Kuwait. Singapore. Russia. China. The government investment funds of these countries, and several others, may have saved our financial system from severe shock. Following over $100 billion in write-downs at the country's biggest banks due to bad bets on sub-prime and other mortgage-related debt, the titans of Wall Street — the banks many of you work for — had to go hat-in-hand to the petrodollar rich nations to shore up their balance sheets.
It's embarrassing, and brokers are fielding some tough calls. “My clients have been fearful — there's some uncertainty about the future of some of our biggest banks,” says one top Smith Barney financial advisor based in the Southeast. “One client was very, very concerned — a very large client, and a long-time Citigroup shareholder — about the lack of risk management.” Other advisors say some clients have called in a panic, worried that the bailouts pose a threat to their portfolios or bank management, while others simply wanted to understand how the foreign-government-backed funds work. “I'm getting a lot of questions,” says one top-tier advisor at Morgan Stanley. “A lot of clients don't really understand what [sovereign wealth funds] are, so I'm spending a lot of time educating them. Their concern is, obviously, they want to make sure that their money is in a place that is safe.”
Brokers can take some cheer in market researcher Strategy One's recent study of public opinion about Citigroup and Merrill Lynch: People wealthy enough to have assets managed by wealth managers have a better opinion of the banks than the population in general. Still, the study did reveal some anxiety: As of mid-January 2008, some 40 percent of so-called “opinion elites” were less likely to trust Citigroup or Merrill as a result of hearing or seeing news about foreign investments in these companies (See table “Sub-Prime Bailouts”).
What's worse, there may well be more write-downs, and bailouts, to come. In January, UBS announced that it would write-down an additional $14 billion, several billion more than it had anticipated just a month earlier, and $2 billion of which is linked to the distressed monoline insurers, MBIA, AMBAC Financial and ACA Capital Holdings. Other banks may end up doing the same. As of this writing, regulators were trying to cobble together a bailout of the bond insurers to prevent a further hit to the financial system, but such a bailout may come too late — if at all. Meanwhile, German finance minister Peer Steinbrück recently said the G7 now fears that write-offs of losses on securities linked to U.S. sub-prime mortgages could reach $400 billion, quite a step up from the U.S. Federal Reserve's estimates for sub-prime losses last year of $100 billion to $150 billion.
In the meantime, politicians (even presidential candidates), academics, executives and government officials have been doing a lot of hand wringing over what it means to have the funds of foreign governments underpinning our financial system. Concern over the so-called sovereign wealth funds' (SWFs) recent investments in big global and U.S. banks has focused on the potential political ambitions the funds' managers might have, as well as the lack of transparency around the funds' holdings. In a speech to the American Enterprise Institute in December of last year, SEC Chairman, Christopher Cox, issued a directive: “Investors and regulators alike have to ask themselves whether government-controlled companies and investment funds will always direct their affairs in furtherance of investment returns, or rather will use business resources in the pursuit of other government interests.”
As recently as January, at a well-attended panel of the World Economic Forum in Davos, titled “Myths and Realities of Sovereign Wealth Funds,” Larry Summers, former secretary of the Treasury and now a managing director at D.B. Shaw, voiced additional worries. For example, because the SWFs are — for now at least — long-term non-voting shareholders, they are actually more likely to protect the management of poorly run companies than to get in the way of good management, Summers said — possibly of equal concern considering the colossal errors in judgment made by Wall Street management where sub-prime is concerned.
These are valid fears. But there are some very good reasons why they are also overblown, why you — and maybe, more importantly, your clients — shouldn't worry about the banks' new alliances with foreign governments. Here' s what you should tell your clients.
The Best Thing That Ever Happened
Let's start with the simplest reason: This has happened before. Foreign investors have been investing here for years, and on this particular occasion the big banks had nowhere better to turn. Citigroup, for example, has already been bailed out once by Saudi Arabia' s Prince Al Waleed. During the early 1990s banking crisis, Waleed injected nearly $600 million into the bank, a stake that is now worth $12 billion. As one Smith Barney broker puts it, “Prince Waleed has been Citigroup' s biggest shareholder since our shares were worth $4.” He continued, “It' s no secret that Middle-Eastern countries have a lot of money and want to spend it. They have the money; we want to use it.”
What's more, sovereign wealth funds aren't going away any time soon. Morgan Stanley predicts SWF assets will soar to $17.5 trillion in the next 10 years, making them among the most powerful investors in the world. U.S. firms better get used to dealing with them, and the sooner the better.
But here's an even better reason to support the bailouts: Many sovereign wealth funds have so far been stable long-term investors. Take Kuwait's sovereign wealth fund, which has been a key and constant investor in Germany' s Daimler since 1969, and in Britain's BP since 1986. Plus, if their returns are any indication, making good investments is more important to these funds than attempting to further political interests: Singapore' s Temasek Holdings, for example, has notched a shareholder return of more than 18 percent compounded annually since its inception in 1974, according to its website. That' s not too shabby.
Of course, not all of the relationships between companies and their SWF investors have been rosy. You may have heard about Norway's SWF, which, in 2006, sold short its plummeting shares of Icelandic banks. No doubt the move irritated banks' management, but it certainly shows SWFs' independence and market discipline.
As for political interference, all of SWFs invested in our banks have taken minority, non-voting stakes, which means, at the very least, they won't likely have the clout to run off with corporate secrets, destabilize the U.S. economy or take steps to decrease competition for their own home-based rivals. China's state investment group actually refused a seat on the board offered by Blackstone Group, for example, which sold the government fund a $3-billion stake last year, according to Blackstone officials.
