As I observed the waning rally this morning, I reflected on what brought us to this situation in the first place: the fundamental shut down of our credit markets and leverage system. This has created a scarcity effect for capital (I say effect because the money is still out there but it is currently frozen with fear). Leverage is a critical component for a sustained rally in the equity markets. In order for the stock market to rise there will have to be a viable credit market — the stock market will not be able to decouple and move forward on it’s own. Period.
So, investment bankers and financiers will have to venture further into uncharted territories of high finance and delve deeply to find a solution for the gaping hole left by the absence of credit. In this global search for viable leverage, I am reminded of Hernando De Soto, no not the explorer searching for the fountain of youth but the award-winning economist from Latin America and what he eloquently outlined in his must read: “The Mystery of Capitalism-how the west succeeds and everyone else fails”; Desoto detailed a number of tenets on why the West was so successful in capitalist exploits–the central tenet he defined was that the wealth of nations was inextricably tied to real estate and that the US essentially had the clearest laws of ownership and transferability.
The unspoken yet implicit tenet in this statement is that of trust–more simply stated when some thing is bought or sold the investor/purchaser can trust on being able to recoup cost or investment through liquidity in the market and in times of conflict through due recourse in the courts. This tenet is also directly tied to leverage because due to the determinability of ownership and transferability of rights, financial institutions were able to provide loans for land on the basis of future value and the ability to access that value and its’ subsequent gains. We are able to unlock wealth of our lands through leverage and development. This tenet has driven offshore dollars to the US in waves for years.
That fundamental trust is now gone and its’ absence has further exacerbated the liquidity issues we currently experience. The systemic risk of failure has been compounded by this as well. The existing liquidity crisis has and will continue to create credit issues on a global macro-economic scale. This will probably continue for the next 8 to 10 months, the dearth of debt will be exacerbate existing problems, raise capital requirements and create more stringent rules for accessing debt while creating extensive value for those with capital. Cash is truly King.
In response to this illiquidity, innovation and new forms of liquidity will be developed from both domestic and offshore sources. The U.S. government attempted to do this with the creation of the TARP/TALF funds. I outlined this in the October 16th 2008 commentary entitled “Capitulation+Stabilization+Nationalization=Creation of the US Sovereign Wealth Fund”. The continued permutations and PPIP all seek to create a procedure to reset value through strike prices in real estate, a tactic similarly used to correct Savings and Loans crisis issues in the 1980’s. I opined on this in the March 23 2009 commentary in which I spoke to the “Rise of Public Private Partnerships. Although the initial response to these programs has been tepid at best, you will eventually see asset managers supporting them in droves, low cost, non recourse leverage is hard to resist…even if it comes with government strings. This will still need approximately 6 months to really get in gear and probably 10 months before we see collective collaboration with significant asset managers and private capital. So what do we do in the meantime to solve our capital issues? A number of financiers have focused intensely on the east–the Middle East that is. I myself began to focus on the region in 2006 after a trip to attend a CEO Forum hosted by Steve Forbes. In 2007, I hosted a conference under the patronage of the Minister of Finance, His Excellency Youssef H. Kumal that was sponsored by the Qatar Finance Center at which Lord Jacob Rothschild had introductory remarks. I initially took the Chairmen of the of the Texas Teachers Retirements and New Jersey Investment Council in the hopes of fostering institutional relationships between the sovereign funds and the U.S. plan sponsors. What I found was what everyone else who travels their finds–vast, immense wealth that is so prevalent — at times it can be overwhelming. I also discovered a proud culture rooted in mathematics and finance that was emerging as a financial power. I was intrigued and I began to assiduously study both.
The Call of the Middle East
The Middle East has joined China as the largest net exporter of capital. The Gulf Cooperation Council (GCC) countries have risen to the top levels of net capital exportation and collectively they are on par with China. The GCC countries will rise as the top exporter and China will reduce because they are the inverse of each other. China has tremendous wealth, but it also has tremendous infrastructure needs and has an enormous population which is capital intensive to the point of being resource exhaustive. This is why they are willing to give $5 billion dollars to African countries for mining rights—their countries resources are outstripped by their needs. The Middle East (GCC) has the exact opposite scenario: they have smaller populations proportionately and comparatively smaller places in terms of infrastructure needs (save Saudia Arabia). The GCC countries must export capital for sound investments to generate returns while they build their infrastructure simultaneously. The inability to export capital will cause liquidity bloat, which will in turn cause asset inflation in both their stock market and real estate therefore creating bubbles. If the GCC countries sustain previous levels of investment there will be roughly $3.2T of investment through 2020, during that same period an additional $3.5T will be in new funds to be deployed. The total foreign assets owned by the GCC countries in 2006 was $1.9T, this equals the top 10 Fortune 500 companies. This trend will continue at a faster pace for the next 20 years. Their return on assets without another investment will be $1.6T over the next 14 years. This will continue to make them unbelievably wealthy.
