Merger and acquisition activity has been almost nonexistent, but that is not to say it has been uninteresting.

A paltry $822 million of deals was announced in the first half, versus $7 billion the year before.

Though the pace is expected to pick up — after all, it could not get any slower, industry participants say — obstacles that made recent deal volume by far the weakest on record are unlikely to go away soon.

Stock prices remain low, despite the rally of recent months. This not only gives companies less buying power but also depresses deal prices so that healthy banks reject selling as an option.

Most banks and thrifts, concerned about their own growing loan troubles, want to conserve capital.

And due diligence continues to be difficult.

Healthy companies also can grow without the risk that comes with buying a bank or thrift.

They can add loans and customers faster now, as competitors retreat.

More importantly, they can scoop up the branches and deposits of failed institutions on the cheap from the Federal Deposit Insurance Corp., with the comfort of loss-sharing agreements on the iffy assets.

"There's another seller in town — which is the FDIC," said Brian R. Sterling, a principal and co-head of investment banking at Sandler O'Neill & Partners LP. "Why would you take on credit risk when you can do transactions without assuming credit risk?"

CREATIVITY IN DEMAND

Any excitement in dealmaking may come from the unusual structures that have emerged in this difficult environment.

What the deals lack in size, they make up for in smarts.

"We have seen some creativity," said Jacob A. Lutz 3rd, the partner who leads the financial institutions group at the law firm Troutman Sanders LLP.

Several observers pointed to First Niagara Financial Group Inc.'s $237 million stock deal for the struggling Harleysville National Corp. as an example.

In announcing the deal July 27, John Koelmel, First Niagara's president and chief executive officer, said that the structure made all the difference in getting him comfortable, despite the risk.

Besides paying Harleysville shareholders, First Niagara would have to plug a $150 million capital hole at the acquisition target, Koelmel said.

So his company looked at the overall deal cost as roughly $400 million and took steps to ensure that it did not end up paying more.

The agreement calls for each Harleysville share to be exchanged for 0.474 First Niagara shares, if loan delinquencies stay below $237.5 million. Otherwise, the exchange ratio can drop.

In effect, if capital needs expand, the shareholder payout shrinks.

Other potential buyers have taken notice.

"A lot of healthy institutions looking for institutions that haven't failed yet are looking at that as one way of mitigating risk," said Rick Childs, a director at the accounting and consulting firm Crowe Horwath LLP.

The deal by the $11.6 billion-asset First Niagara of Lockport, N.Y., was announced in the third quarter, adding evidence that the M&A market is already picking up.

But for every Harleysville, dozens of strugglers are working in vain to find capital.

And Koelmel, who has made it clear he is willing to do even more deals, is widely viewed as an exception.

THE LAST BIG DEAL

Truly sizable deals have been rare in the past six quarters; the most recent happened last fall.

On Oct. 24 PNC Financial Services Group Inc. announced that it would buy National City Corp. for $5.2 billion of stock.

But even this exception to the rule illustrated the themes playing out in an abnormal market, since unusual government help figured heavily in PNC's calculations.

Nat City faced heavy loan losses, and PNC cited a $7.7 billion capital injection from the Treasury Department's Troubled Asset Relief Program as a key element of the deal.

The $280 billion-asset Pittsburgh company, which doubled its size by buying Nat City, could have applied for only about $3.5 billion of capital on its own, but the Treasury approved the larger amount using pro forma risk-weighted assets.

PNC took comfort from the boost, which it said would allow a Tier 1 capital ratio of 10% after the Nat City deal closed in December. It did not agree to the deal until after hearing from the Treasury.

"National City was the last large deal. It was contingent on a huge amount of capital from the government, but it was a deal where shareholders received a premium," said Andrew M. Senchak, vice chairman and co-director of investment banking at KBW Inc.'s Keefe, Bruyette & Woods Inc. "It was based on National City's weakness, but it wasn't so weak that PNC refused to do a deal."

Now few potential deals are left for the nation's banking giants, and observers said they expect activity to remain concentrated among smaller players in the foreseeable future.

That is, the little M&A that comes to fruition.

They predicted improved deal flow in the second half but not by much.

"We don't see M&A volumes changing appreciably over the next six months," said Sandler O'Neill's Sterling.

NO SURGE IMMINENT

In some ways, what is happening mirrors the housing market.

Relatively few have the capital and confidence to buy, and they are being tough negotiators. The sellers generally must sell; others will hold out until later.

So bargain hunting is on.

And in the end many shoppers — whether banks or private-equity firms — are looking without buying.

"There's a lot of walking away," said Crowe Horwath's Childs.

Because of the economic stress, a deal generally offers no quick payoff, he said. Instead the goal is to add longer-term value for a significantly lower price than would have been possible a few years ago.

But "the deals are complicated," Childs said. "They all have a little bit of hair on them."

In figuring out whether the opportunity outweighs the credit, regulatory and integration risks, the math is fuzzy, observers agreed. Even a minor hitch ultimately can scuttle negotiations.

"At this juncture, for the most part, most people are refusing to buy because they think the target is too weak, and even though they might want to buy it, they can't. The risk-reward isn't in their favor," Senchak said.

"So they wait until the FDIC sells it to them and the risk-reward shifts immeasurably in their favor."

BY THE NUMBERS

Regulators seized 45 institutions in the first half, and the failure rate is escalating. They shut another 24 in July alone, bringing the total for the first seven months to 69.

Some observers said that overall FDIC sales could outpace traditional ones soon, given the July figures.

"The government has been reluctant to allow failures because of the fear of another liquidity crisis," said Fred Cannon, the chief equity strategist at Keefe Bruyette. "But deposit activity has been very strong, and I think we're starting to see the dam break."

The M&A market had 68 deal announcements to show for the first half, excluding the nine that were later terminated, according to SNL Financial LC. Another nine announcements were made in July.

But in gauging just how much the market has shrunk, even more telling is the $1.1 billion total of deal values through the first seven months — which puts this year on pace to be the slowest in the past 17 years for which reliable data is available.

The previous full-year low for deal values was a comparatively robust $17.2 billion in 2002.

The low for number of deals was last year's 147.

Even so, deal values managed to hit $36 billion for the year, buoyed by two anomalous large deals in October.

Besides the PNC deal, Wells Fargo & Co. agreed to pay $15.1 billion in stock for the hobbled Wachovia Corp.

The PNC and Wells Fargo deals accounted for 56% of last year's volume.

OTHER STRUCTURES

Observers said they cannot guess when the M&A market might fully rebound.

"When credit quality improves," said one.

"However long it takes to clean up the industry, recapitalize it and achieve economic stability," said another.

Meanwhile, expect unusual deal structures to become more common.

Childs said one option that has been less than successful so far is a "bad bank" arrangement.

Some potential sellers are looking to isolate nonperforming assets in a separate entity while getting a significant private-equity investment.

But coming to terms, and clearing regulatory, legal and accounting hurdles, have made such deals elusive.

"These have proven more difficult than what it may look like on paper," Childs said.

Troutman Sanders' Lutz said deal structures that can create safety for the buyer and upside potential for the seller are in demand.

In one model he has seen, the deal price is fixed initially but subject to adjustment based on the performance of an asset pool.

Such a compromise is particularly handy in cases of differing opinions on loan impairment, Lutz said. "It is to the buyer's advantage as well as the seller's advantage."

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