from Follow the Money

Stable capital? Or scared capital?

April 23, 2008

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A host of banks have raised new capital over the past couple of weeks, in a whole variety of ways -- rights issues, convertible bonds, preferred stock and the sale of new equity.

However, they haven’t tapped last year’s savior: the big sovereign funds. At least not directly. Some of the private equity firms that have invested in the banks may be flush with cash that they raised (at least in part) from sovereign investors. Still, the Gulf has largely sat out the most recent round of recapitalization, despite plenty of petrodollars.

What are sovereign investors doing with their funds instead?

That isn’t hard to decipher. Over the last six weeks, foreign central banks custodial holdings at the New York Fed have increased by an average of $17.8 billion a week.

A week. Let me try to put that in context. $17.8b a week, annualized, is OVER $900 billion a year. If oil averages $100 a barrel in 2008, $900 billion is large enough to cover the US oil import bill (net of petroleum exports) two times over. If oil stays at $115, $900 billion doesn’t quite cover the United States oil import bill two times over, but still provides a comfortable margin of extra financing.

The average increase over the past two weeks was even higher -- $18.5b. That, annualized, is just short of a headline grabbing $1 trillion figure. It is real money.

All that money is going into safe Treasuries and almost-as-safe Agencies – not “risk” assets.

So much for the notion that sovereigns can ignore short-term market pressure because of their long investment horizons.

Right now it seems like no sovereign asset manager wants to take the blame for buying into a firm that performs as badly as Blackstone. Or, to be held responsible for a decision to recapitalize a banks that then fails, a la Bear. Or that buys something that performs as badly as the 2006 “vintage” subprime debt. Ask the Chinese state banks about their experience reaching for yield at the wrong time.

Sovereign investors may not be leveraged – but they face strong political pressure not to lose money. That can translate into risk aversion during times when the market is risk adverse.

That isn’t entirely a bad thing. Heavily reliance on sovereign funds to recapitalize the US financial system raised a host of risks. The big funds don’t seem to really have the capacity to evaluate the true state of the balance sheets of the big US financial firms. Imagining the political fallout had China -- through CITIC -- invested in Bear also gives me pause. Leveraged and illiquid financial firms can fail quite quickly. And I personally doubt that it makes sense to rely on the investment funds of non-democratic countries for a large share of the equity capital of the regulated financial sector in the major democracies. That effectively would make the non-democratic governments the de facto business partners of the US government – which insures that the financial sector, broker-dealers as well as banks, will have access to sufficient “liquidity” to be able to function as financial intermediaries in times of stress.

On the other hand, scared sovereign investors raise another set of problems.

Especially when they account for a large share of all cross-border flows.

UPDATE:  Even central banks occasionally take a week off.   The increase in central bank custodial holdings in the third week of April was quite modest -- only a bit over $2 billion.

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Monetary Policy