Thursday, July 24, 2008

Circumventing Bank Failure Risk

As IndyMac Bank falls, many have witnessed the very real threat of fundamental bank risk, and should take action to hedge against it. As countries like Australia, New Zealand do not offer insurance against bank failure; and the American FDIC remains (very) limited with funding, this calls for an initiative.

Solution Abstract

Since no bank openly admits to having serious fiscal concerns just before crumpling, it makes the risk impossible to assess with certainty for most. Despite that, with a bit of ingenuity and legwork, practically anyone can preserve wealth in the bank, and potentially making a profit.

The solution then centers at gaining value off worst case scenarios to offset the loss in deposit. It is about losing nothing even if the involved bank collapses spectacularly.

Shorting the Bank

Short positions of stocks allow traders to profit off value decline, close to 100% return in the event of corporate bankruptcy. The depositor in this case, let’s say “Bob”, could (through a direct access broker) open a short position against the specific bank stock.

As long as the short position equals in value compared to the bank deposit, fundamental bank risk becomes non-existent. Risk instead, has been reduced to the form of upside market volatility.

Potential Outcomes

Let’s say Bob decides to leave half his wealth at bank X, and use the other half to short bank X stocks. Several outcomes could entail.

1) The bank survives the real estate storm all the way through the credit crisis, and the short position roughly breaks even. Bob makes a return off the interest from the bank account and ends the period with a small net profit.

2) The bank takes a beating, but manages to survive due to some sucker investment institution injecting capital. The stock price suffers, where Bob covers short position and takes trading profit along with interest earned at bank X.

3) The bank reaches its last breath, yet the government steps in and bails it out. In this scenario, the stock price plunges. Bob makes a killing off the short position while preserving the bank deposit along with interest earned.

4) The bank collapses, say in a country with no FDIC. Bob loses the entire bank deposit, but makes 100% off the short stock position. He ends up roughly break even, less transaction costs.

5) Last scenario. However unlikely this may unfold, if Wall Street decides to suddenly apply ethical conduct, Mid East tensions ease, oil prices plummet, and the US Federal Reserve halts inflation, the stock market could rally.

In this outcome, Bob loses some capital off the short position based on average volatility, yet it would still remain a relatively miniscule sum to the potential loss of a naked bank account collapse. (See this for why upside stock moves are relatively mild.)

The economy is in turmoil. Banks are not “safe” anymore.

0 Reflections: