Banks that require funding will have 30 days to present a capital-raising strategy to regulators and then six months to implement it.

It is unlikely that any of the banks will require any additional taxpayer money.

J.P. Morgan Chase & Co. (NYSE: JPM), Goldman Sachs Group Inc. (NYSE: GS), MetLife Inc. (NYSE: MET), American Express Co. (NYSE: AXP), Bank of New York Mellon Corp. (NYSE: BK), BB&T Corp. (NYSE: BBT), Capital One Financial Corp. (NYSE: COF), U.S. Bancorp (NYSE: USB), and State Street Corp. (NYSE: STT) are in the clear in terms of having adequate capital cushioning.

The following banks will be required to raise these assigned amounts of capital:

• Bank of America Corp. (NYSE: BAC): $34 billion.
• Wells Fargo & Co. (NYSE: WFC): $13.7 billion.
• GMAC LLC (NYSE: GMA): $11.5 billion.
• Citigroup Inc. (NYSE: C): $5.5 billion.
• Morgan Stanley (NYSE: MS): $1.8 billion.
• Fifth Third Bancorp (NASDAQ: FITB): $1.1 billion.
• KeyCorp (NYSE: KEY): $1.8 billion.
• PNC Financial Services (NYSE: PNC): $600 million.
• Regions Financial Corp. (NYSE: RF): $2.5 billion.
• SunTrust Banks Inc.( NYSE: STI): $2.2 billion.

The banks will have until June 8 to develop a plan to raise the required capital and until Nov. 9 to implement it. They may choose to raise the money in a variety of ways. They may sell assets, court private investment or convert the government’s existing preferred shares into common stock.

Citigroup has already announced plans to convert a portion of the government’s $45 billion stake into common stock, a move that will give the federal government a 36% stake in the company. Other regional banks – such as Fifth Third Bank or Regions Financial – could be forced to take similar actions, but are loath to do so, as most of the moves would be dilutive to existing shareholders.

Citigroup has agreed to sell Nikko Cordial Securities to Sumitomo Mitsui Financial Group (OTC: SMFJY) for about $5.5 billion. The deal, which is to be completed by Oct. 1, is expected to boost the bank’s Tier-1 capital ratio by approximately 27 basis points.

Morgan Stanley plans to close its capital gap by selling assets or stock to private investors, a person briefed on the plan told The New York Times. And Wells Fargo said late yesterday that it plans to sell $6 billion in new common stock in an effort to raise required capital.

While Bank of America has said it doesn’t agree with the Fed’s conclusions, the bank yesterday outlined its strategy to accommodate the government’s demands. BofA is exploring the sale of such business units as its First Republic private-banking unit and asset manager Columbia Management, The Wall Street Journal reported.

The sale of those businesses could raise a combined $4 billion, David Hendler of CreditSights Inc. told The Journal. BofA could also get about $8 billion for its partial stake in China Construction Bank Corp.

Beyond that BofA would have the options of converting the government’s existing $45 billion investment, or $33 billion in private preferred shares, into common stock.

The Fed wants bank-holding companies to achieve a Tier 1 risk-based ratio of at least 6%, and a Tier 1 Common risk-based ratio of at least 4% by the end of 2010. The goal is to get banks to the point where they are stable enough that they can borrow from private investors without a Federal Deposit Insurance Corp. (FDIC) guarantee, people familiar with the matter told Bloomberg News.

“Going forward, we just need banks to be able to issue debt without the FDIC backing – that’s the next stage for these bank names in terms of evaluating their health,” Mark Bronzo, a money manager at Security Global Investors LLC, which oversees $21 billion in Irvington, N.Y., told Bloomberg.

If the banks fail to meet capital requirements, the government will step in to provide the necessary funds. However, it’s unlikely that any more taxpayer money will be needed, as about $110 billion of the original $700 billion in Troubled Asset Relief Program (TARP) funding remains.

