Whisper it quietly: I've bought more RBS

I was moderately determined not to buy any more RBS shares. But I must admit I had second thoughts when it briefly hit 145p over the Fannie/Freddie scare.

Now that its share price is suffering again, I decided to take one more bite of the cherry. I increased my stake by just over 60%. I bought the latest shares at 168p; my average purchase price is now just over 246p. RBS now forms about 23% of my portfolio. That's too much for such a risky share - but my portfolio is going to be about 3 times larger in 18 months, so it's less than 10% of my anticipated portfolio size.

So why invest so much money in an admittedly risky share?

I think a fair P/E ratio for a big bank is about 12. RBS's future earnings are uncertain, but I'm going to put them at about £6bn after tax in "normal" economic conditions. The final consideration is the risk of (a) significant dilution, or (b) total failure.

Let's assume RBS gets into trouble: depositors are withdrawing cash and/or other banks won't lend to it. What's going to happen?

• The government will not allow savers to lose money - that would be political suicide.
• They can't arrange for a buyer for RBS - it's too big. So the A&L option is out.
• The government cannot afford to take RBS onto its books - again, it's simply too big. So the Northern Rock option is out.
• Another big rights issue is not going to help a liquidity crunch. And getting that away in the current market would be impossible.
• There's no point flogging shares to outside investors, since even another £12bn is not going to be enough to cover the loss of interbank lending or customer deposits.

That pretty much rules out all the options that would punish shareholders. The only remaining options are:

• Government promises that all savings are protected in the event of a bank going bust. Savers are no longer spooked.
• Bank of England extends its special liquidity scheme. RBS no longer so reliant on wholesale lending, and paradoxically will now find it easier to get such funding.

Either of those would be provide a stupendous boost to UK bank shares, not just RBS. The government doesn't want to do it, but I don't think they will have a choice. If RBS gets the jitters, then Barclays for one will also be vunerable. A solution to benefit all banks would be required.

So what are the odds that RBS will get into trouble? I'd say about 1 in 4. They have access to liquidity from the US, UK and European central banks, which gives them more options than a bank like HBoS. They've savagely written down their subprime assets, raised capital and are deleveraging. They don't have such a scary UK mortgage book as HBoS or B&B. But, their shares seem to be the focus of a lot of short-selling, and I think it's possible for shareprice volatility to spook the other banks into freezing their lending. And they do rely on about £150bn of interbank lending.

If RBS did get into trouble, then I think there is around a 3 in 5 chance that they will be bailed out without any shareholder dilution.

So, that adds up to a 10% chance of shareholder wipeout. Let's be conservative and double it. That's an 80% chance that RBS is worth £72bn, and a 20% chance it's worth nothing. So fair value is approximately £57bn. That's 350p per share. 168p is a screaming bargain.

Other risks
To be fair, I'm probably over-egging the chance of total failure, and underestimating some more moderate risks, such as increased impairment charges due to a UK recession. On the whole I think things will probably balance out, so my fair-value assessment is pretty close.