The enormous wealth of the GCC is what has called many from the west to fly to the region in search of sovereign fund sponsorship along with possibility of ensnaring super high net worth investors. A circumstance that was unbeknownst to most visting the region, was that a tremendous amount of this wealth is governed by a specific finance tied to Islamic law. This discipline of Islamic finance is bound by a code of ethics in investing, these rules comprised of principles that are known as Shari’ah. The discipline of Shari’ah cannot be simply distilled into a few simple tenets as practicioners of western finance are want to do, it is a very complex and modular discipline which can be very similar in function and complexity to western finance.
The initial investment bankers, investment managers and financiers who went in search of the capital and wealth were not aware of these principles and they focused on investment from a western finance basis. Recently as the world has continued to twist in the mire of the credit market stagnation, more attention has been turned to the advent of using Shari’ah finance and innovating it for institutional finance and investment purposes. On that basis (and after reviewing the macroeconomic story) I decided to pursue a masters thesis on the subject and began to immerse myself into the Islamic Capital markets community to gain a functional market perspective as well–I can personally speak definitively to the complexity of Shariah since I have been a western finance investment banker. It is not a simple discipline and it requires high levels of expertise. A number of finance magazines now have had prominent articles on Shari’ah and it seems as though the entire institutional finance world is interested.
This new found interest is coming fortuitously, surveys show that structured products, structured investments and private equity are strongly desired along with more innovation being needed in Shari’ah products by retail and institutional investors alike. (5) Five years ago, approximately 1/3 of investors in Saudi Arabia desired shari’ah products– now that has increased to 2/3rds of investors. A sharp increase in demand is coming from the super high net worth individuals which should be specifically noted. The rise in demand is directly due to the dearth of offerings in shari’ah products and is expected to creep into the institutional investor community. That demand is also being driven by the need to diversify by the price of oil, since the wealth of the GCC is tied to oil and subject to the wild volatility and price swings of the commodity. The price shock and swings are easily evidenced as seen from the early 2008 $80 a barrel price, to the $150 a barrel in June 2008 and subsequently the present $50 a barrel in May 2009– this drives their need for diversification. Price swings in combination with the fact that 40% of their population is under the age of 15 years old will continue to power their net capital exportation on a macroeconomic basis. Given the growth of Islam on a world wide basis (bear in mind that Muslims make up almost 25% of the world’s population), you can rest assure that shari’ah products will become one of the stronger capital transport vehicles.
In terms of fund vehicles, there are currently over 700 shariah compliant funds. There were 150 in 2000, 560 in 2007 and there are estimated that there will be 1000 by 2010. These Shari’ah focused funds have outperformed conventional holdings. Morningstar has constructed an Islamic fund index (along with a Dow Jones/Citigroup Sukuk Index) which showed the funds down -29.34 percent versus -34.4 percent in traditional S+P 500. In relative terms that is outperformance over the index. The market size for shariah compliant funds is $1.34 trillion per Ernst & Young in 2008.
Given the size of the market, it will most assuredly be focused on by financiers—especially since none of these assets were tainted with any subprime–the primary tenet is the forbiddance of interest of which is called Riba. This makes the market particularly attractive to the institutional marketplace because it will lead to structuring—Wall Street’s favorite! This is a mission that it will pursue with zeal.
The development of syndication and distribution systems to a large pool of capital that is not visible or easily accessible to others will create manifold opportunities. The ability to raise capital and sell interests become more valuable when developed from dis-intermediated, fragmented sources. The combination of distance and cultural differences assist in exponentially accelerating the value of the relatively obscure financial practices and theories in shari’ah. This will widen the chasm and reduce viability of access to the masses. The development of capital from dis-intermediated sources and the consolidation of these sources will result in greater deal strength.
The syndication and distribution will most likely first begin with the insurance companies, Islamic banks and investment management companies/funds that invest using Shari’ah principles. The coalescence of these institutions and super high net worth individuals (through their bank affiliations), will result in a flexible, malleable and highly elastic source of capital which will be readily responsive. Development of relationships to investing and advisory arms to assist in investment decision will be highly valuable and profitable. This will also create an efficient system of gathering viable cash rich, capital sources untainted by credit market issues. This will be an effective way to accelerate assets.
Since there will be few places on the planet with excess liquidity, the institutional organizations will have more leverage and deal power from a practical perspective due to the scarcity of available capital.
In closing, Shariah financing will become a critical component in finance given the non-functioning credit markets, extensive liquidity within them and expanding base of potential clients. The opportunity to institutionalize and structure around the retail market will be an opportunity that financiers from both the Middle East and West will not be able to pass up. Bet on it.
His Excellency Ambassador Nasser A.A. Al Nassir the Permanent Representative of the State of Qatar in the United States is to the left. Qatar is the wealthiest country in the world on a per capita basis and is a GCC country with a projected $7.4 billion dollar surplus. I am with His Excellency in his United Nations office.