THE MORTGAGE CRISIS: The Next Catastrophe Around The Corner

Over the past six months, Democrats have struggled for solutions to regulating one opaque financial industry after the next. Subprime lenders allegedly using tricks to cheat customers and undermine the housing market. Massive hedge funds that operate with seemingly little oversight. Private equity groups taking large corporations out of shareholders' hands. But the United States has only barely begun to pay attention to an even more powerful, and potentially more threatening, new type of wealth: giant funds controlled by foreign governments.

These funds, known as sovereign-wealth funds, have existed for years. Norway, for one, long has had a fund to utilize its massive oil wealth, and Singapore has operated a fund for decades. But only recently have the funds become global powers. As economist Edwin Truman of the Peterson Institute notes in a new paper, governments around the world--primarily in developing nations and oil-rich states boosted by the rising price of petroleum--have been buying up "a vast amount of international assets in the form of reserves." Many of these nations, from China to Russia, now are using their reserves to create these government-controlled funds. No one really knows the total size of sovereign-wealth funds, but Morgan Stanley estimates they will grow in size to over $10 trillion within a decade, potentially amassing nearly 10 percent of all of the world's financial assets. Some estimates suggest that they are already worth twice as much as all hedge funds put together. And they are already making big moves. China has created a fund worth some $200 billion, Russia's fund has bought into aerospace giant Airbus, and Singapore's fund has purchased a stake in Barclay's Bank.

Compared to sovereign-wealth funds, opaque hedge funds are models of transparency. (Norway's fund is an exception, and Singapore has begun to publish information about its fund.) Few funds disclose many details about their investment portfolios or strategies, so bankers have no idea how stable they are, even though their meltdowns could undermine global financial stability. And within these countries, the creation of massive state-owned funds will make life harder for individual entrepreneurs. "A signal event of the past quarter-century has been the sharp decline in the extent of direct state ownership of business as the private sector has taken ownership of what were once government-owned companies," notes former Treasury Secretary Larry Summers. "Yet governments are now accumulating various kinds of stakes in what were once purely private companies."

Worse, no one knows if these wealth funds will make investments overseas for political reasons or purely financial ones--even more of a problem given that authoritarian nations like Russia control most of these funds, and some of these regimes seem to be trying to dominate strategic global industries like oil or defense manufacturing. If a fund backed by the Chinese government invests in an oil deal in Africa or Asia, is it making the same profit/loss calculations as, say, ExxonMobil, or is it investing because Beijing's leaders desire that asset, making it impossible for another company to compete for the deal? Did Russia buy into Airbus because it thinks the aerospace firm is a good deal or because the Kremlin wants to have more power over Western Europe through this company? If the fund owned by the United Arab Emirates invests in a defense company, is it trying to gain military technology for the UAE, potentially upsetting the balance of power in the Middle East?

Since these funds are inherently political, they also could be used as political weapons. As Summers says: "What about the day when a country joins some 'coalition of the willing' and asks the US president to support a tax break for a company in which it has invested?" Already, purchases by sovereign-wealth funds have led to political backlashes, as when Singapore's fund tried to buy a leading Thai telecommunications company, sparking protests in Thailand last year. It's not hard to imagine a similar protest if China's fund tried to buy a major American telecom firm, a protest that could easily spiral into ugly protectionism.

Yet even as Washington scrambles for solutions to subprime lenders and hedge funds, it says little about sovereign-wealth funds. After an uproar over the possible purchase of U.S. ports by a Dubai-based company, Congress revamped the organization responsible for scrutinizing foreign investments in America, but that reformed institution has not been tested, and no one knows how well it will work. Though the International Monetary Fund has called for more scrutiny, neither the IMF nor the World Bank has created any codes of conduct for sovereign-wealth funds, such as pushing them to hire outside managers to handle their investments.

The White House, perhaps worried about looking too protectionist, has allowed lower-level Treasury officials to take the initiative. By comparison, German Chancellor Angela Merkel has spoken out about sovereign funds, warning, "How do we actually deal with funds in state hands?" It's an important question. For when the sovereign funds finally explode into controversy, they will make the mortgage crisis look like nothing.

By Joshua Kurlantzick