (“PE”) firms and other investors wanting to buy troubled banks, and seeking either my advice on how to profitably run them, or wanting to hire me to run one for them the way that a bank should be run. In fact, considering what banking has been through in the last couple of years, it’s down right refreshing!

How is it that these people who only a short time ago were relying on alchemistic derivatives schemes and others that purport to guarantee
that no one ever loses are now getting some of that old time religion? Thank God for pendulums that swing and for cycles.

Running and restructuring troubled banks is a tough business, and I have been on the front lines several times, primarily hired by the banking regulators as a consultant and “army of one” to run insolvent banks and their wholly-owned mortgage banking companies.

At this point, allow me to cite for you verbatim the entire set of instructions that I was given by a much-older-than-me governmental banking regulatory deputy commissioner immediately prior to my first assignment as a governmental banking Regulatory Supervisory Agent during the mid-1980s-mid-1990s banking meltdown. As we stood in the parking lot of the insolvent bank, he put his arm around my shoulder in a fatherly way and said, “Son, go in there and run that son of a 'gun' the way a bank should be run.” (Notice that I have exercised my artistic license to clean up his language.)

And the funny thing was, I knew exactly what he meant! I knew how to run a bank, and he knew that I knew how to run a bank. No further instructions were needed. So I went in there and ran it the way that it should be run. After extensive organizational restructuring, financial restructuring, product realignment, staff adjustments, and many other required corrections, the result was that the bank was cleaned up to the point that it was merged into Norwest which soon became Wells Fargo. Not a bad outcome for an insolvent bank.

However, I must mention that there is another factor that has to be considered in a situation like this, and that is the old saying: “When one enters a chess game after the twelfth move, one makes the thirteenth move.”

Accordingly, you do not walk into an insolvent or troubled bank and simply sit down and start profitably banking without first dealing with some highly unusual factors. For example:

● Immediately (assuming you did not do so before accepting the job) examine all regulatory restrictions under which the bank is operating, and make sure that you are in compliance.

● Next, “Job One” is to stop the bleeding immediately. Look for and plug any expense leaks, revenue leaks, and any sources that are producing red ink. This is a major job, and not nearly as obvious and easy as you might think. You will find situations within the bank that everyone there assumes are SOP and okay, and many of them are just flat wrong. Ferreting out these problems is a good way to show the banking regulators that you have a handle on things, and that you are turning things around; and it gives them another reason to leave you alone and to go take down the next guy who is not dealing with his problems.

● Do a profitability analysis on every transactional product in the bank, such as all deposit account types, and all loan types. Dump anything that is unprofitable, even if it means reducing deposits or assets. Recognize that customers come and go and that it is stupid to take a loss on a product in order to “gain a customer” when the new customer will immediately jump ship as soon as your competitor offers him a ¼% more in interest on his CD or ¼% less in interest on his loan.

● Jump into the foreclosed properties and those in more serious stages of delinquency, and take corrective actions. Make sure that energetic marketing plans are underway for all properties of all types owned by the bank.

● Determine which officers and employees can help you and which ones are working against you. Impress upon all officers and employees that your success helps the chances of the continuation of the existence of the bank, and concomitantly, their jobs. If some continue to work against you, boot them out.

● Do a periodic GL scrub where you look at every item going in and out. You will be surprised how quickly you can identify problems that are obvious to you but commonly accepted by the bank’s staff.

● Require complete breakdowns on numbers that appear on financial statements. For example, break down the “Real Estate” heading and see if there are any surplus properties. Look at the “Miscellaneous Assets” as well. (Note: Once while doing this, I discovered a hunting lodge that the staff had been hiding from me.)

● Ask questions AND GET ANSWERS. Do not accept throwaway answers, incomplete answers, or answers that dodge the question. In a troubled financial institution (or corporate) situation, you do not have the luxury of allowing your officers and employees to play games with you. You will probably have to pare down some staff anyway, so start with these non-answerers.

Here are some simple Rules that will help you avoid many of the problems that bank managers have encountered recently:

1. Don’t originate stupid loans. Use your head. Make sure you actually have an excess of collateral value over your proposed loan amount, and make sure that the borrower has the income (now) to make the loan payments.