Wall Street’s Reaction

The Dow Jones Industrial Average closed down 102.43 points, or 1.2%, yesterday, with the Dow Jones U.S. Financial Services Index down 3.78%. However, Wall Street’s reaction to the tests won’t be fully realized until the market opens later today (Friday).

“I think this will be a confidence-instilling announcement,” Federal Deposit Insurance Corp. Chairman Sheila Bair told a Senate panel Wednesday. “There will be additional needs for capital buffers for some institutions, but I think there will be mechanisms to do that within the next six months.”

Treasury Secretary Timothy F. Geithner said in an interview with PBS television’s “The Charlie Rose Show” that all of the institutions tested already have “significant cushions” of capital and that Americans have every reason to be confident going forward.

“The results will be, on balance, reassuring,” Geithner said.

But some analysts are skeptical about what the bank stress tests actually achieved, or if their standards of evaluation were even valid in the first place. After all, the tests have occupied resources from both the federal government and the private sector for months, and have increased stock market volatility.

“The banks are healing themselves, and it could have been done a lot faster if government had gotten out of the way instead of parking the emergency equipment in the middle of the road,” Gary B. Townsend, a former banking regulator who now runs his own investment firm, told The New York Times.

Also, many bank employees, and even Elizabeth Warren, who chairs the Congressional Oversight Panel for TARP, have expressed concern that the tests weren’t stringent enough.

Last month, Warren gave rise to speculation that another stress test might be needed by the end of the year, after she called the adverse economic scenario employed by the Fed “disturbingly close” to current economic conditions.

In the Fed’s most pessimistic economic forecast, for example, the government projects the unemployment rate will climb to 10.3% in 2010. But unemployment already hit 8.5% in March and many economists are predicting that it rose to 8.9% in April. If that’s the case, it’s not hard to imagine the national jobless rate reaching double digits by the end of the year.

“The stress tests will make a terrific contribution if they are tough and transparent,” Warren said. “If they are not, they will be useless.”

Still, despite the test’s alleged failings, there is a hope that with more transparency and a greater buffer of equity, investor confidence will be restored.

“This is sending a message that the banks need more capital, but their losses are manageable and the system itself is solvent,” Kevin Fitzsimmons, an analyst at Sandler O’Neill told The Times. “Whether it sticks is something else.”

Source: Bank Stress Tests: The Results Are in; Now What?

Private equity is an asset class consisting of equity securities in operating companies that are not publicly traded.  The name “private equity”is the rechristened, kinder and more gentile label for what used to be known as leveraged buyouts, or LBOs. But make no mistake about it, while leverage may not be part of the name any more, it remains a big part of every private equity deal.

LBO firms, or “franchises”, as Henry Kravis, co-founder of Kohlberg Kravis Roberts & Co. (KKR), likes to call his shop, acquire publicly traded operating companies. Then they streamline management and operations to increase profitability and hope to cash out through a merger, an outright sale of the company, or by taking the company public again through an initial public offering, or IPO.

Private equity firms are the debutante sisters of hedge funds. They raise huge pools of capital from pension funds, endowment funds, sovereign wealth funds, institutional investors and wealthy entrepreneurs. But while hedge funds buy and sell the stocks of companies they hope to profit from, private equity shops buy whole companies.

Generally, once a target is identified, an offer is made to buy a majority, or all of the stock of the company. The trick of the deal is to pay for the target by using as little equity capital as possible, and raising the remainder by actually having the target company borrow the required funds. Except for the private equity firm’s initial equity investment, the target company is essentially buying itself.

And if that isn’t enough of a trick, very often when the target is privatized, their new masters have the company borrow even more money so they can then pay themselves a dividend as a bonus for the good job they did in leveraging the company to the hilt so they can streamline it.

The leveraged buyout business has been around for a long time and it has worked very well for investors and the private investment bankers who make an extravagant living with other people’s money. In fact, the business was so successful it eventually led to its now very problematic fork in the road. The problem facing private equity is that their leveraged deals were at one time in such great demand that it became too easy to borrow too much money.

