Monday, November 24, 2008


The Citigroup share price, like other banks whose prices have fallen 90% is in a crisis of confidence, which reflects the losses that have to be accounted for in the profit/loss but may not reflect a relative and fundamental value of the bank. Essentially what is happening to US banks (and banks in the UK and Eurozone) is that the credit crunch is nominally wiping out 1xBCR (Banks’ Capital Reserves, which in the USA is $1.1 trillion) and the recession is wiping out another 1xBCR. A ‘normal’ recession wipes out 90% of banks’ capital before recoveries, which are worth half of writedown losses. The Government is supplying replacement for 1xBCR (for a % share of the bank + preferred dividend + fee + insurance premium + asset discount). Banks have to recover the other 1xBCR themselves from recoveries, reserves, asset disposals, business unit sales, and cost-cutting). The recoveries over 1-3 years should be sufficient to redeem the capital infusions from Government and the taxpayers should via the Treasury make a medium term profit. The banks are also major holders of treasuries and government bonds not just of the US but of many others countries. Fears about corporate bond defaults are also added to by forced redemptions of government bonds should major banks collapse, but this should be only a temporary embarassment for most governments. Hopefully cognizent of the strategy of helping banks to ensure they help the Government's efforts to reflate the economy, President-elect Barack Obama will introduce on Monday his National Economic Council Director, Lawrence Summers)pictured below), and his Treasury Secretary nominee (subject to Senate Approval) Timothy Geithner (pictured above - see also two men from the same supposed wing of the Democratic Party (if it has wings?) who have worked together before under President Clinton, but with new roles in the Obama administration. Geithner has a double role for the next 2 months as President of the NY Fed and as Treasury Secretary nominee. With, and across-the-table, Geithner was much involved with Robert Rubin in this weekend's bail-out of Citigroup. Rubin is the main eminence in the wings of the new 'Obamanomics team'. The Obama team appears to reflect Rubin's choices. The team projects weight more than ideology, which makes a change from its predecessors (according to James Galbraith, economist at Univ. of Texas in touch with President-elect Obama's economics advisory team). In the opening months of President Obama's administration, Geithner and Summers will be shepherding through Congress some of the most dramatic fiscal policies since The Great Depression (of the 1930s, or The Second Great Depression if the first was the 1880s), and observers caution that President-elect Obama cannot afford politically to look as if he is exploiting the crisis for an ideological agenda, which he won't be. Larry Summers was UK readers may wish to note a major influence (before, during and after his time as US Treasury Secretary) on UK Government Treasury policy since 1997 (when his student Ed Balls was Gordon Brown's principal adviser). A third key appointment is Peter Orszag (pictured below) as President Obama's budget director, who is already Congressional Budget Office Director (the CBO is obsessed with health and pension costs as future unsustainable burdens on the budget, when actually mostly self-financing). He has to calculate the economic reflation packages and their budgetary impacts, including a likely 2009 deficit of $1tn and what the taxation and revenue implications are. For more on the Obama team see comment #1. The political debate in the UK has turned on a £100bn deficit and its tax implications (presented in preview today) that are much exaggerated by CBI and Conservative Party simplifications that assume all higher borrowing translates into higher future taxes. Given that there are tax implications of doing nothing and given that reflation spending generates more tax revenue to pay for it, not necessarily higher tax rates, just as higher rates will also not necessarily generate higher taxation revenue, and given the multiplier effects of a weak banking sector unable to expand lending then it is profitable for both Government and taxpayers that Government should borrow and spend whatever is required to restore positive growth. This should be Alistair Darling's message today. To understand what these decision-makers have to do with banks, take the case of this weekend’s bail-out of Citigroup. Robert Rubin who is a major influence on the Obama team, having served as the 70th United States Secretary of the Treasury during both the first and second Clinton administrations, is also Director and Senior Counselor of Citigroup (and from Nov=Dec. '07 served temporarily as Chairman of Citigroup). He washeavily involved (from all sides) in the agreement for the US government’s $27bn capital infusion into Citigroup. I'm sure he deserves to become its next Chairman(see comment #2) and could not have been more important and better placed at this critical time for Citigroup. The deal (a $20bn SARP preferred stock purchase paying 8% + $7bn payment for preferred stock already pledged to the Federal Reserve) is attached to a TARP agreement that provides a loss floor aka ‘a surety guarantee’ covering $306bn of assets (many of which are not impaired or defaulted). Citicorp was the world’s biggest bank ($270bn share value 2 years ago) and is now the USA’s no.2 i.e. “way too big to fail”. The deal is not unlike a super-securitization issue (off balance sheet ‘bad bank’ like an SPE/ SIV with a massive CDS or standby ABCP); Citi absorbs the first $29bn (9.5%) in writedown loss (from residential and commercial mortgages and real estate, including RMBS and CMBS, also leveraged loans, CDOs and auction rate securities, but excluding credit card assets). Federal government entities stand surety for losses from the remaining 89.5% ($249bn if there are any further defaults in these assets. Treasury is on the hook for the next $5bn, FDIC for the next $10bn, and the Fed everything after that. Prof. Mehrling of Columbia pointed out to me that if the Treasury, instead of the Federal Reserve, had insured the entire $306bn, it would have had to charge $306bn against remaining TARP funds. As it is, Treasury only has to charge $5bn, and gets $4 billion in premium payments for that. The FDIC gets $3bn for its coverage of the next $10bn. The Fed’s involvement comes from its commitment to fund the remaining pool of assets with a non-recourse loan subject to the 90/10 risk sharing co-pay arrangement.
