Fed Throws a Bone to Buyout Funds

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News that Goldman Sachs (NYSE: GS  ) and Morgan Stanley (NYSE: MS  ) are converting to bank-holding companies to avoid the fate of Merrill Lynch (NYSE: MER  ) and Lehman Brothers (NYSE: LEH  ) has dominated the headlines this week. At least until last night, when Warren Buffett swarmed in. However, they're not the ones starved for capital. At 11.6%, Goldman's tier 1 capital ratio is almost twice the Fed's 6% floor for a "well-capitalized" institution. And that was before last night's news.

To relieve the drought in capital that is crippling the banking sector, the Federal Reserve has eased restrictions on private investors who wish to invest in banks. The new rules include a higher ceiling on the economic and voting stakes an investor can take without being considered a controlling investor, and hence without being directly supervised by the Fed (the new ceiling for the economic interest is 33%, up from 25%).

The Fed's goal is clear -- to lower the barriers so that capital can flow from those who have it (private equity) to those who require it (banks). Indeed, research firm Prequin reported the industry had $400 billion to $450 billion in capital available for investments at the end of the first quarter (that number may well have grown -- within the past two months, Blackstone Group (NYSE: BX  ) and TPG have closed two megafunds with an aggregate value exceeding $40 billion).

Just like shooting fish in a barrel?
Critics argue the Fed's action may lead to a repeat of the S&L crisis aftermath, in which private equity firms earned large profits by snapping up troubled S&Ls at bargain prices. However, investing in banks isn't simply a matter of picking gold bars up off the street; it requires capital and expertise.

It certainly isn't a no-risk proposition. When buyout firm TPG led a $7 billion investment in Washington Mutual (NYSE: WM  ) in April, it paid $8.75 per common share; WaMu shares closed at $3.33 on Tuesday. (The investment does contain some protective clauses, but bankruptcy or nationalization would, in all likelihood, wipe TPG out.)

In another example that all banks aren't ripe for the picking, Fortress Investment Group (NYSE: FIG  ) considered investing in BankUnited Financial Corp. during the summer, but eventually walked away.

Capital will find its own level
Removing restrictions on capital flows in a distressed sector will accelerate the process of separating banks that merit additional capital from those that should be allowed to fail. This will move us one step closer to a resolution of the current crisis -- a goal that all can agree on.

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Alex Dumortier, CFA has no beneficial interest in any of the companies mentioned in this article. Try any of our Foolish newsletters today, free for 30 days. The Motley Fool has a disclosure policy.

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