The result was that they chased too many deals, paid too much for targets, paid themselves too many dividends and fees, and now their portfolio companies are straining and collapsing under the weight of too much debt.

Act I: The Two Big Mistakes that Made Leveraging Possible

There are two elements that made massive borrowing possible.

The first was a ready supply of capital courtesy of the U.S. Federal Reserve’s easy money policy and low interest rates. The second was the ability of banks that lend money to acquired companies to pool those loans into securities called  collateralized loan obligations, or CLOs, and sell them off to investors. Banks and investors refer to this asset class as “leveraged loans.”

Since banks were able to sell off their leverage loans to investors they had plenty of recycled money to lend out again and again. Competition to lend out all that money put borrowers in an advantageous position, which they exploited.

Banks and non-bank lenders attach covenants to the loans they make. Typically, covenants dictate to borrowers what specific balance sheet requirements must be met and include debt-to-cash flow leverage ratios, limitations on the total amount of debt a company can carry, minimum equity provisions and other dictates that serve to secure collateral that is relied upon by lenders.

But, banks were so flush with money and so eager to lend that privately acquired companies, driven by their new private equity masters, proposed that the money they borrowed should not be encumbered by the protective covenants lenders are used to demanding. Hence the birth of “covenant-lite” loans.

Covenant-lite loans included insane “reverse covenants” that benefited the borrowers not the lenders.

Among other things, some borrowers demanded and got rights to:

• Increase debt-to-EBITDA (Earnings Before Interest, Tax, Depreciation, and Amortization) levels to 10:1.
• Freely substitute collateral.
• Have collateral “released” outright.
• Issue unsecured debt equal to the total amount of existing debt (if they hedged or effected swaps.
• Employ PIK (payment-in-kind) options, where instead of paying interest in cash they could substitute more debt.
• Employ PIK toggles, sometimes called “extendibles.”

PIK toggles (think of a toggle switch which is used to turn something on or off) let the borrower can roll interest payments into principal and extend the maturity, instead of making twice yearly cash payments. If that sounds like an option ARM mortgage, where borrowers can choose whether to pay the interest due, some part of it, or none of it, and roll unpaid interest into principal, it’s because it is the exact same borrower covenant.

It’s like déjà vu all over again.

Act II: With No Leverage Private Equity Deals Fall Apart

Junk, junk and more junk. When the music stopped and the credit crisis began last August, money and credit evaporated. Only then did it bother leveraged loan investors that the private equity guys were leveraging their private companies to pay themselves huge dividends – enough in many cases to repay the entire initial cash equity investment used to underpin the leveraged buyout of their targets. And only then did they realize that all the debt heaped onto these companies was going to drag many of them into bankruptcy.

At that point, investors simply stopped buying leveraged loans. And the net result is that banks may be sitting on over $150 billion of junk leveraged loans that they can’t place. They are taking hits to their balance sheets as they have to mark down these loans which were securitized and subject to mark-to-market accounting. And they are terrified that the recession will drive more of these leveraged companies into bankruptcy.

Thomson Reuters recently reported that 40 private equity companies have sought bankruptcy this year. According to Standard & Poor’s, of 86 S&P rated companies that defaulted this year, 53 of them were private equity related transactions. Linens ‘n Things which was taken private by Apollo Group Inc. went bankrupt. Sharper Image, Wickes Furniture and catalogue company Lillian Vernon, were all taken private by Sun Capital Partners Inc., all of them are bankrupt. Mervyn’s which was taken private by Sun Capital and Cerberus Capital Management LP. is bankrupt.

Also in the clutches of the three-headed-dog from Hades, Cerberus, is Chrysler LLC; Chrysler Financial, GMAC LLC (General Motors Acceptance Corporation) (GMA) – 51% owned by Cerberus – and Residential Capital LLC, a GMAC company. By most accounting standards, all of these companies are, if not already, close to insolvent.

