Stray thoughts on the crunch

Much has been made of the so-called ‘credit crunch’ that, since August, has squeezed much of the liquidity from the global credit markets, and to be sure, we have seen real, measurable effects of this phenomenon. The highly leveraged mega-deals of 2007 have not made a comeback as investment banks have become less keen to lend to buyout firms; the high-yield debt market has crashed and burned; and even investment-grade corporate debt has gotten more difficult to move. The credit crunch in this context, then, is very real.

But something strikes me as a tad bizarre about the credit crunch. For example, amid $100 billion in writedowns by investment banks worldwide, where are the spectacular bank failures one would expect in such a scenario? Or, at the very least, where are the fire sales during which banks offload assets on the cheap in an effort to raise cash? In short, where is the pain? Of course, a few heads have rolled on Wall Street, but seeing a few CEOs gliding down to planet Earth beneath their golden parachutes is hardly the kind of pain one would expect from such a spectacular failure of the banks’ risk models. Shouldn’t there be some bankruptcies, or failing that, some bailouts?

While the past six months or so can certainly be characterized as a credit crunch, there is a notable difference between this crunch and prior ones: never before in the history of the global financial system has there been such an enormous pool of capital into which the world economy could splash down. We’re used to hedge funds and private equity – they’re old hat, but this new pool of capital is largely comprised of sovereign wealth funds, state-owned enterprises, and foreign central banks. These new – and enormous – players on the world financial scene have radically altered the calculus of how a contraction of traditional credit impacts the marketplace.

Take those investment banks hit hardest by their gambles on the sub-prime mortgage market. As their balance sheets began to teeter, the banks lacked available capital to fund ongoing commitments or to rescue other troubled investment vehicles. Credit contracts; banks won’t even loan to one another for fear of not being able to see risk in the marketplace; risk is repriced amazingly fast, and yesterday’s bargain might become tomorrow’s millstone. All of this creates a crunch and freezes bad bets into place. Traditionally, this is when one of two things could be expected to happen: one, banks would have to conduct a fire sale in order to convert assets into liquid capital quickly, or two, banks would stubbornly wait it out and play a game of chicken with the government in the hopes of being bailed out. This time around, neither scenario happened because of that enormous pool of capital over on the sidelines.

The first big infusion of capital came from Abu Dhabi. As reported in late November, The Abu Dhabi Investment Authority (ADIA) agreed to buy a 5% equity stake in Citigroup, and better yet for Citigroup, ADIA will have no role in the management or governance of Citigroup, nor any presence on Citigroup’s board. Great terms if you can get them. The ADIA investment was crucial for Citigroup, enabling the bank to endure the writedowns without shedding assets or operations. In other words, for 5% Citigroup was able to go about business as usual despite a massive failure in its risk model. This is not quite the way the market is supposed to work, not so much because of the ADIA investment itself, but rather the unusually passive terms of the investment.

No hedge fund or private equity firm would ever agree to a such a passive five-percent stake. So why did ADIA? It’s rather simple, really. Oil has generated so much cash so quickly in the Middle East that it is impossible for home markets to absorb all that cash. Hence the growth of sovereign wealth funds (SWFs). These funds are charged with the responsibility to grow and diversify the sovereign’s wealth, and to do so, they must access the global investment market. In other words, some sovereigns have too much money to simply store all of it in a vault or to keep buying American dollars.

But SWFs – particularly Arab ones – can’t just breeze into town and snap up assets. Remember the kerfluffle when DP World, a company owned by Dubai, tried to acquire Britain’s P&O? You’d have thought Arab marauders on horseback were swarming through the palaces of Christendom to hear the protectionist vitriol spewed forth in reaction to that single, fairly minor deal. What do you think the reaction would be should an Arab SWF attempt to buy a large piece of Wall Street?

While DP World is not a SWF, the funds learned an important lesson during the P&O debacle. The investment itself needs to take primacy over any form of corporate control. Besides, the SWFs have no real management expertise – why would they want to control their investments? This is why ADIA was willing to part with $7.5 billion without securing for itself any say-so in the management of the company. From the investor perspective Citigroup’s stock price will likely rebound quickly once it can put its financial house in order (particularly if it avoids a fire sale of its crown-jewel assets), and ADIA can expect to reap 50% gains or higher in 18 months’ time, although in the short term it has lost about 15% on the investment. The ADIA investment was sound, with or without corporate control.

The interesting question is how will this new pool of wealth affect decision-making in the marketplace. To be sure, the writedowns and credit trouble have likely caused several financial institutions great distress, but once it’s all safely in the rear view, Wall Street might realize that this latest round of pain was not so painful after all. What’s a passive 5% cut of the bank when it enables you to make outlandish bets (and profits) with little regard for losing?