Sovereign Wealth Funds: The Financial Crisis' Secret Weapon

While heavily indebted American consumers struggle to make mortgage and credit card payments, a larger shift is underway. News from Tokyo indicates that politicians in Japan, America's "friendly" creditor nation, are beginning to consider investing the country's massive horde of foreign reserves, in order to "take advantage of the opportunities opening up around the world" during this global financial crisis we are in.

The largest foreign exchange reserves are held by China with $1.9 trillion and Japan with $1.0 trillion, followed by Eurozone countries and Russia, each with about $550 billion. Almost all of these largely U.S. dollar-denominated reserves are invested in conservative fixed-income instruments like U.S. Treasury bonds. However, as noted already in a 2005 article by Andrew Rozonov, who first used the term "sovereign wealth fund," the practical distinction between foreign exchange reserves and their more equity-like sovereign wealth fund counterpart has begun to blur.

In the earlier part of the subprime crisis, we saw high profile investing of $21 billion by sovereign wealth funds (Singapore, Kuwait and South Korea) into U.S. financial institutions (Citi and Merrill (MER)). This week's closing of Mitsubishi UFJ's (MTU) $9 billion capital infusion into Morgan Stanley is a private sector version of the same type of foreign investment. Given the, not billion, but trillion dollar scale of the foreign exchange reserves that China and Japan have amassed, any decision on their part to swap even a small portion of their fixed-income funds into equity-like investments will have a tremendous impact on the U.S. equity market.

Ponder this: The investments last January by smaller sovereign wealth funds in U.S. financial institutions helped to boost capital, but nevertheless Bank of America is now acquiring Merrill and Citi's balance sheet is still under pressure. The U.S. government coordinated JPMorgan's acquisition of faltering Bear Stearns in March, but that did not prevent Lehman (LEH) from going bankrupt in September. After an unprecedented $85 billion government lifeline to AIG (AIG) last month, AIG needed another $38 billion just last week. Despite heightened government intervention in recent weeks, the economic outlook grows bleaker, people worry more about their jobs and retirement and cut back on consumption, and the stock market resumes its downward spiral while real estate prices sag further. These included:

• Paulson's $700 billion bank rescue plan signed into law on October 3.
• A coordinated global rate cuts by many G-7 members and other countries last week
• The government's "no objections allowed" infusion of $125 billion capital into JPMorgan (JPM), Bank of America (BAC), Citigroup (C), Wells Fargo (WFC), Goldman Sachs (GS), Morgan Stanley (MS) and other financial institutions which was announced on Monday

In short, every policy measure to date, however unprecedented and seemingly, "radical" at implementation, has failed to stem the economic bleeding.

So, where do we turn now? Well, recall the proverbial "rich uncle," who is perennially forthcoming with money gifts when you are a kid, lends you the extra money you need for a down payment when buying your first house, and provides half the capital you need to start a new business. As our financial crisis runs its course, we Americans as owners of over-leveraged assets in our increasingly distressed U.S. economy really have only one place to go for the capital we so badly need. Because there is not enough capital internally within our national borders, the much-needed equity capital to stabilize our economy and restore confidence of consumers and among financial institutions must come from abroad.

Like it or not, for equity capital rather than just debt, American financial institutions, large corporations and our U.S. equity markets as a whole need to tap into the trillions of dollars of foreign exchange reserves on the books of governments throughout the world, and particularly the trillion dollar balances of each of China and Japan. Back in March, the House held a hearing on the role of foreign government investment in the U.S. economy and financial sector. More along these lines is needed.

My guess is that our equity markets will not find a firm bottom until cross-border government-level deals are struck to convert from debt to equity significant portions of the U.S. dollar-denominated foreign exchange reserves sitting overseas in Asia. How about a trillion dollar swap out of Treasuries and into a broad-based equity index, like the S&P 500?

A substantial increase in foreign ownership of the American economy is probably a lot closer than we think.