Can Citigroup Be Restructured Without an FDIC Resolution?

Includes: C, GS, JPM
by: Christopher Whalen

First a final clarification about the Q4 2008 data from the FDIC. A reader of The IRA who is part of the regulatory community sends this comment regarding our last missive and our CNBC appearance on Tuesday with Dick Bove and Larry Kudlow.

Says the reader:

Lots of Kool-Aid drinking going on out there with the financials. Your comment on the FDIC numbers is accurate, but does not go far enough. In the fourth quarter, WaMu's contribution to JPMorgan Chase (NYSE:JPM) should be fully reflected since WaMu got absorbed during the third quarter. In the fourth quarter, NatCity and Wachovia's income, expenses and charge-offs were reset to zero on the last day of the quarter, when they changed ownership as per pushdown accounting. So NatCity and Wachovia reported one day of income and expense results in their December 31 reports. Full year earnings numbers contained 95 days of WaMu (within JPM totals) and one day each of NatCity and Wachovia. All periods contained balance sheet amounts for WaMu, NatCity, and Wachovia. Those balance sheet amounts would have been affected by pushdown accounting, and in each case, since they changed control late in the quarter, we have no way of knowing how many non-performing loans they charged-off during the quarter in which they changed ownership. But these units all either filed their own Call/TFRs each quarter, or they were consolidated in the Call report of the institution that they were merged into. What is missing is the operating loss from WaMu during July, August & most of September; and operating losses from Wachovia and NatCity during most of Q4. In addition, the write-downs from purchase accounting did not get reflected in charge-offs, thus the US banking industry earnings and charge-offs for 2008 were way worse and will never be reflected in historical stats.

So based on this input, if we consider the absence of data from WaMu, Wachovia and NatCity from the 2008 FDIC industry data, our guess is that instead of the profit of $10 billion in reported, the US banking industry in fact experienced a loss of at least that amount. Based on the anecdotal reports we have heard about Wachovia charge-offs, for example, the loss for the US banking industry in 2008 could be more than $25 billion. The only way we will ever know the truth is if the FDIC corrects the public record, again. We are going to be following up with a formal letter to the Board of the FDIC asking that they correct or at least footnote the incomplete information in the 2008 data for the US banking industry. If we can obtain the information above, informally, from FDIC officials, why is this data not part of the public record? In this way, investors, researchers and regulators will at least know what the true loss rate was for the US banking industry in 2008.

Second, for users of the professional version of the IRA Bank Monitor, we have activated our beta test version of a new pro-forma tool to support bank M&A analytics. By specifying the RSSD IDs of two bank holding companies, the Bank Monitor will combine the balance sheets and income statements of the two entities into a pro-forma profile. Please contact us for additional information.

Now on to the Zombie dance party, which is already in progress. Over the past several months we have been asserting that Citigroup (NYSE:C) is insolvent and needs to be either restructured or liquidated. Now that the Obama Administration has apparently decided to publicly list the results of the bank stress tests and since C is expected to be near the bottom of the list in terms of stress test results, the question comes whether the Obama Administration will move on resolving C before the May 4, 2009 released of the stress test results. We won't even refer to the Q1 results for C released this morning because, in our view, they really do not show the true condition of the bank nor the ultimate outcome that we expect to see with this institution. As of year-end 2008, C rated an "F" in the IRA Bank Monitor with a overall Stress Index score of 21 vs. the industry average of 1.8. As of the same date, JPM's Stress Index Score was 1.3.

Unfortunately, it is becoming increasingly clear that the Obama Administration lacks the courage to resolve C. Economic policy guru Larry Summers reportedly bought the "systemic risk" argument hook, line and sinker, but the fact remains that with relatively healthy banks like JPM pricing debt at +350 to the curve, the real issue facing financials is not simply capital adequacy as the stress tests suppose, but rather the broader issue of credibility as going concerns. Even were JPM or Goldman Sachs (NYSE:GS) to actually redeem the preferred capital provided by the Treasury TARP program, none of these banks could survive today without government guarantees for their debt. One of the reasons that the Obama Administration provides for not taking action on C and other insolvent money center banks is that regulators lack the legal authority to act against a bank holding company (BHC) vs. the federally insured subsidiary banks. But this is not true. Federal regulators do have the power to compel management and board changes within BHCs. And they have two very powerful threats to use against officers and directors who do not take the "suggestion." First, the Fed and other regulators have the power to issue judicial orders and, more important, to commence enforcement actions against the officers and directors of a BHC. If you have never been the target of an enforcement litigation under Section 12 of the US Code, suffice to say that this makes civil litigation look tame. There is a rebuttable presumption of guilt and very serious civil penalties, including being barred for life as an office and director of a US financial institution.

And by the way, the judges generally defer to the regulators. We cannot imagine an officer or director of C failing to resign if given the choice between a clean exit and several years of litigation with the OCC and Fed in front of an administrative law judge in Washington. And just for added weight, we can have President Obama make the call. Second and more important, the regulators have the ultimate threat of resolution, meaning the FDIC takes control of the subsidiary banks, bankruptcy for the parent holding company, years of civil litigation for the officers and directors, and also a possible enforcement action. Remember that when the FDIC takes over a bank and suffers a loss to the Deposit Insurance Fund, it files a claim against the bankruptcy estate of the parent BHC and can, if fraud or management malfeasance is suspected, begin an enforcement action against the officers and directors.

With that background, it needs to said that the only thing standing between America and a solution to zombie banks is a lack of guts in Washington. We expect C to come it at or near the bottom of the 19 stress zombies next month. It also needs to be said that if there are not at least a few banks that "fail" the stress tests, then the process will be entirely incredible. Given this reality, how would we suggest dealing with C in such a way that minimizes the impact on the markets and the customers of C's subsidiary banks (remember C itself is a non-operating shell holding company)?

