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The financial services industry has already seen an uptick in distressed mergers and acquisitions as institutions hobbled by the mortgage meltdown and credit crisis have been forced to find strategic partners. Now the U.S. Department of Treasury, through its Capital Purchase Program (CPP)—authorized by the Troubled Asset Relief Program (TARP)—seems poised to spur additional financial services industry mergers and acquisitions.
It has been a confusing journey with the Treasury Department to this destination. First, it made a massive shift in policy—from buying troubled loans to buying preferred stock of eligible banking institutions. Then, in less than a week, the Treasury Department offered three different rationales for the CPP.
While not mutually exclusive, these shifting goals fail to provide a clear rationale for the CPP and contribute to the debate over the effectiveness and purpose of TARP. Despite the criticism this has generated, the CPP now seems directed in significant part at getting healthier financial institutions to undertake acquisitions of weaker competitors.
CPP Positions Institutions to Acquire Weaker Competitors
Initially promoted as a means to stimulate new lending and encourage extension of more credit, the CPP morphed into a means of strengthening bank capital and facilitating interbank lending and depositor confidence.
It now appears however, that federal banking regulators and the Treasury Department are strongly encouraging "healthy" institutions to participate in the CPP—thus becoming better positioned to engage in acquisitions.
One institution participating in the program, PNC Financial, is using $7.7 billion in CPP funding to buy National City Corp., a troubled banking institution that was reportedly denied CPP approval. Even reluctant buyers in recent years like U.S. Bancorp and Wells Fargo have, with fresh capital, indicated greater willingness to look at acquisition deals. Well Fargo was among the original group of nine companies "encouraged" by the Treasury Department to participate in the CPP.
Given the added cost the FDIC insurance fund will bear if unhealthy institutions are forced to close, encouraging acquisitions is a reasonable objective. A stable of financially strong acquirers might also reduce the need for open bank assistance of the type initially contemplated by Citigroup in its proposed acquisition of Wachovia—and later foregone when Wells Fargo outbid it for the Wachovia deal.
CPP Approval Involves Assessment of Participant Strength, Long-Term Viability
While it is believed that CPP approval is based in some part on CAMELS ratings (non-public measure by regulators of a banking institutions financial and managerial strength) for eligible institutions, no one outside of government knows the methodology for sure. In order to participate, banking companies must first apply to their primary federal regulator for approval. That regulator then passes a recommendation to the Treasury Department. Banking companies that apply must identify and describe any mergers, acquisitions and other capital offerings that are pending or are under negotiation.
Approximately 30 institutions to date have indicted approval or preliminary approval of their participation in the CPP. These institutions have suggested a variety of potential uses for the TARP funds, including holding them as defense against unforeseen asset problems, drawing on them to increase lending, or using the funds to initiate an active acquisition program.
Disclosure of CPP Participation Left to Companies
Somewhat ironically, the current CPP approval approach may give the impression that institutions not taking program funds are somehow "unhealthy." In numerous instances, companies not in need of program capital have found it prudent to participate in order to preserve their healthy image—and take advantage of a relatively cheap and non-onerous capital infusion.
Recently the Treasury Department decided not to publish lists of unapproved applicant banking companies, leaving it to each institution to determine when and how to publicly disclose participation or non-participation in the CPP. The Treasury Department will, however, disclose a CPP approval within 48 hours of closing.
CPP Funds Intended for Lending, According to Some
Not everyone is happy about this potential use of funds for mergers and acquisitions. A number of congressional leaders have been vocal in their criticism of the use of CPP funds for anything other than lending. In their view, use for other purposes—or not using the funds at all—is completely at odds with the purposes of TARP. Barney Frank, chair of the House Financial Services Committee, has in fact, called use of the funds for any purpose other than lending a "violation of the terms of [TARP]."
Some have indicated that additional TARP funding beyond the initial $250 billion will carry more exacting limitations on how funds are used. There have also been veiled threats suggesting that if funds are not used in some measure for lending, future industry efforts to seek regulatory relief will not be warmly welcomed by Congress.
Although the CPP comes with many restrictions, nothing in the program guidelines limits the use of proceeds obtained through the CPP. However, recitals to the form purchase agreement to be used by the Treasury Department state, "The Company agrees to expand the flow of credit to U.S. consumers and businesses on competitive terms to promote the sustained growth and vitality of the U.S. economy." The binding nature of this recital is not clear.
The Treasury Department, for its part, has been reluctant to impose restrictions on how the money gets used given the already high level of governmental intervention. It has preferred to rely on the premise that to make money, institutions need to lend money.
In addition, economic weakness and the high-risk loan environment make some skeptical the issue of lending can be forced. After all, overzealous lending practices got financial institutions into this mess.
Whatever the formal restrictions may be, participating institutions can expect close scrutiny from regulators regarding how the money is spent. Bowing to public pressure, some bank recipients of CPP money have publicly vowed to make use of it for lending purposes.
Privately Held Banking Companies May Soon Be Eligible
To date, privately held banks have been left out of the CPP for two primary reasons. Privately held banks may be subchapter S or mutually owned and unable to issue the preferred stock security that is the heart of the CPP. In addition, CPP participants must issue warrants that are exercisable for common shares, which could—as the program is currently set up—end up in the hands of a large number of new shareholders. Since there are many more private banking companies than public companies, the effect could be to cut out a very large number of financial institutions from access to an enlarged acquisition war chest.
Treasury officials and industry leaders are working on fixes that would level the playing field between public and private players. To allow more time to resolve private institution participation in the CPP, the Treasury Department announced on October 31 an extension of the November 14 application deadline. It said documents specific to private companies and a "reasonable deadline" would be forthcoming.
Consolidation Likely to Continue
With banking company valuations at historically low levels, attractive acquisition opportunities abound. Other financial service industry targets may be equally attractive, including broker-dealers and wealth managers weakened by the current crisis. The availability of lower-priced federal money only makes these opportunities more compelling.