"What was old is new again," says Lee Meyerson, referring to private equity's recent, albeit frustrated, interest in the banking sector. Meyerson should know. Now co-head of Simpson Thacher & Bartlett LLP's M&A group and chief of its financial institutions practice, Meyerson, 53, began his career in 1981, as an associate at the firm. By the beginning of the next decade, he was fully involved in the savings and loan crisis, helping his client Kohlberg Kravis Roberts & Co. team up with Fleet/Norstar Financial Group Inc. to buy Bank of New England Corp.

Today he's again involved in private equity's forays into the industry, having advised Washington Mutual Inc. when TPG Capital made its ill-fated $7.2 billion investment in that long-gone thrift in April 2008. He also advised Corsair Capital LLC in its investment in National City Corp. that same month and represented the PE consortia that bought IndyMac Bank and BankUnited FSB from the Federal Deposit Insurance Corp. last year.

But the similarities between his early career and the current moment end there. As Meyerson puts it, this most recent financial crisis has been a unique event. "It's unlike anything I've ever seen before in terms of its depth and breadth," he says, noting that even the S&L crisis was limited largely to the thrifts, while the most recent crisis traumatized the entire system.

The crisis has also helped reshape Meyerson's career. He lost two major clients, Wachovia Corp. and WaMu, to a merger and bankruptcy, respectively, but through Simpson took a high-profile position as adviser to the U.S. Treasury when it structured its $250 billion liquidity injections under the Troubled Asset Relief Program.

Meyerson is a graduate of Duke University who received his J.D. from New York University School of Law in 1981. He has spent his entire career at Simpson and made partner in 1989.

In a wide-ranging interview, Meyerson talked to The Deal about the causes and ramifications of the financial crisis, attempts at reform and private equity's ongoing attempts at gaining a foothold in the sector.

The Deal: How would you describe the state of the banking industry?

Lee Meyerson: The state of the industry is stable. It's been largely recapitalized. There's probably some more capital raising to be done, but at least the evidence is clear that the industry will survive. Part of the stability has come from an extremely favorable interest-rate environment where banks have abundant liquidity at extraordinarily low cost, and that provides a nice earnings pickup. But it is also true that some parts of the industry are continuing to deteriorate. Commercial mortgage loans continue to worsen, and that's such a huge exposure for a number of smaller and midsized banks, compared to their capital, that probably several hundred more will fail.

What lessons would you say have been learned by the industry?

There was perhaps too much of a sense that we understood how markets and banking systems connect together and that this could all be measured and captured with different kinds of models. That turned out in many cases to be not true at all. It's a little bit like the sinking of the Titanic. People realized the technology wasn't as good as they had assumed, and it was a painful but necessary exercise to understand what went wrong and implement the right safety measures. The same is now true for risk management.

How do you react to the fact that the locus of the crisis was in the regulated firms, not the unregulated hedge funds or private equity firms? What does that say about our regulatory apparatus?

Well, one of the issues is that there was a shadow banking system that provided more than half the consumer credit in this country. And it was largely unregulated, and certainly many bankers would say that one of the principal origins of the crisis was that unregulated mortgage brokers and financial services providers could write loans that had incredibly risky terms for the owner but that were very favorable for the borrower. In response, many banks lowered their underwriting standards and wrote more aggressive, riskier loans in order to keep up with the competition.

It was a reduction in standards that was caused at least in large part by the unregulated parts of the financial sector, driving many banks out of pure competitive need to match or better their risky terms.

You're suggesting that market forces pushed firms into making loans, which implies some sort of structural inevitability. What about banks that resisted that race to the bottom? Don't banks that got caught have to shoulder responsibility for their decisions?

Obviously, some banks were more aggressive than others, and some were more diversified and so better able to withstand the financial crisis. However, every bank exists in a competitive environment. If you're a banker and all your customers are being offered loans at ridiculously cheap interest rates with no money down, you can certainly stick to your principles and say, "I'm not going to match that," but if the whole market is going there, what do you do? You're a bank -- you can't just begin selling stereos.

