Bear Stearns’s ruin will shake Sovereign Funds

March 22, 2008
Singapore Democrats

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Andy Mukherjee
Bloomberg

In the end, Citic Securities Co. was lucky to sidestep the messy unraveling of Bear Stearns Cos.

Five months ago, the biggest Chinese brokerage wanted to buy 6 percent of the New York-based securities firm for $1 billion.

Miraculously for Citic, the “deal of a lifetime,” as Bear Stearns Chairman James “Jimmy” Cayne then described the tie-up, was never implemented.

That spared Citic the embarrassment of paying 69 times the price at which JPMorgan Chase & Co. agreed on March 16 to take over the beleaguered company.

Citic Group Chairman Kong Dan yesterday announced that the investment plan, as well as a proposed joint venture with Bear Stearns, was canceled.

Citic Securities shares rose yesterday in Shanghai even as China’s benchmark CSI 300 Index fell to an eight-month low.

While Citic may have been saved by serendipitous inaction, some state-owned investment vehicles in Asia and the Middle East may not have been so fortunate.

Banks and securities firms have raised as much as $105 billion of fresh capital by selling stakes to individuals, institutions and governments amid subprime-related losses.

The so-called sovereign wealth funds have provided at least half of the total, picking up stakes in Citigroup Inc., Morgan Stanley, Merrill Lynch & Co. and UBS AG.

After the spectacular collapse of Bear Stearns, these custodians of public money must now wonder whether they have really acquired sizable chunks of great franchises on the cheap, or if, in fact, they have bought lemons.

Only time will tell.

Attractively designed

Several of the sovereign-fund investments in U.S. financial companies are structured as interest-paying securities convertible into equity at a future date.

A drop in the share price in the short run doesn’t immediately – or necessarily – erode the return on the sovereign fund’s investment.

Even so, not all of the investments appear to be in great shape. Take Citigroup, for example. The stock must climb almost 72 percent from its current level for Abu Dhabi Investment Authority to profit from its investment over and above the very attractive 11 percent interest it will receive until conversion.

If one assumes that the U.S. financial system will emerge from the current gloom well before the mandatory conversion of Citigroup equity notes that starts in the first quarter of 2010, then it’s not unreasonable to expect that Abu Dhabi will ultimately make lots of money on its investment.

Shadow of doubt

However, given what happened to Bear Stearns – at the close of last week, its stock traded at $30; by the end of the weekend, the shares were worth just $2 – there’s now considerable risk that the securities issued by one or more U.S. bank or brokerage may convert into shares at a loss for the white knights who rescued them.

What if the magnitude of the loss is so large as to completely overshadow the interest income?

That wouldn’t make sovereign wealth funds look very smart, would it?

Jim Rogers, who co-founded the Quantum Hedge Fund with billionaire investor George Soros in the 1970s, says sovereign funds betting on U.S. financial stocks are going to lose money because they opened their purse strings too early.

Rogers may have a point.

Already there’s heartburn in China over state-owned China Investment Corp.’s $3 billion investment last May for 9 percent of Blackstone Group LP, the world’s biggest buyout fund. That stake, according to yesterday’s market price, has shrunk to less than half its original value.

‘Sweat and blood’

Morgan Stanley shares have lost 30 percent of their value since Dec. 20, the day it announced a $5 billion cash infusion — again by China Investment.

UBS stock has fallen 57 percent since Dec. 10, when it wrote down $10 billion of U.S. subprime investments and announced a bailout by strategic investors, including Government of Singapore Investment Corp.

Sovereign wealth funds are long-term investors.

They can afford to be patient.

But that doesn’t mean they have a complete license to bungle their trades in the short- to medium-term.

Following the Blackstone debacle, bloggers in China have questioned the judgment of state-appointed investment managers, with one anonymous writer on Sina.com, a popular Web portal, asking the authorities to take greater care in investing the country’s foreign reserves, “the product of the sweat and blood of the people of China.”

‘First of many’

If there’s still such a thing as “fundamental value” of a U.S. financial company, post-Bear Stearns no one can claim to know just what it is.

“Bear Stearns’s demise should probably be viewed as the first of many,” Richard Bernstein, chief investment strategist at Merrill Lynch, wrote in a report yesterday.

Comments like those will make sovereign wealth funds in Asia and the Middle East cringe. No doubt they will now be extra- cautious about investing in U.S. financial stocks. But what about the billions of dollars they have already committed?

The fate of those investments is now in the domain of luck and prayers. The fund managers can only hope they haven’t bitten off more risk than their political masters can chew.

Andy Mukherjee is a Bloomberg News columnist. The opinions expressed are his own.

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