Meanwhile, the International Monetary Fund is working to draft rules governing the management of the world's sovereign wealth funds, many of which seem to support the idea. These would include promises to avoid speculative abuses and to keep politics out of their investment decisions. Some funds, such as Singapore and Norway, have already chartered separate (read: semi-independent) corporations to manage the funds in order to foster an investment culture centered on returns, and to protect the investment process from political interference, according to Jennifer Johnson-Calari, director of Sovereign Investment Partnerships at the World Bank Treasury, who contributed to a tome on the management of sovereign wealth funds titled Sovereign Wealth Management.
Looking ahead, there are other potential, if further afield, long-term benefits for U.S. companies of accepting SWF investments. For one, it should help emerging markets gain insight into good business practices and global legal norms, according David Marchick, Managing Director for Global Government and Regulatory Affairs of the Carlyle Group, who testified on the subject before the U.S.-China Economic and Security Review Commission. And that's good for the global economy in general.
It could even help the U.S. position itself for reciprocal investments in emerging markets. To wit: In September of 2007, Blackstone managed to overcome China's traditional resistance to major foreign investments when it bought a 20-percent stake in a state-owned chemical maker for $600 million. But that happened only after China's CIC bought a 10 percent in Blackstone for $3 billion in June of that year.
As the SEC's Cox himself has observed, SWFs could be viewed as having a stabilizing and modernizing effect on global finance, as well as providing a new source of liquidity for U.S. capital markets, and opening up state-run corporations to minority stakes by U.S. investors. While he's not ready to commit 100 percent to that being the case, advisors and investors should take heart.
WALL STREET STOCK: BARGAIN BASEMENT
You certainly can't claim the world's sovereign wealth funds are doing bad business by buying the stocks of Wall Street's biggest banks — they want to make money. The mortgage crisis has taken its toll on the stocks, making them relatively cheap.
|Bank||Stock symbol||Stock price 8//01/07||Stock price 02/20/08||% Decline||p/e* 2008|
|* Estimated||Source: Yahoo Finance|
Last year sovereign wealth funds invested $59.4 billion in banks with large U.S. operations, which were reeling from the sub-prime debacle. Singapore, Kuwait, the United Arab Emirates and China made some of the biggest investments.
|Citigroup||$6.8||Government of Singapore||3.7%|
|7.7||Kuwait Investment Authority;||4.1|
|Alwaleed binTalal; Capital Research|
|Capital World; Sandy Weill; Public Investors|
|7.5||Abu Dhabi Investment Authority||4.9|
|Merrill Lynch||6.6||Korean Investment Corp.||10-11|
|Kuwait Investment Authority|
|Mizuho Financial Group|
|1.2||Davis Selected Advisors||2.6|
|UBS||9.7||Government of Singapore Investment Corp.||10.0|
|1.8||Unidentified Middle Eastern (Saudi Arabia)||2.0|
|Morgan Stanley||5.0||China Investment Corp.||9.9|
|Barclays||3.0||China Development Bank||3.1|
|Canadian Imperial||1.5||Li Ka-Shing, Manulife Financial;||6.1|
|Bank||Caisse de Depot et Placement du Quebec;|
|Bear Stearns||1.0||Citic Securities Co.||6.0|
|Source: Bloomberg/SWF Institute data as of January 26, 2008|
HOW YOU CAN BENEFIT FROM SWFS
Sovereign wealth funds used to invest almost exclusively in Treasuries. Now they are diversifying into U.S. equities and other assets. That could raise the market risk premium.
What do sovereign wealth funds do with the dollars their countries earn from indulging our appetite for oil and cheap consumer products — other than bailout banks? More and more, they are moving their greenbacks out of treasuries, and into equity and other alternative asset classes. Makes sense, right? Diversification is the name of the game for any smart investor, and that's especially true for emerging markets that are dependent on smaller numbers of industries. “Diversification,” as Deutsche Bank analyst Steffen Kern notes, “is to some extent the very raison d' être of these institutions, especially in oil-dependent economies.”
The reason this might matter to you is this: As sovereign wealth funds diversify their assets into riskier asset classes, research analysts say that asset managers, investment banking operations, local government debt, emerging market corporate debt and securitization operations are set to benefit.
On the one hand, the SWFs are presumably going to need help managing their mountains of wealth as they take on more risk, which will kick up demand for asset management and investment banking services, they say. On the other hand, as they collectively shift the trillions they manage into high-yielding securities and debt, it means increasing demand for those assets — and rising prices.
In the most general terms, this shift should raise the overall market risk premium, says Morgan Stanley analyst Stephen Jen. “If a group of investors decides to start to release a part of the U.S. $5 trillion worth of assets currently invested primarily in sovereign bonds issued by the U.S., European countries and the U.K., and instead invest in equities, corporate bonds, private equities, commodities and real estate in a wider range of economies, the balance between sovereign bonds and risky assets must change,” writes Jen in a recent report. “In other words, risky assets will likely trade higher than suggested by the economic fundamentals.”
How they invest can't help but have an impact. SWFs are set to become among the world's biggest investors over the next five years or so. Already, estimates of total assets under management are in the $3 trillion to $5 trillion range, and are projected to rise to between $10 trillion and $15 trillion in the next 10 years, depending on who's doing the estimating. Meanwhile, Merrill Lynch projects the global share of SWF investment in riskier markets to double or triple over the next five years to somewhere between $3.1 trillion and $6 trillion.