The strike price for the warrants Citigroup (C) issued to the Treasury is $17.85. Fortunately for the tax-payer, however, the warrants are exercisable at any time over a period of ten years. If Citigroup's third quarter financial report is any guide, the medium term outlook for its 5,342 million outstanding shares is rather bleak. Dilution above $18 is a non-issue.
The $25 billion perpetual preferred stock issuance to the Treasury has certainly improved Citigroup's Tier 1 capital adequacy ratio (8.2% prior to the bailout money). But what is at stake today is not Citigroup's solvency but the medium-term viability (and sustainable profitability) of its business model.
The fundamental inconsistencies of that business model were comfortably hidden as Citigroup recorded impressive profits in an extended era of growth in its key business segments. Each component of that model is currently under threat; but it is also perhaps the appropriate time to question the logic behind the integration of such diversified components in the first place. By their very nature, investment banking, derivatives trading, consumer banking, housing loans and wealth management are each qualitatively distinct activities, bearing highly specific risk-reward profiles, requiring the preparation of activity-specific financial statements. Today, as the amalgamated business model has started to contract and, in some respects, disintegrate, questions surrounding Citibank's profitability suggests that its shares should be headed towards $8 (and lower) within the first half of next year.
The accumulation of aggressive short positions at or above Wednesday's closing level ($12.63) will be more than justified by the flow of hard facts governing the true nature of the global recession in forthcoming weeks and months. What we already know is that Citigroup's credit costs in North America have risen sharply on the back of adverse unemployment, bankruptcy and housing statistics. This negative trend in domestic credit costs, which includes loan-loss provision, is expected to gather momentum shortly.
But Citigroup's worst nightmare today is grounded in certain core developments in the emerging markets where it is safe to assume higher delinquency allowances in consumer credit and housing finance in the fourth quarter. Of particular concern is the turmoil in currency rates, interest rates and counterparty risk which will cast a darker shadow over Citigroup's diversified banking model. It is common knowledge that Citigroup's units in the emerging markets have been heavily involved in derivatives transactions and structured products in local currencies for nearly two decades.
An implicit acknowledgement of the need to rationalize traditional banking methodologies was evident by the recent linking of a Nestle (NSRGY.PK) standby facility to credit default swap rates. The incorporation of default risk into loan yields by Citigroup is certainly logical, even overdue; and that logic is supported by the extensive loan-loss provisions Citigroup made in its latest financial disclosure. But if that logic is swept right across the bank's portfolio, a significant proportion of its corporate lending stands under-priced. If that is so, the capital adequacy ratio number is misleading.
Citigroup, in sync with the party-line on Wall Street, has not explained its exposure to the credit risk insurance marketplace, in North America and abroad. Nor has it fully disclosed how the risk on insurance-type contracts (credit default swaps, collateralized debt obligations or structured products) is calculated on its books. The better part of valour, therefore, is to read a healthy degree of bearishness into this uncertainty.
Finally, the $25 bailout money may prove to be more toxic than the doubtful assets within Citigroup's balance sheet. How the Treasury expects Citigroup to service the 5% per annum (first five years) dividend payment is anybody's guess, in view of the huge pressure on the real cost of credit (and under-priced loans) in the foreseeable future.
Stock position: Short C.