GateHouse Media Inc. (OTC: GHS), 40% owned by Fortress Investment Group LLC (FIG), is at risk of debt default and may likely be headed for bankruptcy. Former Lazard Ltd. (LAZ) deputy chairman and  media honcho Steve Rattner’s Quadrangle Capital Partners may lose control of American Media Inc., publisher of The National Enquirer and Star magazine, as he battles with bondholders and may also lose portfolio company Alpha Media Group Inc., publisher of Maxim magazine. These few examples of failures are just the tip of the iceberg.

Then, of course, there’s the pure genius of PE firms coming to the rescue of troubled banks. But, TPG Capital (formerly Texas Pacific Group) doesn’t look so genius with its $7 billion investment in Washington Mutual Inc. (OTC: WAMUQ) which was wiped out in a matter of five months.

It’s understandable that bankrupt target companies are suing. Mervyn’s, for example, filed a 57 page suit against its lead dog master Cerberus, alleging fraud among other charges. But what is not as easily understandable is that some other lawsuits have the potential to turn the game viciously against the private equity firms and all the major bank lenders. I’m not talking about the deals that got done; I’m talking about the deals that didn’t get done because private equity firms walked away or otherwise tried to dissolve pending deals.

Apollo Management asked a Delaware Court of Chancery to kill a transaction it had entered into to have one of its portfolio companies, Hexion Specialty Chemicals Inc., buy NYSE listed Huntsman Corp.(HUN) for $6.5 billion. Huntsman sued and won. The judge issued a ruling that Hexion “knowingly and intentionally” breached parts of the merger agreement and ordered the company to complete the deal. Not only is Apollo being forced to go through with the deal, the ruling allows Huntsman to seek damages from Apollo. Apollo is now suing the banks it had lined up to provide debt financing for the deal.

There are hundreds of billions of dollars of abandoned deals that may now be re-visited in courts around the country. The implication for private equity firms and banks is potentially staggering.

Here are a few of the larger failed deals that resulted from a lack of debt investor interest:

• Cerberus’ failed  deal for United Rentals Inc. (URI).
• The Blackstone Group LP’s (BX) failed deal for Alliance Data Systems Corp. (ADS).
• J.C. Flowers’ failed deal for SLM Corp. (SLM), also known as Sallie Mae.
• And Appaloosa Management in conjunction with Harbinger Capital Partners, Merrill Lynch & Co. Inc. (MER), Goldman Sachs Group Inc. (GS), and UBS Securities LLC’s failed financing of Delphi Corp. (OTC: DPHIQ) to take it out of bankruptcy, for which they are being sued for fraud and conspiracy to “derail” the bankruptcy plan; a serious situation because interfering with a bankruptcy is a federal crime.

The amount of leverage involved in private equity deals is a problem if banks aren’t eager, or able, to supply needed loans. But that alone isn’t scary. What is scary is the effort private equity firms are making to actually get into the banking business themselves.

Act III: Private Equity Seeks to Corrupt Banking System

There’s a lot of pressure on banks to raise capital and there’s a lot of pressure being exerted by the private equity guys to lean on the Fed and U.S. Treasury to bend the rules to let them play in that sandbox. Pushing hard from the private equity camp are Randall Quarles, Managing Director of Carlyle Group Ltd. and a former senior Treasury official and none other than the former Treasury Secretary himself, Chairman of Cerberus Capital Management, John Snow.

What the private equity guys want is the ability to buy into banks and control them. If they get their hands on the low cost deposit-based capital at commercial banks, they’ll be unstoppable. How about having the piggy-bank, backed by taxpayers to leverage at will?

The prospect is frightening.

Right now there’s a limitation imposed on investors in Federal Deposit Insurance Company insured commercial banks. Once an investment exceeds 9.9% there must be an agreement with regulators to not “control or influence” management. If an investment exceeds 24.9% the investing entity must register as a Bank Holding Company, and subject itself to all necessary transparencies called for by regulators and the Fed. In addition, the holding company is forced to serve as a “source of strength”, meaning its capital will be called upon to support its bank.

