I'll Sell You All the CDS on Citigroup You Want

CDS spread has gotten undeserved attention as some sort of prophetic leading indicator during this crisis. Is there something special about CDS buyers and sellers that make CDS spreads more insightful than anything else? No, of course not.

If you think the 40 bps CDS premium on the US is ridiculous (for up to 5 years anyway), then I have a surprise for you. Citi (C) CDS was going for 470 bps last Friday. This is close to imminent default range. It's much worse than the usual junk credit.

All the bad news and gloomy speculations about Citi notwithstanding, the simple fact is that:

1. Citi deposits will not be endangered. This is hugely political. Governments around the world cannot afford to let it happen, or else they'd be stoned to death by the revolution.
2. Citi bonds will not default. Although Paulson maintains that he didn't think the decision to let Lehman go down was a mistake, everybody knows (Paulson included) it was a critical mistake in transforming a financial crisis into a full-blown global, economic crisis. I think we've learned the lesson by now. The world cannot deal with another CDS settlement of a big company. Not Citi, not GM.

Beyond the above two points, everything else is in play, including wiping out equity.

But, before you get too excited about the parallel between Citi and Bear/Lehman/AIG, think about the following:

1. Unlike the situation in the weeks before Bear/Lehman, even for weeks before Morgan Stanley (MS), no bank has stopped trading with Citi. Remember, some banks stopped trading with each of them WEEKS before the trouble became public. It's a very easy decision for them to make, with negligible downside compared to the risk IF they seriously think there's a real risk. But no, nobody stopped trading with Citi, as of the past Friday.
2. Unlike Bear/Lehman/MS, Citi is a real bank with a real deposit base. I don't know about the off-balance sheet toxic assets in Citi that everybody suddenly seems to know. But the crucial difference is that Citi is not an investment bank. As long as you believe humanity is not quite stupid enough to march off the cliff, Citi will survive - with pain, maybe, but it will survive.

I think it's quite clear by now that the emerging market crisis of last month is mostly aritificial and technical. Emerging markets are vulnerable for sure. But there's no structural deficiency in the BRIC world in the same order of magnitude as in the developed world. China will be hurt by the decrease in demand for goods. India will be hurt by decreasing demand in offshoring. Russia will be hurt by the slumping oil price. Brazil will be hurt by the slumping oil price (ethanol) and FDI. But none of them is nearly as severe as the chronic, structural deficiencies of future-mortgaging and over-consumption in the developed world. As demonstrated by the 4 trillion Yuan plan announced by Beijing, they are at a point where they CAN create enough demand domestically to get through a temporary glut.

What does this have to do with Citi? My point is the world, not just the US government, will not allow Citi to go down. The US government may not have enough credibility, with Paulson changing his mind every week. But the world ganged up together is a credible threat to the shorts.

And, dare I say, with its truly global franchise, Citi is in a better position to benefit from emerging markets while most other banks, much more concentrated in US and Europe, are exposed to the long struggle ahead of us in the develped world.

If you want to say Citi is too big to manage, that's fine. But it still does not negate the fact that Citi is truly too big to fail -- not just to US, but to the world.

I don't know what will happen to Citi stock. But if you want to buy Citi CDS, I can sell you as much as you want.

Stock position: None.

Comments

[raytayzmd:]

...hmmmm -- "Bo Peng specializes in credit derivatives risk."...uhhh, pardon me if I don't take you up on your offer just right now.

2008 Nov 24 09:53 AM

[mr freddo:]

Hey Bo I love your insightful articles. I go to Bo when I want to find out what is really going on.

What about the Citi preferred shares? I bought some from my broker when they were issued at par 25 and yielded 6.5%. (a long time ago, 12 months or so). I got out at 20 and they are now trading post bailout at about 11 which gives them a 15% yield. Safe? Backed by us govt?

Thanks!

2008 Nov 26 03:21 AM

[Bo Peng:]

raytayzmd, many in risk management and modeling have been talking about counterparty risk in CDS and the risk of correlation going to 1 for CDOs for years. These are the very channels amplifying the current crisis. But in a regulatory and corporate governance structure where all decision makers are incentivized to disregard long-term risk and maximize short-term return, such warnings have only one destiny, the trash can.

Thanks, mrfreddo, although I only wish I can place as much trust in me as you do. Be careful about yield of preferreds, though, since it's subordinate to all bonds and it's most certainly NOT backed by the gov. The risk is higher than subordinated bonds. Even the bonds are NOT backed by the gov in ANY legal sense. What I was saying in the article is that world governments really have no choice but to back Citi deposits and bonds, for pragmatic concerns. This is not unconditional, not in the legal sense, and may change according to the circumstances.

2008 Nov 26 11:59 AM