Gulf investors continue to prop up American institutions, but how much more help will they need?
Will Gulf's white knights end up in a financial black hole?
The queue seems longer now to the Arabian Gulf. First came Citigroup, the world's largest bank, raising US$7.5 billion (Dh27.5bn) from the Government of Abu Dhabi in an intriguing deal that raised more questions than answers as to the true extent of the troubles besetting the US financial sector. The Gulf lifeline to Citigroup has come at a price, though, with the US giant offering 11 per cent to the Abu Dhabi Investment Authority (Adia) for a convertible loan stock, which Adia can convert into a 4.5 per cent stake in Citigroup in 2010 and 2011, at a conversion price slightly above the current share price, which is now at a five-year low. The rate paid by Citigroup is a couple of notches above junk bond rates and must be a humiliation for such a prime financial name.
Then came Barclays, raising about $9bn in new capital from assorted Qatari and Asian investors. It seemed a smart move by Barclays, as the current credit crunch has left some financial institutions - such as Halifax Bank of Scotland (HBOS) in the UK - red-faced and unable to complete a rights issue. What Barclays did was to obtain a cheaper form of investment underwriting from the Gulf and Asia. Is this funding enough? Even after the capital injection, Barclays will still be one of the most thinly capitalised banks in Europe, and yet paying out the same dividends this year as it did in the previous one. This could make the Barclays investment the deal of the decade for Qatari and Asian SWFs, or for those investors being urgently asked to cough up more capital in a year's time.
The troubling thing about white knight rescues such as Adia's is that analysts have led us to believe that, unlike previous banking crises, this time the financial institutions most affected by the subprime implosion were well capitalised and had a large cushion to weather any losses. It seems that some of the prime US banks are now reaching the bare minimum of their Basel Tier 1 capital requirement of eight per cent levels. Citigroup's Tier 1 capital ratio - a ratio of financial strength - stood at 7.3 per cent in the first quarter of last year, below its target of 7.5 per cent, but the Adia lifeline will take it back above target. This move might stabilise the fall in Citi stock prices, but it is coming at a hefty price and makes some wonder why the American bank could not raise these funds in its backyard at better terms.
So have Citi and some of the other financial giants come out of the woods yet, or will Arab funds be requested to pump in more money? Citigroup's investment business has been one of the most heavily affected. Some analysts estimate that excessive betting on subprime mortgages could still cost the bank up to $15bn in losses and other collateralised debt obligations. It is the structured investment vehicles (SIVs), probably amounting to about $80bn, which are causing the greatest concern, should these be brought on to Citigroup's books like others. HSBC and Citi recently announced yet more SIV losses. The other banks are also doing the same, including the latest casualty, Lehman Brothers.
The recent turmoil in the international financial markets has caused some unease about the health of the financial industry, on whether the worst seems to be over in terms of coming clean on the extent of non-performing loans. At the same time, there is a growing consensus emerging that the financial sector as a whole is in dire need of some sweeping internal reforms. What are the perceived flaws in financial models that have seen one household financial institution after another reel from bad debt provisioning, following the subprime market fiasco?
The indications point to a lack of adequate information about the true extent of credit risk of the underlying financial instruments, an excessive dependence on rating agencies that have seen their own reputation battered, and above all, an inadequate liquidity risk management system - the basic tool of any treasurer worth his salt. While some of these flaws might have been lurking under the surface, it was the speed, force and depth of events, which when combined took them to lethal levels not seen before on the markets.
However, all is not lost. Steps are underway to restore investor confidence, and some corrective measures have already started to be implemented. This is especially so in the area of risk management, the review of off-balance sheet conduits and special purpose vehicles and better ways to value complex structured financial products. Bankers are warning that there could be more financial dislocation if such corrective measures are not implemented to counter the market's insatiable demand for higher yields, especially in a period of falling interest rates that have led to inadequate spreads and a lack of attention to fundamentals and market risk differentiation.
So the possibility remains that more Arab white knights will be sought to rescue ailing financial institutions. One of the peculiar characteristics of today's global markets is that in some sectors, particularly commodities and other strategic assets, there is abundant cash for asset purchases by some companies, but such acquisitions are blocked on national security or other political arguments. The barriers seem to have come down as far as US financial institutions are concerned, but how long this lasts is only a matter of guesswork, as once again, the spectre of foreign takeovers of "national" symbols will be hard to accept.
As for Gulf saviours, whether they remain passive investors or try to introduce a little bit more financial discipline is another matter. At 11 per cent rates, Adia seems more than happy to remain on the sidelines for the time being, but the situation could change if the extent of potential collateralised debt obligations and structured investment vehicles becomes clearer. If this happens, then Arab money will be sucked into a bigger and bigger financial black hole, called "Operation Recycle Oil Money".
Dr Mohammed Ramady is a former banker and Visiting Associate Professor, Finance and Economics, King Fahd University of Petroleum and Minerals, Dhahran.