What's To Be Done About Citigroup?

Includes: AIG, BAC, C, GM, IYF, JPM, WMIH
by: Thomas Tan, CFA

FDIC Chairwoman Sheila Bair indicated last week that she is pushing to purge Citi’s (NYSE:C) top management, especially its CEO, Vikram Pandit. It shows that the regulators in the government are losing patience with the snail's pace of “reform” at Citi. In many of my previous posts at Seeking Alpha, and from day one of Pandit's appointment as CEO, I voiced strong disagreement and still think his appointment is the single worst decision ever made by Citi’s board.

There are several reasons. First of all, it is Vikram Pandit’s background. He was basically a quant guy selling toxic structured products at Morgan Stanley’s institutional sales, and then a money losing hedge fund manager. If Citi hadn't been a sucker and bought out his tiny firm after he left Morgan Stanley, for an unjustifiable, overinflated and very questionable price, Pandit's fund would have folded long before it finally did recently at Citi.

Asking a toxic product salesman to fix Citi, is similar to asking a used car salesman to fix GM.

What Citi needs is a turnaround veteran with commercial banking experience. There are quite a few names out there. Some of them, like Jamie Dimon, won’t be available. The rest of them likely never managed a bank as big as Citi. However, this is exactly the reason why we should hire them. The only way to save Citi is to sell off all of its non-core assets and non-commercial bank business units, even if it means at fire-sale prices. It must return back to the good old days of the 1980s when Citibank (a more proper name) was a much smaller commercial bank with international reach. Citi has to face the reality that the financial super-house business model advocated by Sandy Weill was dead two years ago. The earlier they admit that, the less painful the restructuring process is going to be.

Commercial banks and investment banks are totally two different animals, and they are at the extreme ends in the spectrum of financial service industry. The mindset, risk and talent management and the business approach are totally opposite. The investment banking business is basically a shameless sales job while commercial banking is a super boring 9-5 office job of counting pennies.

The whole talk about cross sales with combined investment and commercial businesses to push multiple toxic products and exotic derivatives by leveraging customer database are exactly what they should be: Garbage. Asking Mr. Pandit, an investment banker, to fix and lead a commercial bank is basically asking for trouble and is doomed to be a disaster.

There is a strong reason for the 1933 Glass-Steagall Act that separated commercial banks from investment banks. But the yield to political pressure from a few senators such as Phil Gramm (now vice chairman of UBS) in 1990s, ultimately led the whole country into financial disaster today; a disaster in which the investment banking industry has been wiped out almost completely.

During Q1 2009, Vikram Pandit purposely leaked an office memo which claimed that Citi was making operating income in the 1st two month of this year. A famous fund manager joked that if the whole Citi building was on fire, and Mr. Pandit sold lemonade to the firefighters in the parking lot and made $100, he could still claim that Citi was making operating income. In the current long de-leveraging and de-risking process, operating income is totally immaterial and irreverent, the key is whether you can generate enough liquidity through selling your assets to cover your immediate liabilities to avoid bankruptcy.

The government’s stress test results is based on banks' “self-estimates” of their potential losses in a further economic downturn. We all know how good banks are at estimating their own losses and doing their own risk management. Citi can still suffer another $105 billion in losses according to the government bailout report. What happens if Citi didn’t properly “estimate” or correctly grasp its complex and tangled off-balance sheet commitments and contingent liabilities and exposures?

More importantly, this stress test is only for a two-year horizon beginning with the year-end 2008 financial statement data. It excludes the window where the majority of the second wave mortgage defaults and losses will happen, from mid-2010 into 2012. The stress test procedure also conveniently excludes any mark-to-market losses during 2009 and 2010, as banks “were instructed to estimate forward-looking, undiscounted credit losses,…… rather than discounts related to mark-to-market values.”

By taking all these into consideration, what happens if Citi’s losses are twice larger at $200 billion? I don’t think this number is stretching at all. By the end of this crisis, I fully expect that the total losses from Citi will exceed $200 billion, likely around $300 billion, thanks to the financial super-house model.

It is very likely that there will be a second economic downturn or depression into 2012 after the current “comforting” phase runs its course. How would Citi be able to survive that? Even after a good rebound of its stock price to the current $20 billion market cap, shareholders are still almost completely wiped out. As I have said repeatedly in many of my previous articles, the only way to save banks is to wipe out most of the bondholders. In WaMu’s (NYSE:WM) case, the largest bank in the US that failed last year, not only did all shareholders get wiped out, but all subordinate and junior bondholders also got wiped out, while a few senior bondholders received tiny residual money back for about a dime or two on the dollar. This is the path waiting for Citigroup.

Why didn’t government follow WaMu’s case rather than putting up our money to "rescue" them? The main reason I think is that there are no more U.S. buyers. We can’t expect JP Morgan (NYSE:JPM) to step in every time to buy large banks in trouble. We need to give them a break since they have already bought Bear Stearns and then WaMu for almost free. What do you expect them to do? Buy Citigroup and Bank of America (NYSE:BAC) too? You might as well nationalize the whole banking industry.

How about foreign buyers? The U.S. government will never allow a foreign bank, like a Chinese bank or a middle-east bank or a Russian bank, to acquire a large U.S. bank like Citi for free like JP Morgan. Then the only solution is to use taxpayers’ money to bail them out.

How successful will that be? Not looking good at all. Just look at AIG (NYSE:AIG), which has sucked in $180 billion government bailout money, or our own money, and so far it still can’t sell enough meaningful assets to pay it back. That's because many of its assets are either worthless or non-liquid. You can see the government’s patience is running very thin with AIG too.

The government bailout money is only buying time for Citi’s bondholders, but banks won’t come back to profitability for many years. The public will lose patience and so too will government soon, like in AIG's case.

Then pre-packaged bankruptcy is the only option for many banks to come, as in the GM (NYSE:GM) case. We already gave GM too much time, how long will we give Citi this time? There is not much time left for bondholders, even if the government wants to protect them. Taxpayers won’t tolerate suffering losses while bondholders collect all their dues and walk away from this mess unscathed.

It is also extremely unfair that both shareholders and taxpayers suffer heavy losses while bondholders recoup all their money, as in the case of Bear Stearns. Lehman's case should be the more representative and justifiable outcome as both shareholders and bondholders were wiped out simultaneously and completely. Bailout money, no matter what form it was invested in, senior notes or preferreds, should always hold a higher place in the hierarchy of restructuring and payback than the most senior bondholders in the bankruptcy court. Otherwise it will create greater anguish amongst the taxpaying public than the AIG bonus case.

In addition, government needs to remember that it has a higher obligation to protect customer deposits, a FDIC job led by Sheila Bair, and not the bondholders, which are just another class of investors. Like shareholders, bondholders should do their own homework to understand the risks before investing. They should take their fair share of losses in this financial crisis.

Yet currently the whole bailout package is solely designed to protect bondholders by the Treasury Dept and the Fed due to the close relationship and tight association between those institutions. Most importantly, Bair also provides us good insight into how dangerous Citi’s situation is right now. Citi is likely at the edge of a cliff right before its second free fall, which this time will belong to the bondholders as the first free fall belonged to the shareholders. Fortunately for Citi depositors, at least last I checked, Citi has at least $300 billion various debts as a cushion, enough to get wiped out before tapping into customer deposits.