The consolidation in the banking industry continues as Cleveland-based National City Corporation has agreed to be acquired by PNC Financial Services for approximately $5.2 billion. Unique to the situation is that PNC will be utilizing funds from the U.S. Treasury to make the acquisition. PNC said it plans to sell $7.7 billion in preferred stock and related warrants to the Treasury Department, making it one of the first banks to elect to participate in the government’s effort to inject capital into banks through preferred-share investments. While the primary purpose of the Treasury’s capital injection plans was to free up funds and enable banks to continue to lend to customers and other banks, the Treasury now also supports the use of these funds in acquisitions of banking institutions that may be in a position to fail. Neel Kashkari, the Treasury official running the federal rescue program, yesterday publicly stated that the Treasury department supported lenders using funds from the $250 billion bailout law for mergers.

This is a newly revealed “use of funds” element that has not been widely discussed in the media, although it has been overtly suspected by financial analysts and economists. Larger and stronger banks acquiring weaker competitors using federally guaranteed funds was not part of the selling points of the Paulson $700 billion bailout plan.

National City lost over $3 billion during the past five quarters, and its stock has dropped 87% this year. Its losses were associated with bad real estate loans and has long been rumored to be a government takeover target. Over the past months company executives had insisted that the bank was not in the position to fail in an effort to assure depositors and customers.

Earlier this week, National City posted a $729 million third-quarter loss and a spokesman stated that 4,000 jobs would be cut over a three year period. CEO Peter Raskind said in an interview on October 21 that the bank was “quite interested” in the government’s program and “didn’t feel we were in a position where we needed additional capital.”

National City had more than 1,400 branches in nine states, including Ohio, Michigan and Pennsylvania as of June 30. The bank stated that total average deposits in the third quarter declined by less than $1 billion from the second quarter to $98.7 billion, and increased $5.2 billion from the same period a year earlier. The lender stated that new customers partly offset withdrawals from accounts that exceeded federal deposit insurance limits.

National City ranked among the 10 biggest originators of loans to people with poor credit histories in 2006. National City sold its subprime loan unit, First Franklin Financial, at the end of that year to Merrill Lynch & Co., where it contributed to a record loss at the New York-based securities firm. National City kept some of the loans made by First Franklin.

PNC will pay $2.23 a share, about 19% less than National City’s stock price as of October 23 of 2008 closing. When using a measure of total deposits, the new bank will grow to become the fifth largest U.S. banking concern and fourth largest by branches. PNC expects earnings to be apparent in its 2010 fiscal year as it plans to cut $1.2 billion costs. PNC expects to write down approximately $20 billion in losses from National City’s troubled lending portfolio. It is expected that costs related to the acquisition will be over $2 billion. National City shareholders will receive 0.0392 PNC share for each of their own.