Sovereign Wealth Funds Cool on Further Bailouts of Western Banks

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.

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  1. a

    So the Sovereign wealth funds have lost confidence in IBs but have faith in Flowers and the private-equity ilk? They will soon learn the meaning of “out of the frying pan, into the fire.” The cynic would say that what is great about Western capitalism is the number of different people able and willing to take a fool’s money

  2. Anonymous


    Please be on the look out for this evolving scam, which IMHO is one of the next synthetic goldmines:

    he nascent market for U.S. covered bonds will complement, not replace, traditional mortgage securities despite the crisis in many off-balance sheet transactions, the biggest U.S. issuer said this week.

    Losses in mortgage debt sold by Wall Street issuers and government-sponsored enterprises have put a spotlight on covered bonds, which also are backed by pools of assets but are perceived as less risky because the assets stay on the issuer’s balance sheet.

    I used to follow Irish Covered Bonds and IMHO, these are not good good play toys!!!

  3. Anonymous

    OT somewhat, but the source of funding for offshore finance is like a wormhole:

    Irish Covered Bonds Primer:

    Substitute assets with a maturity of up to three months and up to a limit of 20% of total
    cover assets are allowable

    The Act provides for the issue of two types of covered bonds by designated financial
    institutions according to the nature of the covering assets, namely mortgage credit securities
    and public credit securities. The covering assets must be divided accordingly into two
    separate pools – mortgage and public – and listed in two separate registers, to be maintained
    by the designated credit institution. The register must include details of the covered bonds,
    cover assets hedge contracts and the credit assets and substitution assets that form the
    cover assets pool. The IFSRA and Covered Assets Monitor must have access to this register
    at all times

    The Act defines substitute assets as
    deposits with eligible banks or tier one assets. The Act also provides that any other specified
    kind of property may be designated by Ministerial order as a substitution asset

    Over-collateralisation is required by the legislation. The Act provides that, for both mortgage
    and public credit pools, the prudent market value of the credit assets, including any
    substitution assets, shall at all times exceed the aggregate principal amount of the
    outstanding Irish CB.
    In addition, the aggregate interest payable in any calendar year on the asset pools, including
    any substitution assets, shall not at any time be less than the aggregate interest payable on
    the Irish CB.

    Third, the legislation is flexible in many respects, including
    the relatively wide geographical base for qualifying loans, provision for the use of
    substitution assets and derivatives, and the scope for overcollateralisation. Fourth, Irish
    covered bonds trade broadly in line with German Pfandbriefe, reflecting the high quality
    of both the legislation and the issuers

  4. Anonymous

    To Continue beating on this OT dead horse, look at what a fine job S&P is doing, in regard to helping mitigate risk (reminds me of Buffett):

    Furthermore, S&P welcomes the trend to mitigate market risks in the cover pools through the use of derivatives. However, to ensure that market risk is not simply replaced by the credit risk of the swap provider and to take into account the specifics of swaps used for covered bond transactions, S&P has issued a consultation paper on Swaps in cover pools in March 2006. This should facilitate the use of derivatives in the cover pool and further improve the safety of covered bonds going forward.

    In the covered bond analysis S&P focuses on 4 core areas:
    Review of the legal framework to ensure…..

    A commitment to the Covered Bond compliance test is regarded as an adequate practical application of the above.

  5. Anonymous

    One more kick and a gab for this dead horse, which is news today!!!

    Covered bonds won’t replace securitization – BofA

    The nascent market for U.S. covered bonds will complement, not replace, traditional mortgage securities despite the crisis in many off-balance sheet transactions, the biggest U.S. issuer said this week.
    Losses in mortgage debt sold by Wall Street issuers and government-sponsored enterprises have put a spotlight on covered bonds, which also are backed by pools of assets but are perceived as less risky because the assets stay on the issuer’s balance sheet.

    Fitch Ratings has today ( July 3, 2007) assigned BA Covered Bond Issuer (BACBI) series 4 covered bonds a final rating of ‘AAA’. These securities are issued under BACBI’s EUR20 billion covered bonds programme. The bonds will have a size of EUR1.5 billion, with a maturity of three years.
    In the absence of dedicated legislation for covered bonds in the US, the programme rests on contractual agreements and the pledge of assets under the US Uniform Commercial Code. The issuer is a Delaware statutory trust specifically established for the covered bonds programme while the sponsor of the programme is Bank of America NA. (BANA, rated ‘AA/F1+’ by Fitch), one of the largest US mortgage lenders.
    Under this programme, BANA will issue floating-rate, USD-denominated US mortgage bonds secured on a portfolio of residential mortgage loans originated or acquired by its branch network. The mortgage bonds will be direct and unconditional obligations of BANA, ranking pari passu and without priority among themselves. Each series of mortgage bonds will be purchased by BACBI, which will finance this acquisition through the issuance of contractual covered bonds. USD-denominated proceeds from the mortgage bonds will be swapped in exchange for interest and principal due under the covered bonds in the relevant currency. The programme is designed to protect covered bondholders against the risk that, in an insolvency of BANA, the Federal Deposit Insurance Corporation (FDIC) elects to accelerate the bank’s obligations.

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