MACRO MUSINGS:
Make Way For the Sovereigns
by Justice Litle
Editor, Consilient Investor
August 1, 2007

TO EVERYTHING there is a season, the Byrds sang. (And the good book said.)

For leveraged hedge funds, 'tis now the season for blowing up; the Metamorphosis we spoke of back in June is now on full display.

Stale Prices and Daisy Chains

The spreading subprime contagion has revealed a serious problem: many of the illiquid assets held on hedge funds' books have not been properly "marked to market." Asset values reported to investors are stale, overly optimistic, and not reflective of deteriorating market conditions.

Think of a house that went on the market at $400K six months ago; is it really still worth that much today, just because the price on the realtor's sign hasn't changed? A forced sale would out the true value of the house, or at least a much closer approximation of it. As overexposed hedge funds endure painful "forced sales" of the junk in their portfolios, the gap between hope and reality is being closed. Not a pretty sight.

Another serious problem, perhaps more so for banks than hedge funds, is the daisy chain of mass destruction linked to credit downgrades.

As a recent issue of Grant's explains, global commercial banks are only required to set aside 56 cents ($0.56) for every $100 worth of triple-A rated securities they hold. That's roughly 178-to-1 leverage.

If that same chunk of securities is downgraded to triple-B, the set-aside requirements jump from $0.56 to $4.80... a margin increase of more than 750 percent. Drop all the way down to double-B-minus, and the requirement skyrockets to $52 per $100 worth of securities held... a margin increase of more than nine thousand percent.

The commodity trading equivalent would be buying corn futures at $540 per contract, and receiving notice one day that margins have gone to $49,140 per contract. Think you might sell? There are multiple stops along the way, of course -- it's not a straight shot from the penthouse to the basement -- but each lowered notch requires another hefty whack of the bank's available capital.

The margin spread is huge because a triple-A credit rating has always been sacrosanct. Any debt rated triple-A had to be as solid as the Rock of Gibraltar, thus warranting the microscopic set-aside requirements. That's how it was in the old days anyway. Thanks to the miracle of financial engineering, Wall Street found a way to make the junk look pristine. Complicated asset structures dreamed up by geniuses allowed piles of dubious debt to get the coveted triple-A rating; with that triple-A stamp of approval in place, "conservative" financial institutions were free to buy glorified toxic waste.

And so they did. And here we are, wondering what might blow up next.

Biggest of the Big

Needless to say, the Masters of the Universe aren't looking so masterly about now. The whole Wall Street dog and pony show is taking on an air of tragic farce (as it tends to do after euphoric peaks).

But maybe the Byrds were on to something with that "Turn, Turn, Turn" lyric. If hedge funds have lost their luster, and private equity has peaked, perhaps it's time for a new season... a new player to dominate the scene.

Enter Sovereign Wealth Funds.

Sovereign Wealth Funds, or SWFs for short, are essentially state-owned and state-controlled investment vehicles. They are the blue whales of global finance; in terms of sheer size, Sovereign Wealth Funds are the biggest animals on the planet.

For example, the Blackstone Group towers over its private equity peers with $88 billion under management -- and yet the Abu Dhabi Investment authority, the oldest and largest of the SWFs, is reckoned to manage nearly ten times that much ($875 billion).

The top five Sovereign Wealth Funds -- run by Abu Dhabi, Singapore, Norway, China, and Kuwait respectively -- collectively manage more than $2 trillion, according to Morgan Stanley and WSJ estimates.

That sum alone, representing just five countries, is bigger than the entire hedge fund industry (in terms of assets under management). Many more countries, like Russia, Qatar, Botswana, and so on, have their own SWFs. (Russia has more than $100 billion.) Japan, oddly, does not have a Sovereign Wealth Fund; but could reasonably set aside $500-$700 billion if it did.

Management styles run from completely transparent to completely opaque. Some SWFs disclose all information to the public; others are as secretive as it gets.

What's more, the growth rate is incredible. Stephen Jen, a currency economist with Morgan Stanley, believes that SWFs could go from $2.5 trillion (today's estimates) to approximately $12 trillion within a decade.

Why is this happening?

Most folks know the first half of the story by now. The US has long been spending money with abandon, leveraging its position as printer of the world's reserve currency. Dollars are created from thin air (via the credit creation process) and sent out to the rest of the world, where they are exchanged for oil, imported goods, and so on. A large portion of those dollars get recycled back into US assets, and the cycle reinforces itself. This "vendor finance" arrangement offers temporary benefits for both sides: the US gets to spend money it doesn't have, and developing world exporters get the benefit of rampant economic growth stimulated by an eager customer.

The mercantilist trade-off requires America's trading partners to artificially restrain their own currencies, in order to keep export prices competitive. This results in mountains of dollars piling up in trading partner bank accounts. It also results in rising inflationary pressures around the globe, as local currency is printed to purchase all the greenbacks coming in.

These factors play straight into the hands of Sovereign Wealth Funds. The more the US spends on credit, the faster the dollar piles grow; the stronger that inflationary pressures become, the more pressure is felt to earn an inflation-beating return on paper assets. "If we invest in Treasurys and get 4% or 5%, inflation will eat it," Qatar's prime minister tells the Wall Street Journal. "We need high returns. We need to find a way to break through the cycle of the dollar and interest rates. We are taking the lead in investing in new instruments."

