In these days of distress for large banks, hot money is showing up from all over the world, as if there's a Black Friday sale on financial firms. No sooner had Swiss giant UBS (UBS) announced $10 billion in subprime writedowns than Singapore's state investment fund and an unnamed Middle Eastern investor appeared with $11.5 billion to buy a 9% stake in the bank. Citigroup (C), racked by a cash squeeze in its structured investment funds, received a similar infusion of $7.5 billion from Abu Dhabi last month. The emirate's sovereign wealth fund could wind up with a nearly 5% stake (BusinessWeek.com, 11/27/07) in the bank.
Pulling out these helpful checkbooks is hardly an act of charity. Bailouts play a crucial role in the market whenever one party, be it an investor or government, sees more value in helping a sinking company out of deep water than in watching it go under. "These are investment opportunities for somebody," says Benton Gup, a professor of finance and banking at the University of Alabama and author of Too Big to Fail: Policies and Practices in Government Bailouts.
Investment Opportunities and Risks
While companies like UBS and Citigroup are suffering short-term hits from subprime writedowns, both are widely seen as sound investments for the long haul. For investors with the cash to buy big stakes, particularly when share prices are depressed, meeting firms' short-term liquidity needs promises to pay off. "The American dollar is cheap compared to some of the foreign currencies," Gup says. "There's an opportunity for them to come in and buy some companies."
As the moves by Singapore and Abu Dhabi signal, the problems stemming from the subprime debt crisis have only increased the opportunities for sovereign wealth funds. But some U.S. investors are capitalizing on the situation as well. Private equity firm Blackstone Group (BX) announced this month that it raised $1.3 billion to invest in debt now being sold at a loss, including collateralized debt obligations and leveraged buyout loans. In November, Goldman Sachs (GS) unveiled a similar $1.8 billion fund for distressed debt assets, known as GS Liquidity Partners.
While Blackstone and Goldman attempt to profit from broad investments in distressed debt at a steep discount, other recent deals appear riskier. Citadel Investment Group purchased a 20% stake in E*Trade Financial (ETFC) for $2.55 billion in late November. The agreement took $3 billion in bad debt off E*Trade's books, but the online brokerage still holds $12 billion in home equity loans, and it's unclear what losses related to that portfolio are still in the offing. Of course, distressed assets are cheap for a reason, and a bailout can't always cure a company's financial ills.
When Taxpayers Foot the Bill
Much more controversial corporate rescues come when public money is involved. The U.S. government has stepped in to walk foundering firms back from the brink, usually by guaranteeing loans. It did so for companies such as Chrysler and the former Lockheed, and for domestic airlines facing bankruptcy after the 2001 terror attacks. "Any time they think a large entity is going to do serious damage to the economy, the government's going to step in and bail it out," Gup says.
That was the case nine years ago, when the hedge fund Long Term Capital Management nearly collapsed. The highly leveraged fund, run by an elite team of investors and economists, placed complex bets on futures contracts and derivatives—bets that were estimated to be worth $1.25 trillion just before the fund's crisis, in August, 1998.
Russia defaulted on its debt that month and devalued the ruble. The shock sent a ripple through international financial markets, causing them to behave contrary to Long Term Capital Management's investment models. Because of the size of the fund and the amount it had borrowed, the Federal Reserve feared that the collapse could cause other investors to panic, undermining the stability of the markets. To stave off such a crisis, the Fed orchestrated a $3.6 billion bailout financed by private banks to keep the fund from collapsing completely.
Government bailouts often come amid intense political pressure: The rescue is designed to save American jobs or to prevent a jarring collapse that would destabilize the broader market. They're controversial, not only because they jeopardize taxpayers' money, but because some see rescuing failed firms as a moral hazard: rewarding risky behavior and thereby encouraging companies to take similar risks in the future. To avoid that, bailouts often involve bringing in new management, restructuring companies, or other penalties.
To date, Uncle Sam has not stepped in to bail out individual firms in the wake of the subprime crisis. Instead, central bankers have cut interest rates, injected liquidity into the market, and opened an auction of $20 billion for commercial banks on Dec. 17. Gup says firms are suffering not so much from the number of subprime mortgages that are actually in default, but more from the uncertainty surrounding who owns that debt and how they will be affected. "Because of the complexity of the instruments that they were using, it's so damn confusing that the buyers worldwide didn't really understand what they were buying," he says.
The credit crunch that followed brought on the series of bailouts in the second half of 2007. For big investors able to provide liquidity to firms hit by the crunch, now is a prime buying opportunity. All it takes is a fat checkbook and a strong stomach.
For a look at some of the biggest corporate bailouts of the last century, see BusinessWeek's slide show.