What Can Private Equity Do to Get Rid of Toxic Debt?

Like hunting hounds on the prowl, private equity groups are picking up scents of profits in toxic bank assets. Will this help the Obama administration in its so-far confused search for a way to toxic bad debt off the market? Maybe some, but there are limits to what private equity can do by itself.

A number of private equity groups such as Pine Brook Road Partners, Pacific Investment Management Company and BlackRock are regarded as potential players in the quest for bad debt that can be turned around and made profitable.

The latest twist is that Carlyle Group, the politically-powerful equity group based in Washington, has raised $1 billion and wants $2 billion more to possibly buy distressed assets surfacing in Obama’s financial rescue plan. One of Carlyle’s targets may be BankUnited Financial Corp., a troubled Florida bank with $14 billion in assets.

Many are hopeful that private equity can gallop in like the Lone Ranger and buy up so much toxic debt that burden will be removed from the Obama group as it searches for solutions to the financial crisis. But there appear to be big problems with the concept:

1. The Obama administration had been toying with the idea of a “bad’ or “aggregator” bank that would buy up bad debt just as the Resolution Trust Corporation picked up bad assets from the savings and loan debacle some years back. But when Treasury Secretary Timothy Geithner announced his rescue plans on Feb. 10, he was disappointingly vague about a private-public investment fund, not a bad bank, that would handle this. More details are not expected for at least two more weeks.
2. The idea of such a fund could give big roles to private equity firms. But there are major conflict of interest issues to consider. As Prof. Campbell Harvey at Duke’s Fuqua School of Business, says: “The private investors want the maximum return. The government wants to do what is best for the entire financial system. We are short on details but one scenario is that the government lends people money to buy troubled assets. To me, this is exactly the type of action that got us into trouble in the first place.”
3. While stirrings of interest in toxic debt such as that by the Carlyle Group seem promising, without a larger structure to guide the process, not enough can be done by private money firms acting alone. The costs of toxic debt are so huge, “it is naive to think that private equity can make a dent in it,” Harvey told me.

So what can be done? Harvey says that one idea would be to separate good banks from bad ones (which is what the Geithner “stress test” is intended to do). The government would then inject capital into such “good” banks. They would also get an extra boost in the form of proprietary information from the FDIC to help them with lending and perhaps acquisitions. “Bad” banks would get help from a new version of the Resolution Trust Corporation.

A setup such as this could mitigate the extreme costs of some earlier ideas of a “bad” bank which could run as high as $4 trillion. Geithner has said that he may propose helping private equity firms with government-backed loans. But until he comes forward with a much-more detailed plan, any deals will be small ones and destructive confusion will continue.