By Shah Gilani

A new Federal Deposit Insurance Corp. (FDIC) plan to offload busted banks to vulture investors strikes an uneven balance between private equity players and public taxpayers and may inadvertently sow the seeds for another round of bank failures.

The FDIC currently insures bank depositors up to $250,000 – up from $100,000 prior to the financial crisis. So far this year, 81 banks have failed, costing the FDIC an estimated $21.5 billion.

And the situation is almost certainly going to get worse.

A Growing List of Troubled Banks

The FDIC reported yesterday (Thursday) that the number of distressed banks rose to the highest level in 15 years during the second quarter, thanks to an economic malaise that’s saddling banks with a growing level of bad loans.

The number of troubled banks rose to 416 at the end of June from 305 at the end of March. The FDIC hasn’t had that many banks on its “problem list” since June 1994, when there were 434, the agency said. Assets at these troubled institutions totaled $299.8 billion – the worst level since the end of 1993, according to the FDIC.

The FDIC’s insurance fund, as of March 31, was down to its last $13.5 billion. Bank failures in the second quarter cost the insurance fund an estimated $9.1 billion. These hits were mostly offset by an emergency special assessment of $6.2 billion and an additional $2.6 billion raised as part of the regular quarterly assessment on FDIC-insured banks.

The FDIC just took another hit due to the recent failure of Colonial Bank, which cost the fund an estimated $2.8 billion, and the failure last week of Guaranty Bank, which cost an estimated $3 billion. FDIC Chairman Sheila C. Bair is determined to not have an insolvent FDIC turn to the U.S. Treasury Department to draw on a $500 billion line of credit set up for just this purpose, although that move is clearly inevitable.

In a fatalistic twist of irony, however, the FDIC’s demand for another special assessment in the fourth quarter and another expected special assessment in the first quarter of 2010 may tip several more banks into failure.

Although there seems to be a desperate need for private equity capital to come running to the rescue, the reality unfortunately isn’t that simple.

A Disappointing Decision

As most all consumers and investors know, the FDIC only covers insured deposits. However, the ongoing cost of a busted bank becomes higher for the FDIC if the agency cannot merge that failed institution with a healthy player, or can’t sell it outright. When The FDIC can’t find a willing partner or buyer, the agency must instead manage the “unwinding” of every failed bank’s stockpile of illiquid and toxic assets. With so many more banks in trouble and so many fewer banks willing to acquire additional suspect assets, private equity firms have offered to step up and buy failed banks these professional investors believe can be turned around.

On July 9, the FDIC published and sought comments on its “Proposed Statement of Policy on Qualifications for Failed Bank Acquisitions.” The controversial proposed policy statement suggested tough terms and conditions under which the federal agency would be willing to sell failed banks to non-traditional buyers – specifically, private equity firms.

A total of 61 comments were filed during the 30-day comment period – most of them from private-equity firms, their lawyers, financial-services trade associations and lobbyists. There were also comments from academics, four U.S. senators and six individuals. The FDIC also received 3,190 form-letter comments in support of the controversial proposal.

The FDIC issued its final decision on the matter on Wednesday. The new version was much weaker, once again underscoring the federal government’s proclivity for weakening banking regulations – a willingness we’ve repeatedly warned will have dire consequences for the U.S. financial system, as well as for the broader economy.

These alterations are setting the stage for an escalation in bank failures. The real losers will once again be the U.S. taxpayers, who will end up footing the bill for the FDIC’s failure to take a tough stand.

How much weaker were the new regulations, when compared with the earlier proposals? In one instance, instead of the initially proposed requirement that new investors maintain a 15% Tier 1 common equity capital ratio – three times what traditional bank holding companies are required to maintain – the new entry hurdle is only a 10% ratio.

Private equity firms will be spared the requirement of other bank holding companies and will not be called upon as a “source of strength,” should their investment in a bank need shoring up.

Bank holding companies have to make their resources available if their banking operation requires support. But private equity companies don’t want to expose their vast pools of capital to any one investment. Just as Cerberus Capital Management LP refused to put any more money into its failed Chrysler LLC investment – leaving taxpayers to bail it out – firms are loathe to be put into a position to support a bank holding with anything more than what was deemed as a suitable capital investment at the outset.

The FDIC granted other compromises granted in favor of private equity buyers. For instance, the agency spared them from having to cross-guarantee their portfolio-bank investments – unless they owned at least 80% of two or more banks.

