Middle East's U.S. Bank Buys a Bust

NEW YORK ( TheStreet) -- If Middle East sovereign financiers try to exit their investments in the U.S. financial sector any time soon, it won't be because of chaos in the streets of Cairo and Tripoli.

It will be because the investments weren't such a great idea after all.

Large U.S. banks went to sovereign wealth funds with hat in hand during the crisis. From 2007 to 2009, Wall Street sought tens of billions of dollars from Saudi Arabia, Abu Dhabi and Kuwait - as well as China and South Korea - hoping to shore up their balance sheets with those cash infusions.

But the investments have not yet yielded a profit and probably won't for some time.

For instance, Saudi Prince Al-Waleed bin Talal started investing in Citigroup ( C) when it was first at the brink of bankruptcy in 1991. He invested more money into Citi in late-2008, boosting his stake to 5%, as the firm's stock price plunged from $35 to below $6 in less than a year.

Of course Al-Waleed's Kingdom Holding investment firm has reaped lots of dividend income through the years, and he doesn't seem eager to sell immediately. Yet Kingdom's stake was massively diluted after Citi converted $58 billion worth of preferred stock from the U.S. government and private investors into common shares last year. And since early 2009, Citi shares have failed to stay above $5 for more than a few days at a time.

In a less friendly situation, the Abu Dhabi Investment Authority filed an arbitration claim against Citi in 2009 alleging "fraudulent misrepresentations." ADIA had made a $7.5 billion investment two years earlier when the bank's subprime-related losses first came to light. The sovereign wealth fund received equity units that could be swapped into common stock at $31.83 to $37.24 a share - levels not likely to be reached any time soon.

Citi has denied ADIA's allegations and pledged to defend itself.

Sovereign wealth funds in China and South Korea that bought into Blackstone ( BX) and Morgan Stanley ( MS) haven't fared much better than their Middle Eastern counterparts: Blackstone is down 31% from the I.P.O. price on which the China Investment Corp.'s stake was based and Morgan Stanley, trading below $30, is far from the $50 level that CIC would need to make its $6.8 billion investment worthwhile.

Sovereign investors tend to be content with holding stakes over the long term and don't mind waiting for a decent return. But those who invested as problems first began to surface in 2007 and early 2008 can't help but look back and realize their timing was way off. Others who stepped away from investments in now-defunct firms Bear Stearns and Lehman Brothers can't help but look back with a sigh of relief.

As a result, some experts suggest that sovereign wealth may not flow so freely the next time U.S. banks are in a bind.

"The real concern there has been in terms of their return on investment," says Michel Léonard, chief economist and macro-strategist at Alliant Insurance, a Blackstone subsidiary. "If I were concerned about these funds investing again, I would look at some of the high-profile investments in U.S. banks, for example, which were highly costly to those funds."

Léonard notes that some sovereign wealth funds have "very publicly" expressed disappointment that U.S. investments that didn't turn out to be "as attractive as they had wanted."

Still, their crisis-era direct investments are subject to lock-up periods that have costly provisions if investors want to pull money out sooner. As a result, Léonard doesn't think sovereign wealth funds will pull their money out early - he just thinks they may not come back if and when big banks need big bucks to cover losses, expand their businesses or engage in expensive M&A.

Sovereign wealth funds have been a great source of capital for the global marketplace because of their size and scope. Estimates vary, but sovereign wealth funds are thought to control anywhere from $2.5 trillion to $4 trillion in assets, according to Herb Kaufman, a former Fannie Mae ( FNMA,OB) economist and consultant to the U.S. Treasury, the World Bank and the Congressional Budget Office, who is professor emeritus at the W. P. Carey School of Business at Arizona State University. The Middle East and North Africa are thought to control about $1 trillion worth of those funds, thanks largely to the wealth of petroleum resources in the region.

However, oil-rich countries that haven't traditionally spent a whole lot of their wealth developing infrastructure or creating economic opportunities at home. Poor, young citizens with no jobs sparked the riots and revolutions in Egypt, Libya and Tunisia over the past few months which, in turn, created general unrest in the area.

As a result, Saudi Arabia announced $37 billion worth of additional domestic spending that will go toward pay increases, affordable housing and unemployment benefits. Other countries, including Kuwait, Bahrain and Oman, have also boosted spending on domestic or simply handed out cash to the public to maintain peace.

Eliot Kalter, a former International Monetary Fund official who is now a senior fellow at The Fletcher School's Center for Emerging Market Enterprises, says that the increased spending at home won't lead those countries to pull out of long-term investments abroad.

Instead, he sees a slight danger that sovereign wealth funds will lose their appetite for U.S. Treasurys and other liquid instruments that are held in cash-like reserves. But Kalter also notes that the funds are "very smart and very careful" about not selling assets in a way that will meaningfully affect prices.

"For example, people are always saying, 'We'd better watch out about the Chinese because the Chinese hold a large percentage of U.S. Treasurys and what happens if they just get sick of the dollar and they dump them?'" says Kalter. "Well, of course they won't because if they dump them then they're going to affect their own holdings. They have a trillion dollars almost -- $700 billion or so - of U.S. Treasurys!"

Michael Diaz, Jr., a managing partnerof international law firm Diaz Reus & Targ has extensive experience with businesses and investors in the Middle East. He points out that the recent rise in oil prices has benefitted major sovereign wealth funds in the area and may pay for the domestic programs they're announcing. In fact, the recent social revolutions have, ironically, helped push prices higher as investors became concerned about oil supplies.

"Sovereign wealth funds are based on the price of commodities and the price of oil is going through the roof right now," says Diaz. "They're going to have even deeper pockets and this type of situation that's happening now in the Middle East with Libya and Tunisia, etc., only helps their bottom line. I don't see it as a downside."

However, Diaz doesn't think sovereign wealth funds in the Middle East will be investing in U.S. banks again anytime soon - not because they need cash at home and not because of crisis-era investments but because the U.S. is a less attractive place to invest.

"They're not going to pull their investments in any way from the United States or from our banking system," says Diaz, "but they'll continue to do what they've been doing the past couple of years: Relocate them much more to emerging markets and growing economies. Instead of making 2% in the U.S. with the slow national recovery that we have, they can go to India or China and try to collect 8%."

-- Written by Lauren Tara LaCapra in New York.

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Disclosure: TheStreet's editorial policy prohibits staff editors, reporters and analysts from holding positions in any individual stocks.

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