The credit crunch has wiped out three iconic Wall Street firms, spawned the largest bank failure ever and jeopardized the health of more than 100 smaller commercial banks. But private equity firms see one thing in financial services: opportunity.

Says one buyout shop executive: "It's only going to get better."

Banks, even troubled ones, present a chance to buy cheap deposits that can be grown and loaned out for decent returns. There are many to choose from, even in these perilous financial times. The U.S. is the banking capital of the world, with roughly 561 institutions with between $1 billion and $10 billion in assets. Smaller banks are even more abundant. Some 4,478 U.S. banks hold between $100 million and $1 billion in assets, according to Joshua Siegel, the managing principal of New York-based StoneCastle Partners LLC.

The banking sector has recently seen a spate of buyout activity. In July, Sageview Capital LP invested $100 million equity for a 20% to 25% stake in Jacksonville, Fl.-based EverBank Financial Corp. In September, CapGen Financial Group LP agreed to acquire about 12% of Los Angeles' PacWest Bancorp for about $100 million. And J. Christopher Flowers, head of JC Flowers & Co. LLC, received regulatory approval to buy his own bank, First National Bank of Cainesville of Missouri, in August.

"We think this is a once in a lifetime opportunity," says A. Richard Caputo Jr., a managing principal at Jordan Co. LP, which is part of a group looking to form, not buy, a bank.

Private equity has always had an interest in banks, but regulation limited investments. That changed, albeit incrementally, in September under the pressure of the credit crunch, when regulators relaxed rules governing the purchase by private equity firms of bank stakes. Buyout shops can now own up to 33% of a bank's equity as long as they have no more than 15% of the voting shares. Private equity investments greater than 33% would force the firm to become a bank holding company, subjecting it to greater scrutiny from the Federal Reserve. Previously, the Fed capped equity investments at 24.9%, with voting shares at 9.9%.

The changes are expected to spur more interest though not necessarily a rash of bank deals, particularly given the financial climate. Besides, private equity firms are still barred from taking control of banks. And investing in banks involves a specialized knowledge ordinary buyout shops may lack, .from the ability to evaluate a bank's credit and capital positions to an insight into how management is operating the institution. Moreover, recent bank investments offer some cautionary lessons. Last month TPG Capital saw its $1.35 billion investment in Washington Mutual Inc. vaporize in the largest bank failure in history. WaMu, which had $188 billion in deposits, was seized by federal regulators and sold to J.P. Morgan Chase & Co. TPG's stake was wiped out.

With all these issues, why would anyone want to invest in a bank? The answer: There's potential profits there. Before the credit crunch began in 2007, high-quality mortgages were earning LIBOR plus 120 basis points, or 4.2%. The same loans are now yielding LIBOR plus 480 basis points, or 7.8%. "That's a massive pickup in earnings for the same credit risk -- a very low credit risk," the source says.

Small commercial banks typically sell for 1 to 2.5 times book value. "So if you buy a bank at 1 times book and sell it at 2 times book, you would be able to double your money," a second source says.

The Federal Deposit Insurance Corp. currently has 117 banks, with $78.3 billion in deposits, on its problem list. These institutions are all ripe for PE investments, the second source says.

Some firms are finding ways around restrictions limiting PE ownership. The most notable comes from J. Christopher Flowers, the former Goldman, Sachs & Co. financial institutions banker who now heads the private equity shop that bears his name. In August, the U.S. Office of the Comptroller of the Currency approved Flowers' purchase of 100% of First National Bank of Cainesville. Flowers is expected to use Cainesville, which has only $14 million in assets, as a platform to buy other banks.

Flowers made the investment as an individual and not through his firm. As an individual, he is not subject to federal rules restricting ownership. Though the transaction generated attention, it is not that unusual. Many smaller banks are owned by a single person or a family. "This is a personal investment of Flowers that is subject to extraordinary regulation," another source says.

CapGen, the private equity firm founded by former U.S. Comptroller of the Currency Eugene Ludwig, made its investment in PacWest through CapGen Capital Advisers LLC, an investment vehicle that will register as a bank holding company. CapGen Capital will own CapGen's 12% stake. The investment vehicle, rather than the buyout shop, will be subject to regulatory scrutiny, says a source close to the firm.

Sageview, with offices in Greenwich, Conn., and Palo Alto, Calif., went to the Office of Thrift Supervision and asked for permission to buy a 20% to 25% stake in EverBank -- a thrift holding company with about $6 billion of assets -- plus a board seat and an observer. EverBank is "squeaky clean," with good loans and no exposure to the subprime sector, says Scott Stuart, a Sageview co-founder.

Sageview has no immediate plans to sell its stake in EverBank. To recoup its $100 million investment, the private equity firm could take EverBank public after several years. In a normal market, Sageview might make more than twice its money since EverBank continues to grow book value, a person close to the firm says.

But Sageview would likely press for an IPO or seek out a strategic deal with a larger bank, probably after several years, when the bank has completed its growth strategy, this person says.

In addition to buying existing banks, some private equity firms are investing in startup banks. Jordan, a New York-based buyout shop that focuses on the middle market, is working with a group to form its own bank holding company, Caputo says, therefore avoiding having to conduct due diligence on an existing vehicle, which could take months.

Also, most banks remain overvalued, he notes. Wells Fargo & Co. is currently trading at more than 3 times tangible book value, which Caputo says is too high. "Banks in reasonably good shape are too expensive, and most banks have too little transparency and too many questionable assets to be able to perform due diligence in a short period of time," Caputo says.

Heritage Bank NA, a startup commercial bank targeting small and medium-sized business in the metropolitan New York market, has raised commitments and subscriptions of $60 million to $85 million, with a secondary target of $102 million. FrontPoint Partners LLC, an asset management subsidiary of Morgan Stanley, along with Carpenter & Co., an Irvine, Calif.-based investment bank, have each agreed to buy a 9.9% stake in Heritage, while BH Equity Research has committed $2.25 million. Heritage has about a dozen investors total, including private equity firms, interested in it, says David Bagatelle, Heritage's president and CEO. "Whether we get to $102 million is hard to tell," he says.

Heritage, which expects to have revenue of $10 million to $100 million, is scheduled to begin operations in the fall. Bagatelle expects it to benefit from the credit crunch, which has cut the amount of competition Heritage will face. The number of banks actively lending to the middle market has shrunk, he says, and those that are still around are not actively pursuing business as they once were. Because of this, Heritage expects to price deals better, Bagatelle says.

"Some think this is the best time to invest in a new bank in the metro area," he says.

Still, many private equity firms have shied away from investing in banks, preferring financial technology, middle-market lending or mortgage specialists instead. Lightyear Capital LLC, the firm founded by longtime PaineWebber chairman and CEO Donald Marron to focus on financial services, recently bought a minority stake in Higher One Holdings Inc., a payment processor for universities. Bur while Lightyear has yet to invest in a bank, Marron is excited. "This is going to be a very special time," he says. "It's an extraordinary opportunity for private equity over the next 12 to 18 months." Bank on it.