There were tremendous competitive pressures on the banking industry from the shadow banking system. In addition, few foresaw the extent of the collapse, and so even bankers who thought they were taking prudent risks turned out to be wrong. No one had a model that said we should be underwriting loans on the assumption that there will be a 50% or 60% depreciation in home prices over two years in Las Vegas or Florida. Why would you do that?

If you think about it, with 40%, 50% or 60% drops in prices, it doesn't matter how conservative your standards were. You could have written a loan with a 70% loan-to-value ratio, giving yourself a 30% cushion, which was extraordinary, and your loan would still be underwater.

What do you think of the reform efforts in Washington?

It's interesting to think back to the Great Depression, which started in October 1929. It wasn't until fully four years later that we got the first securities law, and that was only for initial offerings. The Securities Exchange Act, which regulated markets, was five years later.

So when you have a cataclysmic event, as we certainly had, it takes a number of years to fully understand what happened, all the ramifications, all the subtle causes that people don't see at first. And it takes a less political atmosphere than right after a crisis to properly, in a thoughtful, balanced way, address all the problems.

Some of the provisions in the bill probably have a consensus behind them, but actual application is going to be extraordinarily difficult. Just to give you an example: Most people probably say the idea of a systemic risk regulator seems to be a good idea, and the concept of a resolution authority for systemically important institutions makes sense.

But then you start getting into difficult issues such as: What financial institutions other than banks are supposed to be included in this regime? And how do investors deal with the risk of not being able to know whether companies they invest in may someday, and unexpectedly, become subject to this new resolution authority? The consequences of the application of these rules are going to be with us for years.

Many politicians are implying that too-big-to-fail is unacceptable and that no bank should reach that size. Is that a realistic expectation?

There probably are relatively few people who think you could actually break up the existing banks, set some size limit well below where the largest banks are today and enforce it and go back to an older, more tranquil time. I think that's not ­really possible and is based on sentimentalized memories of the past.

In fact, we had a series of banking crises in the U.S., partly due to regional banks being completely dependent on regional economic conditions or industries, such as the Texas banking crisis in the 1980s. They were not too big to fail, but they also were focused on Texas, and therefore the oil market, and when the oil market collapsed, it took all the local banks with it.

There's also the economic reality that lots of businesses are global and financial markets are global and interconnected. There's a definite advantage to a bank that is also global, can serve those different markets and those different clients. That's just economic reality. If the U.S. moved to shrink its banks, I don't think anybody else would, and we'd have a third-tier banking industry.

Alan Greenspan suggested that increasing capital requirements might be the way to decrease risk without over-regulating. What are your thoughts about that?

Most bankers definitely agree that having a stronger capital cushion is important, just given how volatile the world has turned out to be. The Great Moderation ended in a very unpleasant way, and there are no bankers who feel they have excess capital at this point. I think most bankers also probably have greater concern at this point about maintaining liquidity than they did a few years ago. Before the financial crisis, liquidity had not been an issue for banks for a generation, and it turned out to be a terrible issue, a fatal issue for a number of them.

So I think most bankers and most regulators agree that more capital and more liquidity are appropriate, but the question is how much more? Banking is supposed to be a leveraged business, and when you have a housing market collapse like we've had, it's not clear that having an extra few percentage points of capital would be enough to absorb all the losses caused by the collapse.

The other issue is that as you raise capital and liquidity requirements, there's a social tradeoff. The banks will be stabler with more capital and liquidity, but that will raise the cost of credit for everybody.

What are your thoughts about resolution authority?