The news sent Citi’s ordinary shares up 55% in Germany before US market open after they lost over 60% last week. Analysts (including myself) estimate Citigroup, like many big banks such as HboS or RBS whose shares have fallen 90% in a year, is really worth six times its present share price just to get back to something close to book value or reserve capital! Citigroup has 200 million customer acvcounts across 106 countries! In addition to the $27bn preferred stock capital infusion, the reconstruction of Citi’s balance sheet that this deal makes possible frees up $13bn, so the total additional buffer is $40bn and adds 50% to reserve capital (on top of a $25bn loan loss reserve). This follows $25bn and over £3bn in Citi’s preferred stock and warrants invested in by Government in October. At the end of 3Q’08 Citi had a strong Tier 1 ratio of 8.2% plus the loan loss reserve. Tier 1 is now a whopping 14.7%!. The bank's capital will be further strengthened by the sale of its German retail banking operation and assets finalizing in the fourth quarter. With revenues running at over $70bn annually ($14bn costs) less $13bn in writedowns and provisions plus $2bn cost savings and over $300bn lower year on year assets to about $1.6tn now or about 5% of all US banking assets (non-gov. loans). At Friday’s share price, the bank’s ordinary share capitalisation stood at $20.5bn (implying even after share price leaps up today by over half that Government will still own a majority of the bank!) Following the agreement Citi will cut its dividend to 1c. per share and restrict executive compensation. The bank with $80 rising to 120bn capital reserve should now withstand the current market downturn. Responding to a criticism that Citi was getting special treatment the Government insisted the arrangement is deliberately “plain vanilla” so it can be applied to other banks that pose risk to financial system stability. The 9.5% first loss equates to the current default rate on mortgage asset and securities. This I expect could rise over the next year to a maximum of 20% whereby the impairment loss = $60bn, but should be only $30bn after recoveries i.e. fully absorbing the bank’s $29bn but not a loss to the Government. Citicorp’s credit card losses could mount up to $10bn leaving it with $81bn capital just sufficient to support $1.9tn assets ($350bn more than currently). Further losses from corporate bonds and loans etc. should be manageable during next year. For the moment the bank has excess capital that may be employed, according to some officials and commentators, buying securities in the secondary market that has been frozen up since the Treasury’s announcement that it would not buy distressed mortgage securities through TARP. Further significant losses from Citigroup's $43bn mortgage book (Sept '07) is unlikely after so many writedowns already from all related exposures, totallying $65bn. My friend Prof. Mehrling tells me this deal for Citicorp is akin to a co=pay insurance deal, and that the agreement permits Citigroup to use the $306 billion of assets as collateral in borrowing from the Fed at the overnight index swap (OIS) rate plus 300 bp, the rate currently being charged for asset-backed commercial paper at the Fed’s Commercial Paper Funding Facility. This ensures the full liquidity of these assets. Citigroup could possibly afford to buy toxic assets at the right price and thereby provide private (nationalised) sector support for TARP. Actually, in some respects buying assets, but as a mix of good and bad, is what Government is now doing only doing so indirectly. In that respect TARP lives, but only as an aspect of SARP (the recapitalisation strategy credited to Brown & Darling, though also modeled on the Sfr60bn Swiss National Bank ‘bad bank’ deal with UBS). Given the losses yet to be booked it seems unlikely to me that recapitalised banks will begin to use such “excess capital” to buy troubled assets in size in the secondary market along the lines envisaged by TARP – even at levels that many believe are artificially depressed – to create a floor for prices, that in turn could break the logjam and kick-start lending in the interbank credit market, the primary bank bond issuence market and trading in the always illiquid secondary market for securitized assets. This seems to me a hope expressed only for political reasons. Much more likely is that hedge funds, when they have repackaged themselves following a drop in fund under management from $2-3tn to 1.7-2.7tn (depending on how estimated) will be the only vulture fund buyers of impaired assets and at something well below 55% of face value.

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