Sunday, July 6, 2008

Are We Near The Bottom Yet?

The short answer is still “Not yet.” The news continues to be grim without any signs of letting up. In fact, the major media appeared to have all climbed on to the Bear market bandwagon. As any prudent investor knows, one can make money in a Bull market as well as a Bear market. The converse of this is equally true.

My readers have been aware, several months ago, the risk factors that are manifesting themselves in current events. Hopefully, the readers have made some good and wise investments based on the risk factors, as I have presented previously. Continuing on this theme of taking prudent risks, here are additional ‘futurescape’ of the global economic condition, in my opinion, based on the publicly available data.

Will Large Banks Fail?
While it is highly improbable that many large money center banks will fail, there are certain candidates that are closer to the precipice than others. The risk manager, using a standard six-sigma approach, would note that we are currently in a ‘tail’ event economy - an economic event that typically has 0.3% or less of occurring. This means that an unthinkable can and may occur, including at least one “too-big-to-fail” bank failing. It is not a matter of “IF,” it is a matter of “When” and Which.”

In my view, the front-runners, vying neck to neck, for this dubious distinction are: Citigroup, Lehman, UBS, Merrill Lynch, and Morgan Stanley. I wonder if Ladbrokes would open betting lines on this action. If so, I would take UBS as being the candidate to fail. This is based on three factors, in addition to the general malaise affecting all banks: (a) it is still losing its high net worth clients, (b) is downsizing its investment banking division, in attempt to cut costs, and (c) the unwillingness of its senior management to admit its mistakes. With its sterling reputation tarnished, clients leaving, revenue sources drying up, it would be very difficult for it to remain independent for too long.

Banks will need to continue raising capital as more assets are reclassified to tier-2 and tier-3. The only problem is that most potential investors have already been burned and are sitting on substantial paper losses. That means that banks will have to juice up the preferred rate of return and provide a recast trigger should the stock prices drop below a threshold. Furthermore, the banks will have to go to lesser known investors and SWFs (think Brazil, South Korea, India, Taiwan, and Russia).

Ed Kim
Practical Risk Manager

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