Banking Keeps Changing: BankUnited and China's ICBC

There were two pieces of banking news last week that seemed to fall below the radar screen due to the visit of China’s President Hu Jintao and the events in Tunisia and Egypt. These two pieces of news had to do with BankUnited, a Florida bank that was “saved” by a group of buyout firms, and with ICBC, the world’s biggest bank by value which happens to be a Chinese bank, who announced that it was buying an American bank.

Bank United sold 29 million shares of stock at an initial public offering on Thursday evening for $27 per share. This put the value of the bank around $2.6 billion.

To me the important thing about BankUnited is the owners of the bank which include Wilbur L. Ross, Jr., the Blackstone Group, the Carlyle Group and Centerbridge Partners. BankUnited was Florida’s biggest bank when it failed in May 2009. The unique ownership of the bank came about when the FDIC sold the bank to this group of “private” investors.

The FDIC was “desperate” to attract capital and private-equity firms were where the money was. So the FDIC cut a deal with this group to “unload” BankUnited. This was a first because private-equity had never shown much interest in owning commercial banks…the returns were just not that great given the risks. And, the regulators never cared much for this kind of money…private-equity firms were only interested in a “quick” buck.

The deal for BankUnited was “rich” because the FDIC needed to unload the property. But, once one deal was cut, more followed, but they were not necessarily as “rich” as the first one. Now private-equity firms have acquired more than 50 banks.

The IPO on Thursday produced a lot of money for the owners. The owners are expected to take away more than $500 million from the offering and they still will maintain an ownership in the company of about 70%, more than $1.8 billion. The buyers put up $945 million to complete the deal with the FDIC.

The stock price rose almost 5% on Friday.

BankUnited is now highly capitalized, very profitable, is growing deposits, and also is making loans. And, management is now looking to buy other banks.

Commercial banking meets “Shadow” banking. But, this wasn’t the way it was supposed to be. Banks were supposed to get smaller because there was too much systemic risk when banks were too big to fail. Also, we had to go back to the “good ole days when banks were banks and other financial institutions were “other” financial institutions. But now we have private-equity firms owning more than 50 banks!

It seems like everything that the Obama administration and the regulators wanted has just been the opposite of what they have actually done.

In the decline in the number of banks which now exist, about 7,700, to less than 4,000 over the next several years, banks are going to continue to get bigger and the boundary between financial institutions and money sources are going to get more and more blurred.

Why? Well, for one, it pays, and it pays well. Second, there are just too many banks that need financial help and the Federal Reserve and the FDIC are going to do everything in their power (and maybe more) to make sure the weaker institutions are absorbed or consolidated into other organizations in as orderly a fashion as possible.

The second piece of news has to do with another foreign bank acquiring an American bank. This time, however, the foreign acquirer is Chinese: ICBC will acquire 80% of the Bank of East Asia’s retail branch system in New York and California. This acquisition must still be approved by United States regulators. If this deal is approved it will be the first time that a mainland bank in China would be operating under the regulatory framework of the United States. Up-to-now, American regulators have not approved the soundness of the Chinese banking system because it is government controlled and politically directed.

Although some wholesale business has been allowed in the past for Chinese banks, approval of this transaction would be entirely different because it would mean that the deposits of this bank would now be insured by the FDIC. Thus, the Chinese banks will not only have to open their books to the regulators, but it would also expose the Chinese regulators to scrutiny.

This acquisition will not alter the American banking landscape much in the near future. The bank was already foreign owned, it was Hong-Kong based, and it already had strong ties to China. The bank is only about $700 million in asset size and most of the bank’s business is with Chinese businesses.

However, the crucial thing will be that the Chinese will own a bank in the United States. How big it is at first and how much business it does with Americans at first is not the important thing. I go back to the advice given me some years ago: the Chinese think in terms of decades while people in the United States think in terms of years. The Chinese will own a bank in the United States!

Thus, the ground continues to change. The American banking system is going to become more and more global with the presence of foreign banks taking on a bigger and bigger role within the country. And China, and Russia, and Brazil, and India, and Canada, and others will be included. As I have stated before, I believe that the branches of foreign banks and the largest twenty five domestically chartered banks in the United States will hold more than 80% of the banking assets in the United States. There is just going to less and less need and less and less room for smaller domestically chartered banks to exist.

It is just not realistic to believe that the banking system of the next five years is going to look anything like the banking system that existed before the recent financial collapse. The owners of banks will also be different and will include governments and private-equity firms and individuals and others. We are only kidding ourselves if we think that we are going to return to anything like that. Cries of support for Main Street are just the wishful thinking of those that would like to return to the past. The world moves on.

Rather than trying to retain the past we need to ask what will be needed in the future. Parts of the American landscape are fading. One part of that landscape is the small, locally owned bank that serves just the community it resides in. My grandfather ran a small bank in a small town in the Midwest. He hated the large banks in the nearby big city and wanted to keep them out of his territory. He argued that large banks just “sucked deposits” out of a local community and only made loans to large businesses within the big city. As a consequence, the local community suffered. The small, vibrant, self-sufficient and morally-driven local community has always been a part of the American dream.

