Private equity, sovereign funds and the global credit crunch

December 5, 2008Duke Law News

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Dec. 5, 2008 — Three leading investors offered their views on the causes of and possible solutions to the global credit crisis before a capacity Duke Law audience on Dec. 4.

John Canning Jr. ’69, chairman and co-founder of Madison Dearborn Partners, a private equity firm in Chicago, Stephen Schwarzman, chairman and co-founder of New York-based private equity firm the Blackstone Group and a former head of Lehman Brothers’ global mergers and acquisitions team, and Gao Xiqing ’86, general manager and chief investment officer of the China Investment Corp., China’s sovereign-investment fund, discussed U.S. accounting methods, the government’s decision to let investment bank Lehman Brothers fail, and the ongoing effort to rouse a comatose world economy during their wide-ranging conversation.

Moderator James Cox, the Brainerd Currie Professor of Law and an expert in securities law, began the conversation by highlighting the rapid downturn of world financial markets over the last year.

“A year ago, we would have been having a debate and discussion here about the role of sovereign wealth funds… this was a burning issue,” he said. “Little did we know that in a few months time, sovereign wealth funds in various parts of the world were going to be bailing out our banks, financial institutions, et cetera.”

Origins of a crisis: leverage, lending, and fair value accounting
Canning and Schwarzman identified an aggregate of systemic problems in financial markets, bad business models for investment banks, and an overly optimistic housing strategy as key sparks for the financial crisis. Leverage is “right at the top” of the many causes, said Canning.

“In 1982, outstanding leverage was 200 percent of GDP,” he said. “It went straight up to 365 percent in June. If it takes that long to get back, or if it takes 16 or 18 years, it’s going to be a very painful time, because deleveraging just drops the price of assets.”

Blinded by a vibrant economy, most leading financial minds failed to discern what should have been clear, Canning added.

“It all looks so obvious in hindsight that the business model of an investment bank was not sustainable. In 2004, Henry Paulson led a group of investment banking people to the SEC, and said ‘Take off the rules that limit our leverage.’ As a result… these entities were levered 30 to one. And the problem with them was funding long-term illiquid assets with short-term credit.”

Schwarzman pointed to bad mortgages as the first link in a long causal chain leading to recession.

“The idea of lending money to, basically, poor people, is the story of how this started,” he said. “It was a well-intentioned, government-oriented objective … In 2002, low-income people were comprising about two percent of the mortgage market for buying homes. By 2006, depending on how you measure who is poor — or poorer — you had as high as 30 percent of mortgages being made to people who, fundamentally, couldn’t pay them back.”

Congress’s initial failure to pass the Troubled Asset Relief Program (TARP) “bailout” bill in September, along with the government’s decision to let Lehman Brothers fail, had profound and far-reaching consequences, Schwarzman said.

“For people in the United States, we just looked at it as another mess, another bunch of incompetence by our government,” he said. “But if you’re outside the United States, you have a different view. The U.S. is 26 percent of world GDP, the U.S. dominates finance, and the world expects us to make things right. And as you watched the television and saw these people wandering around the House of Representatives, setting their own house on fire, the rest of the world looked at this and said, ‘These people are out of control, they’re not going to rescue us, we’re all going to go down, [so] the answer is let’s not shop.’”

Schwarzman was alone in suggesting the mark-to-market fair accounting method required by the Securities and Exchange Commission helped exacerbate the crisis.

Gao disagreed, saying the SEC’s fair accounting requirements were one reason why his country felt safe investing in America.

“I have the baggage of being a former regulator and also a former lawyer, and I’ve been working on securities issues for more than 20 years,” he said. “In China, we still believe that the United States is the best country to invest in, and for this particular reason: It’s a lot more transparent, a lot more predictable. But once you change the rule, like Steve was suggesting, then we would have problems [investing].”

Canning said blaming mark-to-market accounting for the financial crisis was “like arguing you should do away with your police department because they keep catching you driving drunk.”

Lehman’s failure pivotal
Schwarzman called the government’s decision to let Lehman fail a “triggering event.”

“All of the people in the world who give financial institutions money all of a sudden said ‘I don’t trust this system to give me my money back, so I’m not going to give you money,’” he said.

Canning agreed. “It was the first time creditors were not protected. When Bear Stearns went, when Freddie and Fannie were rescued, creditors were protected and the equity guys got creamed. As soon as creditors were not protected and they wouldn’t let Lehman become a bank over that weekend, Merrill Lynch smartly sold itself, Goldman and Morgan Stanley became banks, immediately the buck was broken on the money market funds, AIG had to be rescued, the London Interbank Rate went up by 400 basis points, and banks stopped lending to each other because no one wanted to try and figure out which entity wouldn’t be rescued.”

Contemplating a long, hard recovery
Gao urged Americans to change their attitudes towards spending. “I think the basic problem is that… Americans have been spending other people’s money or your own futures money for too long.”

“Do you feel pretty confident that it’s at least going to take us a double-digit number of years to de-lever, and that we’re going to be looking at pretty flat asset values going forward for some time?” Cox asked Canning.

“I do, because there are no buyers for these assets,” Canning said. “It’s going to be write-offs, it’s going to be sales at pennies on the dollar, and it’s going to be a very long, painful period of time.”

Schwarzman praised efforts by world governments in recent weeks to unfreeze the credit markets, saying that continued worldwide cooperation will be necessary to fix the problems plaguing finance.

“It was the most extraordinary coordinated action that, at least in my life, I’ve ever seen in finance,” he said. “They basically saved the system.”

The role of private equity and sovereign wealth funds
As to the future of his industry, private equity, Canning predicted that it would operate on a reduced scale going forward. “In 2006, 2007, there were 18 buyouts of $10 billion or more,” he said. “I don’t think there’s been a $5 billion buyout since that time.”

Cox asked Gao about the changing perception of sovereign wealth funds as the crisis unfolds.

“This time last year, we were regarded as being a sinister institution with ulterior motives and people were looking at us with a lot of suspicion, and not only in this country,” Gao said, adding that large-scale investment by China’s sovereign wealth fund has also been viewed negatively in Western Europe.

“Now, a year later, we seem to be hearing different stories – but really it’s not that different. It is my humble, lawyerly, pessimistic view… that we need to do something right now because the market is coming down and people are panicking about the situation, so we probably need to make some investment to feel welcome in these places.

“[Our chairman] said, ‘Well, the price is going down further, and we don’t want to catch a falling knife.’ I said, ‘This is what they want us to do. We’ll try to catch a falling knife, and if we get cut, people will still love us, but if the market turns up, nobody will want us.’”
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