Known on Wall Street as the “smart money” crowd that turned quickly dumb due to bad bets during the bubble years, the private equity crowd is now pushing to buy troubled banks, posing new problems for government banking officials whose banking oversight has not been so state of the art.

The Federal Deposit Insurance Corp. is meeting today to decide whether to open the door wider to private equity firms hungering after buying distressed banks.

Would the descent of the vulture fund crowd on the damaged banking system pose a new systemic risk, at a time when the US government is desperately battling to stop any future dangers given the costly Chernobyl-like meltdown in the banking sector, and the US economy?

At a time when the US government is still struggling with a bailout of the banking sector which has not been so cinematically picture perfect?

The vulture funds are coming to roost in the troubled banking sector at a time when the Federal Reserve is now being asked to take on extraordinary new ‘systemic risk' regulatory powers that would let it wind down lethally large companies.

No bank regulator had such powers before over large companies such as AIG, Bear Stearns and Lehman Bros.

At the same time, the Federal Deposit Insurance Corp. has 305 problem banks on its radar screen which either need bailouts or are potential insolvencies, with few buyers in sight.

Pension funds, which the FDIC courted to help, including funds in Texas and California, have yet to step up to the plate, and powerhouse banks like Bank of America and JPMorgan Chase are already struggling with digesting their purchases of Countrywide Financial and Merrill Lynch, and Washington Mutual and Bear Stearns, respectively.

At the same time, 105 banks have failed since the crisis began, depleting the FDIC deposit insurance fund to a record low of just $13 bn, as banks have not paid into the fund for about ten years when times were flush.

The idea now is to let private equity firms buy banks by relaxing federal restrictions preventing outside investors from owning more than 24.9% of a deposit-taking bank. The thing is, for bankers, the private equity crowd is already here (see below).

And FDIC officials have noted that the private-equity crowd was on the scene during the S&L crisis of the late ‘80s and early 90s buying failed thrifts, including Bank of New England and CrossLand Federal Savings Bank.

Just as several vulture funds circled to buy Lehman's money management arm, Neuberger Berman, when the Wall Street investment bank collapsed in the fall of 2008. Neuberger Berman was eventually taken private in a management buyout last May.

Private Equity Firms Lobby Bank Regulators

However, the vulture funds want all the access to deposit without the onerous banking regulation rules. The likes of Henry Kravis, Steve Schwarzman and J. Christopher Flowers also don't want bank regulators crawling through their financial operations, so the business model here is to 'silo' the bank into a separate holding tank with its own operations.

How far will private-equity firms push back on being regulated like bank holding companies?

And wouldn't any push back come at the worst possible time for the US taxpayer, which has already ponied up mightily in the government bailouts?

Already the private equity firms are lobbying hard to get the government to relax the ownership restrictions limiting outside stakes to a maximum 24.9% in a deposit bank.

And the private equity firms are balking at stiffer capitalization rules they may face, the ratio of a bank's capital which acts as a cushion to its assets. Bank regulators are considering a ratio of 15% for three years, nearly double the roughly 8% tier one capital ratio required under the Basel accords.

Already, the FDIC is being pressured to drop that ratio back to 10%, or to what banks face now, 8%. The FDIC is also facing pressure to cut back on its cross-guarantee provision, which would lte the FDIC use the assets of a healthy bank owned by a private-equity firm  to guarantee losses at other banks the firm may own, a backstop that would be pro-rated based on the firm's level of investment.

If the FDIC eases up on the rules, will vulture funds then descend on banks to use deposits to buy and flip other companies for profit? And if their market bets sour, will vulture funds then try to get at taxpayer bailout money through their banks? Will private equity owners then more aggressively, via their banks, choose own bank regulator, as banks are already doing now?

Worth noting is that the US taxpayer has already bailed out a big private equity firm--Cerberus Capital Management, a co-owner of the troubled automaker Chrysler Corp.

Federal Reserve Chairman Ben S. Bernanke is asking for rules for investments in banks so private investors can't take advantage of U.S. assistance.

But will that be enough to protect taxpayers, who have done more than their fair share in bailing out the financial system?

Here Come the Vulture Funds

The vulture fund crowd has had a dicey track record lately. It has made some bad investments during the bubble years, overpaying on the order of tens of billions of dollars to buy or invest in companies such as Hilton Hotels, First Data, Freescale Semiconductor, United Rentals, and Alliance Data Systems.

Their modus operandi is typically to asset strip them, lever them up and then take the companies private in what's known as a ‘leveraged buyout.'

Their business model took a shot during the recent credit crackup, as institutional investors demanded steeper yields on highly leveraged companies' debt.

That helped caused deal volume to dry up and profits to get hurt at private equity companies like Steven Schwarzman's Blackstone Group and Henry Kravis's Kohlberg Kravis & Roberts.

Private equity firms are now sitting on tens of billions of dollars of investments in a number of heavily leveraged buyouts, including Harrah's Entertainment, Univision and Clear Channel Communications.

So what better way to burnish a battered portfolio then by buying a distressed bank with a solid deposit-taking footprint?

The Vulture Funds Descending

IndyMac – The Pasadena, Calif. bank was bought out with $13.9 bn in rescue funds from seven private equity firms, including JC Flowers, Dune Capital (both run by ex-Goldman Sachs executives). Federal regulators had to look to private-equity buyers for IndyMac. Other investors include a fund controlled by billionaire George Soros' Fund Management; Paulson & Co., which made hefty profits buying distressed home loans; Dell Inc. founder Michael Dell's investment firm, MSD Capital; Stone Point Capital; and a fund controlled by Silar Advisors. Watch this neat end-run likely to be aped by other players--because each of the firms are pitching in some money, no one firm owns more than 10% of IndyMac, thus circumventing the 24.9% federal ownership limit.;

First National Bank of Cainsville - LBO investor J. Christopher Flowers bought this Missouri bank himself, which poses an unusual conundrum for regulators. Flowers reportedly saw the Cainsville acquisition as a way to get a foothold into the banking business and make it easier to buy other banks. Flowers reportedly overhauled the board of directors and informed the Office of the Comptroller of the Currency of his plan to make more acquisitions—including possibly other lenders. Question for regulators: Is an individual person a bank holding-company? Can Flowers' individual ownership then circumvent regulations in any way?

BankUnited Financial – took in investments from Blackstone Group and WL Ross, led by famed vulture investor Wilbur Ross;

National City - Corsair Capital, which did nicely on its investment in National City; Washington Mutual - TPG (Texas Pacific Group) nearly lost all of its $7 bn in Washington Mutual, which went belly-up and was eventually bought at a fire sale price by JPMorgan Chase;

PacWest Bancorp - CapGen Financial, a private equity firm run by former U.S. Comptroller of the Currency Eugene Ludwig, which invested $100 mn.