Sovereign Wealth Funds to the Rescue?

Global banks may turn to Asian and Middle Eastern Sovereign Wealth Funds with plenty of capital

After years of rising profits and sound financials, the global banking industry finds itself in a much more difficult operating environment. Capital levels have become depleted as asset values, particularly for asset-backed securities (ABS) and collateralized debt obligations (CDOs), have dropped. As a result, banks took significant writedowns in the third quarter and may announce more in the fourth. In order to shore up their capital bases, major global banks may look for help in Asia and the Middle East where sovereign wealth funds (SWFs) have a significant amount of capital and a predisposition for investing in financial firms.

Banks around the globe took significant writedowns to their mortgage-related assets in the third quarter. The writedown at Citigroup (C; 33) was about $3.3 billion in the third quarter, and the bank is expected to take between $8 billion and $11 billion in additional writedowns. A number of others, including UBS (UBS; 50) ($3.4 billion) in Switzerland, HSBC (HBC; 85) ($3.4 billion), Bank of America (BAC; 46) ($3.3 billion), Barclays (BCS; 46) ($2.7 billion), and Wachovia (WB; 43) ($1.3 billion) all wrote down the value of assets in the third quarter.

Amidst these devaluations, the capital ratios at many banks have come under pressure. Overall, the Tier 1 capital ratio (a measure of capital adequacy) for U.S. commercial banks is on the decline, according to data from the Federal Deposit Insurance Corp. (FDIC). In the third quarter of 2007, the industry's Tier 1 capital ratio was 9.5%, down from 10.1% a year prior.

For some individual banks, this decline has been more pronounced. At Citigroup, for instance, the Tier 1 capital ratio was 7.3% at the end of the third quarter, down from 8.6% at the end of 2006 and below its target level of 7.5%. Wachovia's Tier 1 capital ratio has slipped more modestly, declining to 7.1% as of the third quarter from 7.4% at the end of 2006, while Bank of America's ratio slid to 8.2% from 8.6%. UBS has seen its Tier 1 capital ratio fall to 10.6% as of the third quarter from 11.9% in 2006.

Citigroup turned to the Middle East, where SWFs have been amassing cash as a result of the boom in oil prices. The world's largest SWF, Abu Dhabi Investment Authority (ADIA), agreed to invest $7.5 billion in Citigroup. The ADIA will receive convertible bonds that carry an 11% coupon, which will then convert into a 4.9% stake in the bank between March 2010 and September 2011.

According to S&P equity analyst Frank Braden, Citigroup's deal with ADIA underscores its need to boost capital levels, while it attempts to avoid a dividend cut.

Other banks looking to raise more capital to offset these asset declines may also find willing partners in the Middle East and Asia. In general, SWFs have been frequent acquirers of bank stakes. In July 2007, China Development Bank agreed to buy a 3.1% stake in Barclays for about $3 billion. The Dubai International Financial Centre (DIFC) recently took a stake in Germany's Deutsche Bank (DB; 132). Temasek Holdings, based in Singapore, has equity in a range of banks, including Barclays, Standard Chartered (STAN.L), China Construction Bank (601939.SS), DBS Bank (DBSM_pb.SI), ICICI Bank (IBN; 61), and Sberbank (SBER.RTS).

In total, SWFs have an estimated $2.5 trillion in assets, which are expected to continue to grow rapidly on the back of the boom in oil prices and the torrid pace of economic expansion in China and the major oil producing countries. As U.S. and European financial services firms struggle to overcome the current credit crisis, one solution may be found in these state-run funds, which are increasingly looking for new places to invest their growing wealth.

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