From the November 2008 issue of Wealth Manager Web • Subscribe!

CAPITULATION WATCH?

Nowhere to run; nowhere to hide. In the midst of the current economic calamity it is hard to tell if we are still at the edge of the abyss or in it. But in certain ways it doesn't matter if we are actually in it or not--what's important is whether your clients perceive we are in it. This is where the true value of the best wealth managers' good counsel becomes evident. Who imagined a storm in which, all at the same time, a client's assets might reside on a platform with a custodian that could become unstable or even vanish virtually overnight; whose homes are insured by the largest insurer in the world--which has just become nationalized; and who has some assets deposited in a bank that may soon be a party to a shotgun merger at best, or some more unpredictable and unpleasant event at worst?

Even though many wealth managers have allocated assets prudently and have done all the classically "right things" for clients, there will still be losses as this unprecedented series of economic events unfolds. Is capitulation imminent? Wealth managers' clients who have had an allocation to cash for some time will, of course, fare better and have the ability to wade in selectively at a reasonable inflection point. With the DJIA off as of Oct. 9 some 40% from last Oct. 9, and--as we go to press--off more than 20% in the last seven trading sessions alone, one can at least begin to look for that inflection point, just as Warren Buffett has made selective purchases--driving some hard bargains to be sure--of Goldman Sachs and GE.

Just as surely, there will be some bargains to be had someday in high-quality municipal and corporate bonds, and because of the sheer volume of new Treasury paper issued to fund the bailouts, there may even be attractive parts of the yield curve there.

For wealth managers, there are vast implications for the equity crash and even more for the credit market dysfunction. Clients are likely to feel at least some of the fears that abound in this environment and, even for the very wealthy, assets are declining in even the most diverse portfolios, not to mention in their personal real estate and other assets. Of course, as client assets evaporate, so does an important source of revenue for wealth management firms.

But there will be additional challenges as well. It's going to be much harder to value non-financial companies that will be feeling the pinch of consumer de-leveraging and a subsequent downturn in consumption.

More important from a valuation standpoint, however, is an ongoing fight over how to value securities at banks, insurers, institutions and brokerage firms: whether to use mark-to-market; mark-to-model (for securities that are not trading now), or mark-to-maturity.

How will an analyst properly value a financial firm that has used mark-to-model or mark-to-maturity valuations for toxic securities? It would seem that this is likely to result in vastly overstated security prices, understated risk, or vastly inflated financials--resulting in too-low capital requirements. And there you go again to the brink of the abyss.

In the meantime, wealth managers have to perform one of their hardest tasks as they communicate with clients while all around them the news is truly awful, and, as the saying goes, there's blood in the streets.

As Roger Ibbotson, now chairman and CIO of Zebra Capital Management LLC in Milford Conn. and a professor at the Yale School of Management, noted in a Sept. 24 Wealth Manager Webinar about asset allocation: The crisis is "dramatic" and there's nothing "comparable since the 1930s." Ibbotson says it's "hard to find a spot to put assets." That's tough talk for clients to hear over and over.

However, if you fast forward to the time when we've gotten through this crisis, Ibbotson thinks that because there is undoubtedly going to be more regulation of other types of financial firms, along with higher capital requirements and lower leverage, "hedge funds may actually be pretty appealing...they have more flexibility than other financial institutions." He still believes that over the long term, stocks will be the way to go--not that he's advocating that quite yet--but eventually.

"About 71% of the economy is the consumer, and that's the over-levered entity--and how do they de-lever? Either they're going to sell assets to pay down their debt...or they just spend less than they earn," says Thomas Atteberry, a partner at First Pacific Advisors in Los Angeles. He believes consumers are "not going to be the driver of the economy." Atteberry, who co-manages the FPA New Income fund and separate fixed-income accounts, argues that post-catharsis, we could see "very sluggish, positive growth in GDP...nagging unemployment, which wouldn't be coming down as fast as it normally would when an economy recovers...and the remaining banking and finance sector players would try to earn themselves out of the mess they're in," with more "plain vanilla" kinds of businesses.

"You could have this economy that's very slow in its growth for one, two, three, four years," Atteberry explains, "I wouldn't use the word depression, or even recession, but it's not going to make any difference; earnings are going to be slow, growth is going to be slow; things are just not going to be great."

Atteberry asserts that wealth managers "still need to shepherd your capital, you need to have no risk, need to take your credit risk off the table. Have very short maturities; have lots of liquidity. Be willing to take lower returns in exchange for the return of your capital." Be "very patient," he counsels, have "high levels of cash," and don't worry about missing the absolute bottom--"being late's better than being early," in his view. "Just ask the guy at the sovereign wealth fund. He was early."

What wealth managers "need to do to be successful in 2009," Stan Kelly, president of Wachovia Wealth Management, told the crowd at the Wealth Management Congress in Boston on Sept.11, is to "help your clients weather one of the stormiest markets in our lifetime." Continue to be the "trusted, objective advisor...build client loyalty...explore family dynamics."

Wachovia itself is in a state of flux as Citi and Wells Fargo battle over its carcass, although the wealth management arm of Wachovia was not part of the original Citi deal. M&A (or rescue) notwithstanding, what Wachovia Wealth Management has done with its model could be a template for other wealth managers large and small. Wachovia Wealth Management saw client loyalty climb, Kelly says, "from 35% in Dec. 2004 to 44% in Dec. 2007," after the firm took steps to open the architecture of its investment platform so that it's "not tied to proprietary funds" and added choices that include separate accounts, funds, state-specific munis, ETFs, alternatives, commodities and real estate. He credits these moves with boosting "annual revenue per relationship to $54,000 in Dec. 2007 from $40,000 in Dec. 2004."

Additional measures are being considered to mitigate the U.S. credit crisis, and those include nationalizing some U.S. banks in a fashion similar to what was proposed in a U.K. bank bailout package announced Oct. 8 by British Prime Minister Gordon Brown and Chancellor of the Exchequer Alistair Darling. "This is not a time for conventional thinking or out-dated dogma, but for the fresh and innovative intervention that gets to the heart of the problem," Brown said before he unveiled the details. The Prime Minister outlined a "comprehensive program" to recapitalize U.K. banks, partially nationalizing them by buying "preference shares" as a direct government investment. Brown stipulated that banks will have to lend money to individuals and businesses if they want to participate, and says he expects that the program "will earn a proper return for the [U.K.] taxpayer." That wouldn't be such a bad idea for the U.S. taxpayer either.

In the meantime, it is abundantly clear that the damage done to the global economy is not likely to recover anytime soon. As bank after bank and firm after firm run up on the rocks during this financial hurricane, the best wealth managers will have an opportunity to bring in clients who have been dislocated from or disgusted with their former advisors. Independent wealth managers may have the most golden opportunity of all, since so many institutions have become weak or are rank with the stink of bad paper and self-serving recommendations. The weather always clears up eventually and so do the markets and economy--it's a question of how long it will take.

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