Looking Overseas for a U.S. Financial Sector Bail-Out: It'll Cost You

There were two stories this weekend that solidified what I already knew:

1. The Fed is between a rock and a hard place with respect to interest rate policy; and
2. Overseas investors are being viewed as a possible savior to buy up depressed U.S.-dollar assets.

Problem is, with 1 above being the case due to a still-growing economy together with a plummeting dollar, a banking sector in disarray and locked-up credit markets, 2 is looking less likely unless the terms are substantially more attractive than they've been during the first three quarters of 2007. Consider this article from Saturday's New York Times (I have bolded certain key themes):

A Federal Reserve governor (Randall S. Kroszner) said yesterday that another interest rate cut would probably offer few additional benefits to the economy, a hint that the central bank plans to hold rates steady at its meeting next month.

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Mr. Kroszner warned that the housing recession was likely to worsen and predicted weaker home sales and a cutback in consumer spending as mortgage rates rise and foreclosures increase. But he said he expected the economy “to return to its longer-run sustainable rate” after a difficult few months. “Conditions for subprime borrowers will get worse before they get better,” he said.

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The bank’s statement (in October) at the time suggested a reluctance to ease rates further. In his remarks, Mr. Kroszner warned against a series of consecutive rate cuts, suggesting such a move could set off inflation. “All else equal, each successive action in the same direction tends to lower the incremental benefits and to raise the incremental costs of additional actions,” he said.

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The weak dollar has kept domestic business activity growing as foreign demand increases, but the report suggested companies are taking a more conservative stance, lowering inventories in anticipation of a spending slowdown.

“Exports can only take you so far,” said Joshua Shapiro, chief United States economist at MFR, a research firm. “I think we’re starting to see the evidence pile up of the effects of weaker domestic demand.” He added, “There doesn’t seem to be much reason for optimism, with housing continuing to decline.”

The themes in this article represent the two-sided nature of the Fed's dilemma. Housing is likely to worsen, mortgage rates rise and foreclosures increase yet the economy will "return to its longer-run sustainable rate" after only a few months? Huh? And even in the face of such weakness a series of consecutive rate cuts are viewed by the Fed as inflationary? But the export-driven growth in the face of the weak dollar is likely to abate and falling domestic demand come to the fore? What is the prudent man supposed to believe? The credit crunch and banking sector instability is clearly a prime driver of this Catch-22, but it is what it is: the Fed is stuck with poor, blunt weapons and little understanding of the true nature of the enemy.

And given the U.S.'s debtor status to the world and trillions of dollars in wealth stored up by sovereign wealth funds, they will come to our aid and bolster our ailing financial services sector and scoop up bargains in distressed debt and other asset classes, right? Well, maybe... My friend Thorold Barker over at the Financial Times penned an interesting piece this weekend on this very issue:

As the credit crunch saps liquidity from a number of traditional finance sources, the sovereign funds provide an interesting alternative for some US companies.

The idea of deep-pocketed overseas investors, who want to diversify their governments' holdings, is beguiling. Sovereign funds tend to be stable investors, who should not be too panicked about short-term share price volatility. So far, they have not tended to demand active board roles, in contrast to more aggressive hedge funds or private equity firms.

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Financial stocks could well prove to be a classic value trap for the unwary. But the likelihood of a big firm being forced to raise capital will increase if credit markets remain dislocated. And that could offer the bargain of the decade for sovereign funds, or others, willing to step up at short notice.

The trouble is, financial companies should not assume sovereign funds will provide easy cash on demand. The Chinese government is already red-faced due to the falling value of its Blackstone investment.

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Now, any sovereign wealth fund tempted to open its wallet for a struggling financial company that actually needs money is likely to drive a much harder bargain.

I think Thorold is quite right that sovereign funds now find themselves in the enviable position of having lots of investable cash at a time when relative bargains might become available. And given the scarcity value of their liquidity and the rough shape of many U.S. financial firms, they will likely demand far more onerous terms than they've gotten previously. That said, I think there is another massive point of negotiating leverage for these sovereign funds: the weak dollar. These funds are looking more and more to non-U.S. and Western European investments for better growth dynamics and appreciating currencies. Why put more assets in the U.S. when the sinkhole of banking sector losses is not yet quantifiable and domestic demand is poised to fall? Neither of these trends speaks well to the status of the U.S. dollar.

In order to attract this offshore capital long-term Treasury rates will have to rise to keep our bulging deficits financed, and private sector deals will have to be done on terms far more advantageous to foreign investors than six months ago. It is what it is. If you run large deficits, have weak accounting rules and governance practices and investors lose faith in your currency you get what we have today: a meaningful risk of stagflation, a hole out of which we'll be digging for years.

Comments

[Nancy]

There’s more fallout from the subprime mortgage debacle. The NewsVisual article on Freddie Mac http://www.newsvisual.com/newsvisual/2007/11/knowledge-map-s.html talks about the company’s plan to issue $5 billion in preferred stock in order to raise capital the company requires to offset its huge losses in the subprime market.