The resolution authority as a general concept is a good idea. Who will be subject to it, how it will actually be implemented, who will pay for it and how much it will cost are very important questions that aren't ­really answered. The basic concept is that if a large financial organization is about to collapse, rather than having a splintered process where the bank is seized by the bank regulators, the broker-dealer is seized by [Securities Investor Protection Corp.], the holding company goes into bankruptcy and so forth, one federal agency would step in, stabilize the whole entity and then, as they do with a failed bank, sell off pieces of it, transfer some creditors' obligations to the buyers of those pieces and pay off the other creditors. But there has never been any regime in the U.S. where a financial services company, which could be doing insurance and brokerage and mortgages and commodity trading and all kinds of things all over the world, is taken over and unwound or dismembered by a single regulator.

I think there's a potential for enormous confusion in the market -- when a bank is seized, insured depositors know their deposits will either be transferred to another bank or paid off. But with many different types of creditors, how will they know what is likely to happen with their obligations? That uncertainty will be compounded by the fact that any financial company can later be designated as subject to this regime.

If you bought a 30-year bond in a midsized insurance company, how do you know what it will become in the future? Will it be too big to fail, will it be subject to the special resolution regime? If it does, what's your place in the hierarchy of creditors?

There's been talk about the public utility model of banking. But basic banking isn't a very profitable business.

That's how banks got into these ancillary businesses to begin with. The basic business of banking, particularly before the crash, was not very profitable, especially for business lines subject to competition from the shadow banking system. Ironically, one of the factors that drove a number of banks into making subprime, option and nonconforming loans was the fact they couldn't compete economically with Freddie Mac and Fannie Mae as well as the nonbank mortgage providers.

These effectively government-subsidized [government-sponsored enterprises] dominated the market for prime quality conforming fully documented loans, and so many banks concluded they couldn't profitability compete on those products and had to find products that were more profitable. A bank is like every other business and has to earn a return on capital that will satisfy investors, or investors will go elsewhere with their money.

What about the smaller and midsized banks. What sort of dynamic are you seeing in that sector?

It's clearly headed for a major shakeout. This is as a result of trends that have been developing for at least a decade, probably more. A lot of the retail and consumer financial services in the U.S. have become national products, such as home mortgages, home equity loans and credit cards. These are scale businesses dominated by either the GSEs or by the largest nationwide bank players.

And for a small bank which is limited to its community and which doesn't engage in diversified financial services, many of them were shut out of their plain-vanilla, bread-and-butter businesses, and to make a return on their invested capital, they were pushed into the riskier parts of the spectrum. That's why so many small banks have such a large portion of their loan portfolio in real estate development and commercial real estate loans, because those were some of the few remaining segments where they did not face intense competition from national players.

The FDIC, in particular, but the Fed as well, have been reticent in allowing PE into the industry to help recapitalize it. What explains their hesitation?

First of all, the financial needs and resources of the banking industry have changed markedly over the past year, although to some extent this is a tale of two cities. The biggest banks have almost limitless access to liquidity and close to unlimited access to the capital markets if they need it. For smaller banks, liquidity right now is good, but it's more vulnerable, and access to capital markets can be difficult or nonexistent, particularly for banks encountering financial difficulties. So I think there's definitely a role for PE.

Secondly, regulators have clearly struggled to find the right balance between bringing new capital in and ensuring that investors don't exercise control without being subject to regulatory oversight.

The historical concern of the bank regulators is that people that they don't regulate and have no control over are behind the curtain pulling strings in ways that are inconsistent with the best long-term interests of the bank or the safety and soundness of the bank.

The other issue is more about optics. The FDIC is always subject to congressional and press scrutiny, which inevitably creates risks of second-guessing on deal terms. That certainly happened with some of the [Federal Savings and Loan Insurance Corp.] deals of the '80s, which resulted in a congressional outcry as being unduly generous to private equity investors at government expense. I think there's always an overhanging concern that the deals be favorable enough to bring in investors and give them a fair return but not so lucrative that it becomes a cover story in Fortune magazine.

Why have we seen so few deals by PE in the sector?