This, for better or worse, is not the future. In fact, to some, it was not the past, but that’s
another story.

The Great Recession has changed things. Let’s prepare for the future, not hope for the past.

Are There Bubbles All Around?

One thing we learned in the 1990s and the 2000s is that there can be asset bubbles in the economy without growth in either money stock variables or increases in consumer (flow expenditure) price inflation. The financial system seems to be flexible enough so that it can leverage up where it wants to even though monetary policy and consumer spending seem to be “in control”. This is the lesson of modern “financial engineering.”

However, the monetary statistics are not benign for most of the time period from January 1961 up to September 2008. During this time period, the monetary base which is supposedly under the control of the Federal Reserve System rose at a compound annual rate of slightly more than 6%. Total credit during this time period rose much more rapidly. Consequently, the United States experienced a period if “credit inflation” that dominated everything going on during this 47 years or so. This secular inflation drove the financial innovation that took place as the whole financial system took on more-and-more leverage and more-and-more risk.

Since September 2008, the Federal Reserve has caused the Monetary Base to increase explosively by more than 130%. However, the banking system is not lending and much of these funds seem to have ended up on the balance sheets of the banking system. Excess reserves in the banking system went from about $2 billion in August 2008 to almost $1.2 trillion in February 2010. Excess reserves for September 2010 averaged slightly below $1 trillion.

Even with all of these excess reserves, the current concern is whether or not the economy will go into a period where prices actually decline. That is, might the United States be headed for a period of deflation?

Everything mentioned above is true. Yet, there is more going on in the economy than just what we see here. In some areas, a lot is going on and in these areas we are seeing lots of upward price movement which leads one to ask whether or not these price movements are bubbles or indications of something else taking place. Certainly, the “bubbles” are not increasing employment, or capacity utilization, or getting the economy going again.

I have written about this before: “Where the Action is: The Bond Market”, http://seekingalpha.com/article/230048-where-the-action-is-the-bond-market. I wrote in this post:

“There is a lot of money in the financial markets…in the shadow banking system…and worldwide.
Where is the action taking place?
Well, for one, in the bond market. We have major companies issuing bonds at ridiculously low interest rates.”

Of course we know that government bond prices are inordinately high causing yields to be excessively low. But, this is also true in the market for high-grade corporate debt and for junk bonds. One could certainly argue that there might be “asset bubble” in the bond markets.

Thank you shadow banking system!

And, the cash continues to build up on the balance sheets of “healthy” large corporations. It also appears as if many hedge funds and private equity funds are attracting “large bunches” of new money.

But, capital is almost perfectly mobile in the modern world: it can escape almost everywhere.

Because of this, writers like Martin Wolf have argued that one of the goals of American leadership is to “inflate the world” in order to get United States economic growth going again.

So, are we seeing the results of this?

Well, we might be seeing this flow of capital going into world commodity markets and also into emerging markets. There is the possibility that bubbles may be occurring here.
The movement in commodities seems to be worldwide but repercussions are being felt domestically in the United States. (See “Dilemma Over Pricing: From Cereal to Helicopters, Commodity Costs Exert Pressure”, http://professional.wsj.com/article/SB10001424052702304741404575564400940917746.html?mod=ITP_marketplace_0&mg=reno-wsj.) This article indicates that, year-over-year, corn prices are up by 34%, wheat prices are up 34%, milk is up 32%, copper is up 30%, and oil is up 14%. It is also the case that sugar is up about 50% year-over-year.

The question many companies are facing is, “How can we raise prices to cover these costs when the economy is so weak?” A real dilemma!

Funds are also flowing into emerging markets. All one has to do is watch the stock exchanges in those countries. And, all indications are that large companies are looking to locate in many of these markets or acquire firms in these markets. We are also seeing the hedge funds and private equity funds looking in this direction. (See for example, “Buy-outs set to divide private equity”, http://www.ft.com/cms/s/0/726ce11e-dc6d-11df-a0b9-00144feabdc0.html.)

In a world where there is a fluid movement of capital, money is not going to stay at home if the home economy is not strong, structurally. The American economy is having major problems in its economy. Why would “big” money want to invest here? (See, for example, “Globalized Finance: Advantage China”, http://seekingalpha.com/article/229600-globalized-finance-advantage-china.)

The Federal Reserve, and the federal government, may need to change their economic models to include the fact that organizations other than domestically chartered commercial banks can create credit and can cause bubbles to occur anywhere in the world where an opportunity exists.

Modern finance with internationally mobile capital does not seem to exist in the models the leaders of the United States are using. This is one reason for my skepticism of all the new financial reform systems that are being constructed. (See my post “Banking at the Speed of Light”, http://seekingalpha.com/article/208513-banking-at-the-speed-of-light.) Money is becoming more and more fluid and hence less and less controllable.

The American banking system may currently be dormant, but there seems to be plenty of money and plenty of action, elsewhere.

Yes, there are bubbles all around.

