From the December 4, 2007 Sunday Times
December 3, 2007
by Irwin Stelzer
The housing situation is deteriorating. Credit markets are snarled, as lenders hoard cash. Bank earnings are down some 25%, driven by mortgage and consumer credit-card defaults and late payments, which forced banks to increase their loan loss provisions to the highest level in 20 years. Lay-offs in the construction industry are picking up speed. Consumer confidence is down, partly because oil prices are so high as to be sucking the purchasing power out of the economy; retailers fear that the Grinch has stolen Christmas. The dollar is sinking, driving the euro and the pound to levels that price European and British exports out of many markets; America’s newest export might well be a recession.
For about 15 years credit has been somewhere between cheap and virtually free. Result: lots of borrowing to buy houses, credit cards worn to the nub by hyperactive consumers, and deals by private-equity firms based on cheap loans. Now, it turns out that too much of the collateral for too many mortgages and loans is not quite as good as it was thought to be. Indeed, some of it has no market at all, which should pose a problem for auditors asked to certify a value higher than zero.
So much for a summary of the news. A popular American broadcaster attracted millions of listeners with promises of “the story behind the story”. Let me try to repeat his success.
We are indeed witnessing a credit crunch – banks are less able and less willing to lend. But banks are not the only game in town any more. Although traditional banks remain important financial institutions, there is reason to believe that their woes are less relevant to the long-run performance of the economy than they have been in the past.
Start with the commercial-property market. Banks are demanding that property developers put up 25% of their projects’ finance, compared with only 10% before the troubles started this summer, and want to see current cashflow rather than projections of future income. As a result, the issuance of securities backed by commercial mortgages dropped from about $30 billion per month to $6 billion.
But the absence of traditional banks has called into being new players, including nonUS banks, such as the Bank of Ireland, insurance companies and what The Wall Street Journal describes as “smaller real-estate shops”. So property developers are paying more, but they can get financing for sound deals.
Then there is the deals business. Small buyouts, those under $200m, are having little trouble getting the debt needed to complement the equity being put up by buyers. Sources in the City say that funding for transactions in the £200m to £400m range remains available. And not all big takeovers are being called off. Dealogic reports that companies and private-equity firms pulled off $435 billion of acquisitions in the first three weeks of last month, a 23% increase over the same period last year. European deal volume tripled. So although lenders are charging higher interest rates and demanding increased equity, the deals business is hardly at a standstill.
Most important of all is the rise and rise of sovereign wealth funds – huge aggregations of capital in the hands of the world’s oil producers and major exporters such as China. China’s $200 billion pile of money looking for a home pales in comparison with Abu Dhabi’s, variously estimated at $650 billion to $1 trillion (these funds are less than transparent, so estimates of their size vary). It would be an exaggeration to say that the managing director of Abu Dhabi’s sovereign wealth fund, Sheikh Ahmed bin Zayed al-Nahyan, had only to dip into his petty-cash drawer to come up with the $7.5 billion needed to make his country the largest shareholder in Citigroup. But not much of an exaggeration. If estimates that the Abu Dhabi fund earns a return of about 10% annually are correct, the Citigroup investment represents approximately a mere one year’s earnings.
The high 11% interest rate that Citigroup will pay, in addition to giving Abu Dhabi convertible stock – the so-called equity kicker – shows how desperate the bank is to get its hands on new capital. But to leap from that to a conclusion that the credit markets are in terminal decline would be unwarranted. Citigroup was having problems long before market conditions deteriorated. It is regarded by many observers as a huge, inefficient and possibly too-big-to-manage dinosaur that should be broken up.
Besides, the banking sector as a whole is going through a long-term change that is merely compounded by current credit-market tightness. The world has changed. Wealth has moved into new hands. Morgan Stanley estimates that the world’s sovereign wealth funds hold some $2.5 trillion in assets, more than the global hedge-fund industry. And they are adding about $500 billion to their assets every year. One Gold-man Sachs banker told me that until recently he had never been to the Middle East; now he makes several trips each month.
Traditional banks, licking their wounds and trying to restore their balance sheets, are reluctantly selling off pieces of themselves to these funds, to the tune of $37 billion so far. Look for more such deals.
Also, expect these funds to take equity positions in nonfinancial companies. Equity capital from these sovereign wealth funds is replacing the debt capital that in the past 15 years greased the wheels of commerce. The result will be a healthy deleveraging of the world’s business: less debt, more equity. Since equity costs more than debt, profits will drop, but so will the risk that bad times will lead to bankruptcies and defaults – not a bad trade-off.
Irwin Stelzer is a Senior Fellow and Director of Economic Policy Studies for the Hudson Institute. He is also the U.S. economist and political columnist for The Sunday Times (London) and The Courier Mail (Australia), a columnist for The New York Post, and an honorary fellow of the Centre for Socio-Legal Studies for Wolfson College at Oxford University. He is the founder and former president of National Economic Research Associates and a consultant to several U.S. and United Kingdom industries on a variety of commercial and policy issues. He has a doctorate in economics from Cornell University and has taught at institutions such as Cornell, the University of Connecticut, New York University, and Nuffield College, Oxford.
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