Sovereigns at the gate

Beggars can't be choosers. Almost on a daily basis banks, investment banks and other financial institutions destabilised and threatened by the tidal wave of sub-prime losses are being bailed out by unconventional sources of capital.

Overnight UBS announced $US10 billion of sub-prime write-downs, having already announced $US4 billion of losses in October. Simultaneously it said that the Singapore Government's Singapore Investment Corp and an unnamed Middle East investor would pump in $US11.5 billion of new capital to stabilise its balance sheet.

In the US, MBIA Inc, the world's largest credit insurer, announced that private equity firm Warburg Pincus had agreed to inject $US1 billion of capital into its coffers. MBIA shares had more than halved amid concerns about its ability to meet claims on mortgage-backed securities and the threat posed by a review of its AAA credit rating to its ability to continue in business.

Late last month the Abu Dhabi Investment Authority invested $US7.6 billion in a five per cent stake in Citigroup after the bank admitted losses from the sub-prime crisis could be as much as $US10 billion.

Citigroup, UBS and MBIA aren't the only institutions in need of new capital. By the time the US and European banks, investment banks and credit insurers rule off their books on the impact of the sub-prime meltdown, the running count of the losses, now at close to $US70 billion, could be as high as $US500 billion. To survive losses on that scale, vast amounts of new capital will be required.

The only obvious voluntary source of capital on the scale required in such uncertain circumstances is the same place that Citibank and UBS turned to – sovereign wealth funds. Those funds, government-owned or controlled entities like our Future Fund, have become the repositories of close to $US2 trillion of funds generated from surging crude oil prices and burgeoning foreign exchange reserves. The Middle East and Asia (China and Singapore so far) are in the vanguard of deploying those reserves.

US treasuries, the traditional politically-neutral safe haven for foreign government-sponsored investment, are now out of favour in an environment of falling rates and a tumbling US dollar, so those funds are increasingly interested in equity stakes. The flurry of big dollar investments in distressed financial institutions suggests they see a "straw hats in winter” opportunity created by the sub-prime crisis.

Large equity investments in strategic and sensitive sectors of the economy by Middle Eastern and Asian governments might normally create a political backlash. While there has been some unease within the US about the emerging trend, that appears to have been muted by recognition that the US banking and financial system is so stressed that its participants need to accept help from any quarter available.

The growth rate of the sovereign wealth funds, and the emergence of new funds, is such that they are expected to quadruple their funds under management within five years. That's a lot of capital to be invested, particularly if the fear in global markets generated by the sub-prime ripples subsides.

The Warburg Pincus investment in MBIA is somewhat different, but perhaps points to another funding source for stretched institutions.

There were vast amounts of capital raised by private equity funds ahead of the sub-prime crisis. The credit crunch that ensued, however, means that the funds can't raise the debt on reasonable terms to leverage that capital and generate something approaching their normal internal rates of return. The capital usually generates no fees, or only minimal fees, until it is deployed.

If the impact of the crisis on the big banks and investment banks isn't open-ended – if there is a conviction that at some point in the not too distant future the losses will peak – private equity might join the sovereign wealth funds in an opportunistic attempt to generate their returns from something more akin to vulture fund activity than the type of highly-leveraged deals the funds have pursued in recent years.