Mattresses Full

At an exclusive seminar in Switzerland last month, central bank managers representing $4.8 trillion worth of foreign exchange reserves gathered under one roof. The general consensus of the gathering? It's time to get more aggressive with excess assets. More risk, more reward.

Central banks have historically been very cautious in the deployment of their reserves. Top priorities are safety-oriented -- keeping the exchange rate in line, maintaining a cushion for defense of the currency, addressing trade balances and government funding needs, and so on.

But with the mattresses stuffed full to bursting, the need to "do something" with all that extra dough becomes pressing. One can only save so much for a rainy day.

There is also the fact that the dollars just keep coming. Tiny Qatar's asset managers are expected to put another $1 billion to work every week; according to the FT, China's reserves rose at the rate of $1 million per minute in the first quarter.

Private Armies, Public Capitalism

The rise of Sovereign Wealth Funds could have some odd long-term effects.

For one thing, a more aggressive SWF investment focus would mean fewer reserve dollars invested in treasury bonds. On balance, this would cause long term interest rates to go higher (as rates rise when relative demand for bonds falls).

Higher interest rates would make it harder for non-government entities, like private equity funds and hedge funds etcetera, to compete in the buyout space. Funding-cost hurdles favor entities with lots of cash; SWFS could thus have less competition, and a greater array of pickings for themselves.

Depending on the stomach linings of government managers, SWFs could also have more flexibility in terms of buying distressed assets -- stepping in when things look ugly (as they have started to look recently), and buying even more if markets don't respond.

This potential trend is inverse to the rise of private security contractors, as discussed in Macro Musings: Murky Water a few weeks back. The disturbing mix is one of slow privatization on the military side and slow nationalization on the market side. All hail the industrial conglomerate military complex...

The New Keiretsu?

It is the potential for dubious motives that has Larry Summers worried about SWFS. In a Financial Times editorial titled "Funds that shake capitalist logic," Summers writes:

The logic of the capitalist system depends on shareholders causing companies to act so as to maximize the value of their shares. It is far from obvious that this will over time be the only motivation of governments as shareholders. They may want to see their national companies compete effectively, or to extract technology or to achieve influence.

...To the extent that SWFs pursue different approaches from other large pools of capital, the reasons have to be examined. The most plausible reasons - the pursuit of objectives other than maximizing risk-adjusted returns and the ability to use government status to increase returns - are also most suspect from the viewpoint of the global system.

It is easy to imagine a Sovereign Wealth Fund putting political consideration ahead of shareholder value. That is how politicians and central bankers think; nation states routinely take courses of action that are completely mad from a financial perspective. (And other perspectives too, but we won't go into that.)

In line with political consideration, it is all too easy, too, to see Sovereign Wealth Funds as a handy tool for smoothing out the business cycle. What government could resist another back-door way to keep the party going, along with the traditional massaging of credit?

Combine the financial firepower of Sovereign Wealth Funds with natural political overtones, a distaste for the cleansing effects of the business cycle, and coordination-oriented thinking among friendly governments, and you get a recipe for a sort of new keiretsu on a grand scale.

"Keiretsu" is a Japanese term for an interlocking series of business groups. The Economist explains:

...the point of shares was not to raise capital, but cement ties with other business groups in an interlocking set of cross-shareholdings. These groups, with a principal bank at their core, became known as the keiretsu. In this system, the strong carried the weak.

For a while it worked spectacularly. Banks, cosseted by protected markets, regulated interest rates and a maternal finance ministry took in households' cheap savings and channeled them towards chosen industries. Savers did not get much in interest, but back then the Japanese were nothing like the consumers they have become. Japan was making things chiefly for export. And the virtue of the system was that everyone had a job.

The strong carrying the weak... everyone with a job... chosen industries... sounds like a politician's dream. An informal system of publicly managed capitalism, via the global reach and coordination of Sovereign Wealth Funds, could certainly have its boosters. After all, some people just prefer the trappings of a nanny state. How else does one explain a country like Norway, where the government runs a $300 billion investment pool on behalf of just 4.6 million citizens... and yet taxes those citizens to the eyeteeth.

No Free Lunch

In the end, any kind of global keiretsu system would likely be a disaster... and self-destruct in due time regardless.

The very concept of Sovereign Wealth Funds is a questionable one. There are many thorny issues, relating to philosophy, politics and logistics, that have gone unmentioned here.

Governments aren't too good at massaging the free market anyway, as the ultimate derailment of Japan's keiretsu -- and virtually every currency intervention attempted -- has shown. The more complex an arrangement gets, the shakier it gets. Conflicting elements hold for a while, imbalances build, and then it all comes tumbling down.

Bretton Woods II (the current vendor finance system, in which greenbacks are traded for mercantilist growth) has held together for quite some time. But the piper has not yet been paid... and he will probably want to be paid in gold.

As we watch the existing credit crisis unfold -- and try to prepare for what markets might do next -- it could be wise to keep Sovereign Wealth Funds in mind. Their influence will certainly be felt, for better or worse, in the days to come.

Profitably Yours,

Justice

© 2007 Justice Litle
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