We believe there is path other than FDIC resolution for the subsidiary banks and liquidation for C that may allow the company to address the issues of capital adequacy without C's bondholders taking a total loss and without the disruption to the markets that a traditional FDIC resolutions implies. Here in general terms is how we would address the issue: First, federal regulators need to impose immediate board and management changes at C. The new officers and directors should be selected based upon their willingness to take whatever steps are necessary to address the issue of capital adequacy of C's subsidiary banks, including the sale, restructuring and even liquidation of C in its entirety.

This condition regarding the makeup of the new officers and directors is crucial to the success of what will be a voluntary restructuring process. Second, once a new management team and board are in place, then C must next formally contact the bond holders of C and invite them to form a creditors committee and enter into a negotiation to convert a significant portion of their debt into common equity. C has approximately $500 billion in long-term debt and another $400 billion in short-term debt. If roughly half of this $900 billion in debt was converted to common equity, then C's capital problems would be resolved without the need for an FDIC seizure of the group's banks, the need for further government assistance would be at an end, and more important, the bond holders would have a significantly higher probability of a recovery than in a traditional FDIC resolution. Indeed, part of the new capital proceeds from the conversion by bond holders could repay the C TARP investment in its entirety and without the need to go to the equity markets.

Third and assuming that agreement could be reached with the bond holders, then C would approach regulators and formally request their support for a voluntary Chapter 11 filing by C, essentially a prepack restructuring under the FDIC's open bank assistance where the dominant creditors, namely the C bondholders, would support a petition by C management. The FDIC would also enter the bankruptcy as a creditor and assure the Bankruptcy Court that the FDIC was supporting the process and, most important, would not seize C's bank subsidiaries. The Fed and OCC would likewise support the process via official statements to the Bankruptcy Court. The prepack agreement between C management, the creditor committee and the FDIC would make the restructuring process fast, perhaps ending in less than a year if adverse litigation in bankruptcy is avoided.

Suffice to say that with the bond holders, management and the FDIC all supporting the petition, it will be very difficult for other creditors to prevail - especially if the alternative is an FDIC resolution and a near-total loss for bond holders. To speed the decision process by bond holders, the FDIC could simply state that without full and unconditional agreement from all creditors, C will be resolved and the FDIC will commence an adverse litigation in bankrupty to recover all losses to the DIF, meaning a total loss to bond holders. Now you are probably wondering whether it is even possible for a BHC to file bankruptcy without immediately losing the control of the FDIC-insured banks.

The answer is yes and the partial example is called MCorp, a Texas BHC that was forced into bankruptcy by creditors in 1989. Click here to read the FDIC study on MCorp, which was part of the Texas oil patch collapse and one of the most costly resolutions in FDIC history. But the cost to the FDIC of partially resolving the bank subs of MCorp pales in comparison to the current government assistance to C and other zombie banks. The MCorp case was complex and very contentious. The issues involved are very different from those facing C and other troubled money center banks, but the fact remains that while the OCC declared the subsidiary banks of MCorp insolvent, after cross litigation, MCorp was able to retain five bank subsidiaries with $3.2 billion in assets. These banks operated in bankruptcy while the parent was reorganized. Indeed, as the FDIC study notes, the success of MCorp in defeating seizure of the five subsidiary banks by the FDIC "led to the section of FIRREA that added provisions related to cross guarantees. The cross guarantee provision would be used most notably in the Bank of New England resolution." In the case of MCorp, had the cross-guarantee provisions that exist today been in effect, then the FDIC would have seized all of the MCorp banks and used those assets to reduce the loss to the Deposit Insurance Fund, as required by law.

But with the case of C, the situation is the opposite, namely that by leaving C operating, albeit in bankruptcy and operating under "open bank" support, the FDIC, OCC and Fed can arguably make a case that this is the "least cost resolution" and also avoids systemic risk issues. Assuming that C's new management team and board is able to win the support of a) bond holders and b) regulators, then the way would be open to file a voluntary Chapter 11 petition and restructure C into a new format that aligns the interest of shareholders, the US government and the counterparties and customers of C's bank units.

Specifically, once in bankruptcy, C should be restructured into a unitary national bank, with all of the subsidiaries of the group moved to beneath the lead bank, in this case Citibank NA. One of the evil side effects of the BHC structure that has been illustrated by the failures of WaMu and Lehman Brothers is the reality that the customers and counterparties of the bank subsidiary are actually senior to the debt holders of the parent BHC. This tension has caused a great deal of delay and confusion in moving forward with a solution to the solvency problems facing the large zombie banks. Foreign bond holders, like the government of China, have reportedly told the Obama Administration that further losses to debt holders of US banks will result in a boycott of US Treasury auctions. Not only would the unitary structure eliminate any conflict between creditors and customers, but it would also leave the Citibank NA unit as the top-tier, publicly listed company and the issuer of all of the remaining debt and equity.

The restructured Citibank would have tangible common equity above 30% and half the debt it now supports. The BHC's interest expenses would fall dramatically and the excess capital would allow C management to quickly deal with all problem assets, sell operations and emerge from bankruptcy with a profitable, well capitalized bank. This outline does not address a number of technical issues related to the bankruptcy of a large BHC, but when you consider the alternatives - including the current approach of doing nothing being pushed on President Obama by Larry Summers, perhaps it is time to start thinking outside of the proverbial box. The US has already wasted months via inaction and political posturing. But if you understand that banks like C may very well be forced into a resolution before the end of 2009, perhaps it is time to start considering some creative alternatives before we are compelled, finally, to take effective action to start eliminating some zombies.

Positions: none