There have been two big deals: the IndyMac deal, which was signed up at the very end of 2008, and BankUnited, which was done in May 2009. And those deals were done at a point where there was no real bidding competition from U.S. banks. Essentially, most of the banking industry at that point was still trying to stabilize and rebuild and had no interest in bidding for failed thrifts at all. But a couple of things have happened since BankUnited.

One is that the largest U.S. banks raised an extraordinary amount of capital in the late spring of 2009. I think most people were surprised by the ease of access that the large banks had to the capital markets. And the second was that much of the industry, especially the larger banks, stabilized a lot more quickly than people expected.

The results of the stress tests and the capital hurdle they set reassured a lot of people, including probably some of the banks themselves, that in fact the crisis was abating and that they could climb out of the bomb shelter and start thinking about expansion. And so subsequent to those two deals you did have significantly more interest by U.S. banks in bidding for failed banks.

Also, most of the expected failures over the next couple of years, with a few exceptions, are likely to be of relatively small banks, and so I don't think there will be a lot of opportunities for PE firms to form a club and buy a very large failed bank from the FDIC. As a result, the approach that some PE firms are taking is a rollup strategy where investors fund a management team that will go out and do the work to identify and buy small failed banks and attempt to put together a significant branch network out of it.

Are we talking about blind pools?

Well, the blind pools are one avenue, but you can still have the traditional consortium deal where management will find a few anchor PE investors and then supplement it with other investors, such as pension funds, family funds and other accredited investors, and then use the committed capital to buy failed banks.

The original blind pool was NBH, which was like a [special purpose acquisition company] except shareholders had no voting rights. Most investors held less than 5% of the common stock. The $1 billion was cash on deposit with management, who could use it as they saw fit.

The market has changed somewhat since then. Some deals are done where investors commit to a specified investment amount, but the decision to bid for a particular target would only be done with investor approval. There certainly is a significant sector of the investment market that does not want to commit their money on a blind basis. They will participate in a deal, but only if they get approval rights for it.

What about the potential for foreign buyers moving in?

It's not going to be a tidal wave. I think for focused foreign buyers there will be opportunities in the U.S., particularly because there is so little competition in bidding for non-failed banks. If you're a non-U.S. bank, you'd definitely be worried about how sustainable the U.S. recovery is. You also have an issue in the U.S. that a lot of the nondistressed banks that might otherwise be sellers right now are not interested in selling because market prices are depressed. There are so few buyers, liquidity is ample, capital is adequate, and having no reason to sell, they don't want to sell.

I think the experience of U.K. and Japanese buyers are lessons many foreign banks have absorbed, which is that the U.S. is a very large and competitive market, and unless it's something really central to your business plan and something you're prepared to put a lot of resources into, both in terms of market share and in terms of understanding and dealing with the risk, then it's too dangerous. It's not a market where you can play in small steps.

Is the FDIC open to allowing foreign buyers in?

I think the FDIC is a pragmatic seller. They have a statutory mandate to resolve banks at the lowest cost to the deposit insurance fund, and a non-U.S. bank which doesn't have any supervisory issues and whose money is green is welcome.

Do you think coming out of the downturn we could see a pickup in nondistressed M&A, maybe the mythical end game of U.S. bank consolidation?

Every few years you hear about the end game, but we always get to the end game and a new one begins. There can't really be an end game because I don't think people know how the business will evolve.

There certainly is the possibility that you will end up with a barbell distribution of banks, with a handful of very large ones at one end that have geographical diversity, extensive branch networks to provide copious liquidity and specialized business lines which give them economies of scale and therefore market advantage.

And at the other end you'll have the very small regional banks that tap into less price-sensitive community banking markets and customers, and the middle will be squeezed. But we still have over 8,000 banks in the U.S., so any end game, even if there was a clearly defined end to this process, is still years away.

To learn more about Lee Meyerson, use The Deal Pipeline's People Search. Click the People button to the right of the search box. A window will open with Last Name and First Name fields. Input the name. Select Meyerson's profile page to see stories about him or peruse the Deal Dashboard to see 50 deals he has worked on over the last decade.