Getting “Real” About Private Equity

Private equity interests certainly didn’t get everything they wanted. For one thing, the final policy statement prohibits “insider” and “affiliated” loan transactions and strips firms of using a controversial “silo” structure to obfuscate ownership and control positions.

The final policy statement reads like the painful enunciation of a split decision in a controversial heavyweight title fight. The valiant efforts Bair, the FDIC chairman, to keep the howling wolves of private equity at the door and out of the banking henhouse were ultimately undermined by the rapidly dwindling coffers of the Deposit Insurance Fund, which brought the FDIC to its knees. The compromises in the final policy statement grant the private-equity crowd a lot of what it was lobbying for while only momentarily sparing the FDIC the embarrassment of being knocked out.

But make no mistake. That day of reckoning is on its way. And not even the entrepreneurially gifted private-equity set will be able to keep that from happening.

Let’s be clear: We’re not saying that the private-equity sector is made up of angels (angel investors, yes, but outright angels, no way). Indeed, as we’ve demonstrated in past columns, the private-equity set is actually a group of uber-capitalists who are hell-bent on turning their gargantuan ambitions into extraordinary wealth – and who aren’t above shopping for regulators or hardballing Congress to get what they want.

Private-equity players demanded – and got – the FDIC to agree to share whatever losses they might incur, whereby the government (meaning taxpayers) must bear the brunt of the losses incurred when risky loan pools are acquired.

In all fairness to private equity firms, acquiring banks also have loss-sharing agreements with the FDIC. But they are regulated entities and private equity firms are not. Nor will private equity firms willingly become regulated in order to buy banks.

And there are actually some advantages in having private equity investors acquire failed banks – including a host of issues that critics describe as “self-serving,” grousing that the private-equity benefits come only at a cost to taxpayers.

Given the new set of rules, private equity firms can swoop in and pick up failed banks by banding together and dividing the equity commitment and investment liability assumed upon purchase. If there is no recourse against other private equity firm assets or even any cross-guarantees against other acquired banks, unless they are 80% owned, the consortiums cannot be called upon and certainly not relied upon to be a “source of strength” for their depository, taxpayer-backed portfolio banks.

Regardless of any rules on self-dealing, as sure as “bank” is a four letter word, private equity firms will find a legal way to lend from their taxpayer-backed banks to leverage their other portfolio companies and extract their usual exorbitant fees. If they don’t lend to their own portfolio companies, they will surely lend to other private equity firms’ portfolio companies in a modified version of the “club deals” that bind them together. These firms have a mutual interest in generating deal fees and in controlling their lucrative franchises.

A Glimpse of What’s to Come

The problem with banks is that they became too leveraged. When they couldn’t amass assets on their books, against which they had to set aside “reserves,” they established “off-balance-sheet” vehicles to acquire leveraged pools of assets. They were leveraged inside and out.

But now the originators of the leveraged-buyout business model want to control taxpayer-backed banks, to apply another round of leverage to already crippled banks in order to squeeze out all the profits possible. Although this comes at a cost to duped and already drained taxpayers, regulators, legislators and the American public would be foolish to expect anything else from the private equity crowd. If the FDIC thinks it has a problem now, wait until the next implosion of leveraged banks happens.

In a comment letter to the FDIC on the original policy proposal, the Private Equity Council, an industry advocacy group, without recognizing the irony of its comment, suggested that mandating higher capital ratios for private equity buyers of failed banks would actually increase the risk at those banks because their owners would essentially have to employ more leverage to generate sufficient returns to meet the higher capital standards – while still generating returns high enough to satisfy the investors in their private-equity funds.

If that’s not an advance look at the next round of financial-sector problems we could be facing, we are deluding ourselves.

Private equity should be allowed to buy banks, but should also be held to a higher standard. They have a proven record of success at leveraging companies when they have access to cheap funding, and they also have a record of spectacular failures that resulted from their leverage. The last thing that American banks need – especially right now – is a hyper-aggressive management that leverages them to the hilt in order to generate “acceptable” rates of return for a select group of private investors.

Unfortunately, we’ve once again placed ourselves in a position where the viable solutions to the problems that were created will end up causing an entirely new set of problems – problems that always seem to provide a benefit to the old crony network while leaving the battered U.S. taxpayer as the ultimate victim.

We have no one to blame but ourselves.

More town hall meetings and more vocal opposition to being duped and used by Wall Street would be a good place to start.

[Editor’s Note: For more insights into the quandary facing the Federal Deposit Insurance Corp., check out this related story that appears in today’s issue of Money Morning. The story, accessible at no charge, can be accessed by clicking here.