Private equity guys do not want any part of either of those restrictions. They don’t want their business looked through nor do they want their capital encumbered. The private equity firms are sitting on hundreds of billions of dollars of fresh money raised recently. While it may seem reasonable and expedient to allow private equity capital to be infused into ailing banks, any compromise of existing regulations would result in the creation of the mother of all moral hazard enablers.

There’s no doubt that if the recession is as deep and as long as feared,, the continuing failure and bankruptcy of leveraged private equity portfolio companies will result in far greater unemployment, and in and of itself, has the potential to deepen the recession on an inordinate scale.

There’s too much greed and far too much power in the form of private equity firms. Their greed has encumbered American banks with significant CLO and leveraged loan exposure and encumbered American companies with too much debt. Now, they threaten to undermine sound banking (wait a minute, that’s already been done by the banks themselves) by investing capital into them in order to control them.

Until concrete underpinnings replace the glue and duct tape that’s holding together the banking system, and until leverage is wrung out of companies, investment vehicles and households, banks and private equity firms will both be on a slippery slope.

Source: Overly Leveraged Private Equity Deals Add to Unemployment and Deepen Recession

• The U.S. Federal Reserve released its Beige Book report yesterday (Wednesday), which looks at the economic conditions in the 12 Fed regions. “The pace of economic activity has been slow in most districts,” the report said, Bloomberg News reported. “Wage pressures were characterized as moderate by most districts amid a general pullback in hiring.”

• August was another weak month for auto sales as most major carmakers reported declines. Ford Motor Co. (F) reported 26.6% decline, while General Motors Corp. (GM) sales fell 20.4%. Toyota Motor Corp. (ADR: TM) fared better with a 9.4% decline, but Japanese rival Nissan Motor Co. Ltd. (ADR: NSANY) had a surprising 13.6% increase, Reuters reported.

• GMAC Financial Services (GMA) announced yesterday that it would close all 200 GMAC Mortgage retail offices and reduce and its Residential Capital LLC unit in an effort to cut costs and streamline operations, The Wall Street Journal reported. Approximately 5,000 employees, 60% of Residential Capital staff, will be let go.

• U.S. government officials charged two former Credit Suisse Group AG (ADR: CS) brokers with fraud and conspiracy yesterday (Wednesday) concerning sales of subprime-related debt, the International Herald Tribune reported. The two brokers gave clients the impression the debt was secured by federally guaranteed loans. “In September 2007, these former employees resigned after we detected their prohibited activity and promptly suspended them,” the bank said. “Credit Suisse immediately informed our regulators.”

• Orders to U.S. factories rose by a larger-than-expected amount in July, the Commerce Department said yesterday (Wednesday). New orders increased by 1.3%t in July, much stronger than the 0.8% increase economists expected. The July advance follows a 2.1% increase in June and represents the fifth straight rise in orders, The Associated Press reported.

• Staples Inc. (SPLS) the world’s largest office supply company, reported profit of $150.2 million, or 21 cents per share, for the quarter ended Aug. 2. Down from $178.8 million, or 25 cents per share, a year ago. Sales climbed 18% from $4.29 billion to $5.07 billion.

• A division of United Technologies Corp. (UTX) received a $78.1 million contract from the U.S. Navy for parts and materials to build propulsion systems for a variant of the Joint Strike Fighter, The Associated Press reported yesterday (Wednesday). United Technologies’ Pratt & Whitney will also build 10 propulsion systems for the U.S. Air Force, two of the same for the Royal Netherlands Air Force and three for the United Kingdom’s Royal Navy.

• Liberty Media Corp. (LMDIA) will spin off its stake in DirecTV Group Inc. (DTV) and other assets into a publicly traded company called Liberty Entertainment Group SA, according to Reuters. Liberty’s 50% stake in DirecTV will be the dominant asset in Liberty Entertainment, accounting for more than 80% of its value.

Sourcce: Global Investing Roundups Thursday, September 4th, 2008