Where the Action Is

Commercial banks aren’t lending. That we know.

But, there is action elsewhere and, I believe, that this behavior tells us a lot about how the recovery is working itself out…although it is not a recovery like the ones of the recent past.

There is a lot of money in the financial markets…in the shadow banking system…and worldwide.

Where is the action taking place?

Well, for one, in the bond market. We have major companies issuing bonds at ridiculously low interest rates. For example, Microsoft just completed a new bond deal. On September 23, 2010, Microsoft Corp., the world’s biggest software maker, sold $4.75 billion of bonds, “at some of the lowest rates in history for corporate debt.” The offering information stated that “Proceeds may be used to fund working capital, capital expenditures, stock buybacks and acquisitions.”

This follows Microsoft’s “first ever” debt issue which came in May 2009. An analyst noted at the time, “Redmond, Wash.-based Microsoft is sitting on $25 billion in cash, so the company doesn’t need the bond proceeds ‘unless they have something big in mind.’”

And, Microsoft is not the only major company taking advantage of the AAA bond market.

Then there is the “Junk Bond” market. The New York Times trumpets “Junk Bonds Are Back on Top.” (http://www.nytimes.com/2010/10/08/business/08bond.html?scp=1&sq=junk%20bonds%20are%20back%20on%20top&st=cse)

Jim Casey, “one of today’s junk-bond kings” and who runs the junk-bond business at JPMorgan Chase claims that “even those heady days of the 1980s” when Michael Milken ruled Wall Street and who Mr. Casey worked for at Drexel Burnham Lambert, “seem a little tame.”

So far this year, it is reported, that in the first nine months of this year corporations have raised $275 billion in this market worldwide, up from $163 billion in 2009.

“In high-yield, it’s undeniable that these are the best years that anyone has seen in their career.”

Whew!

It is estimated that “about 75 percent of the deals are aimed at refinancing, rather than taking on additional debt.” The risk profile of the companies has gone up!

And, who are big players helping to underwrite these deals? Let’s see, JPMorgan, Bank of American and Merrill Lynch and Citigroup…the top four!

Further action?

Well check out the private equity interests. They are raising capital in the billions. To do what? “Many banks are looking to sell large portfolios of commitments to private equity funds that they made during the credit bubble.” Banks are doing this because these “assets” are underwater and also because new higher capital requirements will make their “ownership” very expensive.

This just points to a whole host of private equity interests moving into the area of distressed assets. And, they are moving in aggressively. We read the article in the New York Times this morning about short-seller David Einhorn, the founder of Greenlight Capital. (See “A Bear Roars”, http://www.nytimes.com/2010/10/14/business/14views.html?ref=todayspaper.) One of the interesting insights relating to the work of Mr. Einhorn is the detail that Greenlight Capital put into its “due diligence” of the target.

The attention being focused on “distressed assets” today is not just a casual thing. Fund managers are aware of the risks they are under taking, just as they are aware of the potential returns that are available. As some have said, they are “taking care.”

One analyst remarked on the condition of the market: “We are seeing a steady river of deals” and “we expect this stream to carry on for some time.”

This is all part of the movement I reported on in “Corporations are Hoarding Cash and Keeping Their Powder Dry,” (http://seekingalpha.com/article/228507-corporations-are-hoarding-cash-and-keeping-their-powder-dry).

There seems to be a tremendous re-structuring of the economy taking place. I now believe that the re-structuring that is going on is beyond the power of the government to reverse. I believe that a similar re-structuring took place in the 1930s and 1940s, a re-structuring that the government, at that time, could not reverse. The 1950s represented the start of a “new era”.

The structure of the industrial base of the United States is dis-located with American industry using only 20% to 25% of its capacity. The structure of the work force is dis-located as 20% to 25% of the age-eligible workers in the United States are under-employed. And, the income/wealth distribution in the United States has become more and more skewed over the past fifty years.

These “dis-locations” will not be resolved by what corporate America seems to be doing now. Large companies, large banks, private equity funds, hedge funds, and other money sources are building up their cash reserves. They are looking, I believe, to buy assets, to buy “distressed companies” and so forth.

Imagine that Microsoft, a company that had never issued any debt in its history, has raised over $8.5 billion in new cash over the past 18 months or so while it is sitting on $25 billion in cash. Can you picture this money going to fund working capital and capital expenditures? I can’t but I can certainly see it going to fund stock “buybacks” (which raises its ability to purchase other companies) and to fund acquisitions.

Actions like this, however, will not result in higher levels of employment or greater investment in capital that would spur the economy along. If anything, a re-structuring, like the one I am writing about will have exactly the opposite effect.

Yet, this may be how the economy goes about recovering!

As I said above, I now believe that the re-structuring that is going on is beyond the power of the government to reverse. If this is true, neither a further quantitative easing on the part of the Federal Reserve System nor additional fiscal stimulus on the part of the federal government will do much in the way of achieving a more rapid economic recovery. If I am correct, the economic re-structuring will take place at its own speed. But, this will require a different response on the part of the government.