2. Don’t originate a loan that you would not want to retain in your own portfolio. Be a gatekeeper for the financial system, and make sure that only decent quality loans enter it.

3. Don’t make loans for the wrong reasons, such as: The borrower is financially irresponsible, but he is a relative, neighbor, buddy, golf buddy, lunch buddy, club buddy, hunting buddy, fishing buddy, church buddy, been in town a hundred years, etc.

4. Don’t extend an irresponsible borrower’s loan just because he is a relative, neighbor, buddy, golf buddy, lunch buddy, club buddy, hunting buddy, fishing buddy, church buddy, been in town a hundred years, etc.

5. Don’t hire someone just because he is a relative, neighbor, buddy, golf buddy, lunch buddy, club buddy, hunting buddy, fishing buddy, church buddy, been in town a hundred years, etc.

6. Make sure that you have a healthy spread (at least 3% minimum and hopefully more) between your cost of funds and your interest rates on your loans. (Note: I once worked for a CEO that believed in paying savers 13.5% interest and lending that money out at 8.5%, and people thought he was a genius. I thought he was an idiot. Soon afterwards, he was out of banking.)

The Question of Allowing Private Equity Firms to Buy Banks

Private equity firms have very astutely recognized the potential profits to be realized from acquiring and rehabilitating troubled banks in today’s economy. Every time one of these financial system meltdowns occurs, the handwringers declare that banks are toast and will not survive to be a significant part of the economy in the future. And every time, the handwringers have been wrong. Banks are essential to our economy; and if you look around the world, you will see that every strong economy has strong banks, and every weak economy has weak banks, or virtually no banks at all. Banks in the United States of America will survive and will thrive in our soon-to-be-rejuvenated economy,

It is my opinion that PE firms can inject significant capital funds that will make a positive contribution towards resolving many of the problems in banking today. Even today, there is apparently an incredibly large pool of funds available to be tapped for investment in, among other things, the acquisition of banks. (Don’t take my word for it on the large pool of funds, just ask Bernie Madoff.)

It is also my opinion that the banking regulators are justified in having some concerns about bank owners who have no experience at managing banks. Nevertheless, it is my opinion that it is erroneous for the banking regulators to place unrealistic capital, future funding, and cross-guarantee requirements on PE firms that acquire banks. Enacting these stringent requirements will certainly scare off a potential significant source of capital funds that can be used to recapitalize troubled banking institutions. Furthermore, enacting unreasonable requirements on PE firms that purchase banks is like punishing the guy that closes the corral gate rather than the one who opened it in the first place. Certainly there is some middle-ground position that will be acceptable to the PE firms and the banking regulators.

Having been through the previous banking meltdown in the mid-1980s to mid-1990s, it is my opinion that the banking regulators should welcome the entry of PE firms into the ownership and recapitalization of banks; but the banking regulators should make sure that the decision makers and the top management of each bank are not investment bankers and financial alchemists but rather are truly knowledgeable bankers that know how to run a bank the way a bank should be run. Increased capital, from PE firms and other sources, and competent management will be major steps toward the restoration of the health of our country’s banking system.

Don Coker is a heavily experienced financial institution management professional and former high-level governmental banking regulator who was previously chosen by the banking regulators to serve as an interim manager and in regulatory oversight positions. Based upon extensive experience and achievements in banking and lending at Citicorp and entities that are now Bank of America, JPMorgan Chase Bank, and Regions Financial, he was chosen to serve as the on-site supervisory regulatory agent interim manager for two insolvent financial institutions and two bank-owned mortgage banking institutions. Duties included the hands-on management of $1.8 billion (2009 USD) in assets including over $600 million in troubled assets, and participation in the review, restructuring, and recommendation of various recapitalization and merger plans.

Copyright Don Coker

Disclaimer: While every effort has been made to ensure the accuracy of this publication, it is not intended to provide legal advice as individual situations will differ and should be discussed with an expert and/or lawyer.For specific technical or legal advice on the information provided and related topics, please contact the author.

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