The Treasury Department's latest effort to wind down the Troubled Asset Relief Program might be a positive for taxpayers, but it could prove to be a mixed blessing for the banks involved.

Last week the Treasury informed roughly 200 banks with Tarp funds — or two-thirds of those still participating in program — that it was considering divesting its stakes through pooled auctions that would start this fall. The banks selected were those that the Treasury concluded were the least likely to be able to repay in the next year and a half.

Depending on how the pooled auction is structured, the agency could be replaced with multiple investors. Those new investors could be hedge funds or other types of firms that may not exactly be friendly to community banks.

"I've experienced every emotion from my clients," says Rob Klingler, a partner at Bryan Cave in Atlanta.

"Some see it as an opportunity for a potential investor to buy both the Treasury stock at a discount alongside some new common equity and put the company on better footing," Klingler says. "Alternatively, there is some trepidation … over who the third party is going to be if they end up in the pool. What kind of influence will they try to have?"

It is unclear which banks have received a letter. The Treasury declined to comment for this story. But lawyers and advisors across the country said in a series of interviews that the banks are trying to figure out what this means to them.

The selected banks have the opportunity to opt out of the pooled auction if they, or a designated investor, can submit a bid by early August.

Though most of the chosen banks are unlikely to submit their own bids, industry observers believe the next six weeks could bring a flurry of activity as potential investors assess individual banks that they would like to bid on.

"I think some private investors will approach certain banks in the next month and start due diligence," Klingler says. "That maximizes the Treasury's return, but it gives the banks more say in who ends up with their" preferred shares.

The individual bids must meet a minimum price level. Klingler worries that even though the bids are due in early August, the Treasury could place those bids in limbo until it completes the first pooled auction. Doing so would ensure that individual bids are in fact the best outcome for the taxpayers.

"If they just want Treasury out, it might be easier to just be part of the pool and move on," Klingler says.

Zsolt Bessko, a partner at Jones & Keller in Denver, says he doesn't expect many of the banks involved to submit bids.

"The bid deadline is way too short for banks to be able to do something," Bessko says. "Maybe they can pull an outside investor in, but why didn't they do that months ago? The reality is that most of the banks won't be able to do anything."

For the banks that end up in the pooled auction, their fate depends on their financial condition. The relatively healthy banks will still have the option to redeem the preferred shares, as they would with the Treasury, as long as they obtain regulatory approval.

The biggest challenge might involve the troubled banks that are searching for recapitalization deals. Several recapitalizations, including those for Sterling Financial in Spokane, Wash.; Pacific Capital Bancorp in Santa Barbara, Calif.; and Hampton Roads Bankshares in Norfolk, Va., provided for the Treasury Department to convert its preferred shares, which carry a 5% coupon, to common stock at a discount in order to get the transactions done.

"Treasury has shown, for a government agency, remarkable flexibility and patience in dealing with unique circumstances," Klingler says.

Advisors say that private investors might not be so pliable because their interest is purely financial; there is no incentive for them to seek out the optimal outcome for taxpayers.

Converting to common equity "is certainly a possibility, especially if the shares are sold to a 'white knight' or other friendly investor who would agree to such a conversion," Philip Smith, president of Gerrish McCreary Smith, wrote in an email.

"We do not believe the unrelated third-party investors that are looking at this purely from a financial return aspect will have serious interest in engaging in that type of exchange," Smith added.

Beyond investors' willingness to strike such deals, the pools could present the same sorts of challenges that pooled trust-preferred securities have presented in recapitalizations. Getting the holders of those debt instruments to consider conversions has been difficult because of their complex structure.

"There are a lot of questions about how the banks are going to be able to deal with these investors going forward," Bessko says.

Frederick Cannon, the chief equity strategist at KBW's Keefe, Bruyette & Woods, says he doubts that the pooled Tarp auctions will present the same problems as pooled trust-preferred securities.

"It was something I thought about immediately, but we think it is going to be structured as a straight pass-through, while [trust-preferreds] were structured securities," Cannon says. He adds that, like the Treasury, new investors should be willing to strike a deal if it is part of a bank's best chance at survival.

"The alternative is that they wouldn't be able to repay at all," Cannon says.

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