Wall Street is abuzz over whether the Federal Deposit Insurance Corporation will encourage pension funds to invest in failed banks. The FDIC needs the money, but the potential collapse of the commercial real-estate loans could pose a danger to pension funds, and the retirement security of their clients.

Seeking new sources of capital is nothing new for the agency. In 2009 the FDIC loosened its restrictions on private equity funds that invest in banks, lowering the capital requirement to 10% from 15%. At the same time the FDIC stipulated that these funds would have to maintain their investments for at least three years, in order to keep them from flipping.

The government doesn't have to worry about that from pension funds. Large and long-term oriented, pension funds offer the capital and stability the FDIC looks for when it re-releases banks back into the wild. Unlike private equity funds, which are oriented towards buying a company, fixing it, and selling it as soon as possible, pension funds seek stability for their clients--namely retirees.

The problem is these banks may not provide that. While marquee names like Goldman Sachs and JPMorgan Chase grab profits and big headlines, small- and medium- sized banks are still struggling under the weight of bad commercial loans.

"What's compounded the problem is that as liquidity has started to return to the markets, banks mistook that liquidity for value and haven't been selling off their bad assets, giving us a zombie-bank problem," said Len Blum, managing partner at Westwood Capital in New York, "and a big reason why banks aren't lending is because small- and medium- sized banks are sitting on tons of commercial real-estate that's about to go bad."

Despite market interest in these troubled assets, banks have been turning away potential buyers, presumably on the hope that the real-estate market will recover, saving them from failure. In the mean time banks have been playing what Blum calls "extend and pretend". The commercial real-estate market has been the financial market's perpetual other shoe to drop, and a major reason why it hasn't yet is because when a commercial real-estate loan matures, borrowers will borrower from other banks when they need to pay off another.

Thus far, the FDIC has not given official word on its position in regards to pension funds. Nonetheless, the prospect is being taken seriously, despite the potential trappings. "Pension funds have been getting bad yields, and there has been increasing scrutiny of fund managers' fees," Blum said. "The FDIC wants more participants, and pension funds want more yields."

The FDIC did not return requests for comment by the time of this article's publication.


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