There is an old saying, “Fool me once, shame on thee, fool me twice, shame on me.”
We’ve said it was a mistake to assume that sovereign wealth funds would continue to write checks uncomplainingly to salvage our troubled financial institutions. They’ve already been through one round of fundraising and things are getting worse, not better. Coming to the well again is a sign of weakness. First, it confirms that conditions have deteriorated, and thus any earlier investment is under water. Second, it says that the heads of the firms didn’t raise enough money the first time around. That means they either estimated losses poorly, which says they don’t have a good handle on their business, or they knew how bad things were but decided to put on an optimistic face and raise a smaller initial amount on more favorable terms, on the assumption that would lead to less total dilution. The latter possibility says the CEOs were, ahem, less than candid.
The funds are not going to be made into fools. An article by Gillian Tett in today’s Financial Times says that the SWF are becoming resistant to appeals for cash from financial firms. Resource and industrial investments are higher economic priorities for them. And though the article doesn’t mention it, I am sure they are also wondering why domestic investors like the big private equity firms aren’t doing their part.
That doesn’t mean they won’t stump up the cash in the end. But it will be on much tougher terms, which means more dilution of existing investors. If the government investors wind up with very large economic interests, say 20% or more, it is fantasy to think that they don’t have sway over the business.
It has been remarkable that American policy makers have blithely assumed that the rest of the world will continue to make up for our lack of domestic savings out of a misguided faith that no one would dare crimp US consumption.
In the past, central banks have been content to buy Treasuries, which has been an easy and painless way for us to get our debt fix. Many have depicted the growth of sovereign wealth funds as a plus, since it means that the foreign governments will be buying more asset classes. No one seems to have considered that they expect higher returns on these investments and will do more due diligence. In other words, the shift of investing to sovereign wealth funds means the cost of our heretofore cheap funding will rise. Our foreign money sources don’t have to cut off funding to discipline our behavior; all they have to do is increase its cost.
From the Financial Times:
Earlier this week, I chatted with a jet-lagged senior US financier. Like many of his ilk, he is flitting around the Middle East and Asia trying to extract finance from sovereign wealth funds and other investment groups.
His latest travels have delivered a surprise: some funds are quietly getting cold feet about the idea of putting more capital directly into western banks, he says.
“There is a backlash building,” he muttered into a crackling cell phone.
This is striking stuff. In recent months, many equity investors have taken comfort from the idea that sovereign wealth funds could ride to the rescue of Wall Street, if not the City of London too.
For as the subprime scourge has spread, US policymakers have leant on the largest US banks to raise capital, almost at any cost. Consequently, they have passed the begging bowl around the sovereign wealth funds, with considerable success. Thus far some $40bn to 60bn worth of injections have been promised to groups such as Merrill Lynch and Citi, depending on how you measure the promises.
But having stepped into the breach so visibly late last year, some funds are now getting jitters. In China, for example, there are rising complaints that funds are foolish to shovel cash directly into risk-laden US banks when they could be using it in better ways, such as purchasing western commodity or manufacturing groups.
“The Chinese are worried they are turning into [the source of] dumb money,” says one well-placed Asian financier, who partly blames the trend on the Blackstone saga, which produced significant paper losses for the Chinese investors.
Meanwhile, in the Middle East, the latest round of Federal Reserve interest rate cuts has created unease. For sure, some powerful Gulf investors have been heartened to see that the US authorities are acting in a resolute way. They are doubly relieved that the dollar has held up so well so far. But the dramatic scale of Fed cuts has prompted concern that Wall Street is still sitting on a putrid mess – contrary to what the US banks told the sovereign wealth funds late last year.
Unsurprisingly, this leaves Gulf investors cynical about promises from Wall Street banks. It also has some Asian and Gulf funds concluding that if they are going to invest to take advantage of the subprime mess, they are foolish to do so directly or alone. Hence some are now turning to private equity funds such as JC Flowers which are at least trained to analyse the subprime mess.
Now, it would be nice to think this sentiment shift does not matter too much for the US banks. After all, the recent infusion of funds means the largest Wall Street groups are looking pretty well capitalised on paper. It also means they should be able to absorb subprime losses, which banks such as Goldman Sachs think could reach $200bn for the banks soon.
However, the problem is that subprime is just one of several potential looming shocks. Defaults on other forms of consumer debt and commercial property could rise this year. So could defaults on corporate leveraged loans from 2009 on.
Meanwhile, the monolines insurers are threatening to blast another hole in banks’ balance sheets. Indeed, if you tot up all the hits that could emerge in the next couple of years, it is easy to reach a sum of $500bn, or far more. This is sizeable, given that Goldman Sachs calculates that the banks’ capital is around $1,600bn.
I would bet that in the coming weeks large western banks will once again start passing the begging bowl around the Middle East and Asia. But I would also bet that these banks will find the going increasingly tough.
Yes, US political pressure might produce a bit more money for banks. The Gulf and Asia remain flush with cash. But if the sovereign wealth fund money is now flowing to private equity funds instead of western banks, this gives this tale a whole new twist.
Stand by to see a new chapter unfold in this financial crunch.