Tuesday, February 3, 2009 0 comments ++[ CLICK TO COMMENT ]++

There is chance, albeit very small, of another credit lockup in the future

One should never invest based on low-probability events, although Nassim Taleb of Black Swan fame may disagree. Nevertheless, one can avoid being shocked if they at least think a little about such events ahead of time.

One of the low probability, high risk, events that I have warned about is a potential implosion in China. I am not predicting it but it is something one should at least consider in case it actually materializes.

Another largely negative event is the potential for a major trade war. I'm not going to go into this becaue it's sort of obvious if you share my view that we are seeing the beginning of the end of present-day mercantilism.

Finally, and a new thought I would like to present, is the notion for another major lockup in the credit markets. The first lockup occurred when Lehman Brothers and Washington Mutual failed--many ascribe the cause to the Lehman failure but some believe the cause may actually be Washington Mutual. A second lockup in the credit markets seems like a low probability event and I'm not predicting it but it's something to think about. I have a really bad feeling that the credit market--basically bond investors--are going to panic if banks are nationalized and some losses accure to bondholders.

It seems, to my newbie eyes, that several major banks are going to have to be nationalized. I don't know what it would actually entail but I suspect it is going to involve losses for junior creditors and maybe even some senior lenders. The most likely case seems to be the British megabanks. The British banks have assets far greater than the GDP--according to sources quoted at PrefBlog, it is as much as 440% more! These banks are way too big and unlikely to survive (assuming they actually own toxic assets that are overstated on their balance sheets presently.) Private investors are not going to fund these banks anymore (on top of their reluctance to invest in questionable and risky banks, I don't think private investors have enough money.) So there is no way any private investor is going to rescue these banks. So the only entity that can save them is the government. Free-market extremists would simply let the market take care of things. Namely, let these banks collapse and take down the banking system with it. But since most governments do not subscribe to those views--there are no libertarians during a crisis after all--the governments will support their banks.

Now, if the government keeps funding these banks, the government is not only going to take ownership, but there will come a time, if the situation is severe--and I think it is--when (i) the public will want to penalize the bond investors who funded these banks, and/or (ii) the government can't afford to continuously throw money at the banks. Already we have some radical views such as those of left-leaning economist Joseph Stiglitz suggesting that banks should be allowed to fail. I don't think the banks will be liquidated but something half-way between the two (i.e. government nationalization with possibly heavy losses to bondholders) may result.

In two or three years, when the British banks are still insolvent and unable to raise any capital or make any sort of progress, will the British citizens still want to keep funding them while the economy is still, possibly, in a recession and other industries might want help? I don't know but I'm just throwing out that possibility.

If Britain (or others) nationalize the banks and write off the losses, with the losses being absorbed by bond investors, foreign investors will shun the country and its banks (this doesn't mean that banks won't be able to issue bonds, but just that they cost will be higher--there are many developing countries with dubious records still issuing bonds.) But it may be a price that the government may decide is worth it.

Small investors may also be directly impacted. To see an example of a side effect, imagine what happens to ETNs issued by Barclays--these are supposed to be unsecured obligations if I understand correctly--if it followed the dire scenario outlined above (note: so far Barclays claims it is ok and is avoiding government intervention so this is just a speculative example.) Investors investing in the iPath ETNs ranging from the India fund (INP) to one of the commodities ETN (say DJP) to carbon ETN (GRN) will see losses.

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