NEW YORK (TheStreet) -- While on a recent visit to England I frequently passed branches of the Co-operative Bank in ragged city centers. I got a feeling of nervousness as I walked by these places, and upon my return found out why.
England's Co-operative Bank was founded in 1872 by a membership co-operative called Co-operative Group Ltd. in Manchester, with seven million members. It operates under a 20-year-old set of ethical principles and it's said to be losing its soul over a mountain of debt.
The bank saw the financial crisis as an opportunity to grow. In 2009 it agreed to acquire the Britannia Business Society; then, in 2011, it agreed to take some 632 Lloyds Bank branches. The lefty bank seemed to be on its way into the big leagues, the Big Four of British banking.
But Britannia had a ton of bad loans, some 1.7 billion British pounds worth (over $2.7 billion). These were mainly loans on commercial property. The result, for Co-operative Bank, was a 1.5 billion-pound capital shortfall, announced this year.
Enter two hedge funds, Silver Point Capital of Greenwich, Conn., and Aurelius Capital Management of New York, stage right. They bought 43% of the bank's Lower Tier 2 debt, at a price The Telegraph newspaper estimated at 300 million pounds ($480 million).
The hedge fund then organized the remaining bondholders, who held a total of 940 million pounds ($1.4 billion) of debt, and blocked a deal that would have allowed the Co-op to retain 75% of it.
Instead, the hedge funds demanded 70% of the bank, which said it had assets of almost 82 billion pounds ($131 billion) as of January, and 12.598 billion pounds ($16.3 billion) in revenue for the previous year.
Amazingly, they got it. The hedge funds turned a relatively small debt stake into 70% of a $131 billion institution. That's good business.
The Co-op is now trying to distance itself from any new policies while shareholders consider their options.
The Co-op wants to put the bank's ethical principles, which date back to 1992, into the bank's articles of association, which define the company's aims and objectives. This language could be changed only through a vote that would give the Co-op its own veto over operations.
The fig leaf should matter to the hedge funds because the bank holds the assets of a host of charities and left-leaning groups, from Amnesty International and Greenpeace to Britain's Labour Party -- assets it could lose if it changes its stance radically.
On the other hand, the bank's Web site brags it has withheld over 1.2 billion pounds of funding from business activities that its customers have said are unethical over the last 20 years. Maybe the new owners don't want to lose about $100 million a year on principle.
The ethical guidelines were broken by the bank itself when it got greedy and tried to buy Britannia, then the Lloyd's branches. By contrast, the hedge funds acted ethically, never misleading their intent.
When you buy bad debts, you become responsible for them. That's the real lesson here. You can't pretend to be above reproach on the one hand and then try to grab the brass ring with the other.
Not if you want to keep your soul.
At the time of publication the author had no position in any of the stocks mentioned.
This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.