Last week the Wall Street Journal reported that banks who suspected they were parties to fraud in commodity-backed loans were expanding their investigations. Several banks, including Citigroup (NYSE:C), are party to loans backed by aluminum and copper stored at Qingdao Port in northeast China. The borrower uses the metal to secure financing, yet holds the deed to the metal. Bankers are afraid that the borrower(s) in question - the "Quingdao Whale" - has fraudulently pledged the metal as collateral for multiple loans. Chinese authorities are investigating the matter with the hopes that the fraudulent scheme has not spread to other ports.
The Carry Trade Strikes Again
The Whale made bets on a continued economic recovery with complex trades that moved in relation to the value of corporate bonds. Though the Whale lost billions as prices moved against him, a pack of opportunistic hedge fund traders, led by the "Monster," made millions from credit-default swaps designed to take advantage of mispriced credit derivatives held by the Whale.
The carry trade concept is also at the heart of the scheme involving the Qingdao Whale - borrowing commodities from Citigroup and other banks at one rate, and lending it out at a much higher one. A year ago China raised domestic interest rates to tamp down on the asset bubbles in real estate and other asset classes. That created an opportunity for trading to profit from the arbitrage in interest rates in China (5% for short term bank loans) and the U.S. (0.5% for short-term interbank loans).
And so it appears there is easy money to be made borrowing money from the U.S. and Europe, and lending it in China. The trade's been growing for a while, but it has attracted attention lately. And it's a bit dicey, at least for the U.S. banks ... The scheme has shed light on the fact that a large portion of the overseas lending that Chinese companies are doing to capture the interest rate spread has been with loans collateralized with commodities. Goldman Sachs estimates that commodities-based lending has resulted in an inflow of $110 billion of foreign currency into the Chinese economy in the past four years.
If wider fraud is uncovered, the losses for Citigroup or other banks could grow. It could also result in a sharp decline in commodities lending in China, roiling the Chinese commodities markets and cutting off the flow of credit from U.S. and European Banks.
What It Means For Citigroup Shareholders
The Quingdao Whale saga underscores two things. First, Citigroup may need to revamp its underwriting procedures for commodities lending to Chinese companies to ensure the collateral cannot be pledged for multiple loans. Secondly, since many of the clients of commodities lending are (i) either cash-strapped or (ii) or can only secure loans outside of China's traditional lending channels, should Citigroup be in the business? Such "shadow lending" circumvents China's curbs on lending, are risky by nature and there may not be much recourse if borrowers default on the loans. That's a long-winded way of saying, "Is Citigroup being rewarded for the risk involved?"
In Q1 2014 Citigroup earned $3.9 billion on revenue of $20.1 billion. Net income grew 4% over Q1 2013 while revenue growth was flat at (-1%). Personally, I am already taken aback by the Justice Department's proposed $10 billion fine for soured mortgages Citigroup sold at the height of the financial crisis; such a fine would potentially wipe out Citigroup's 2014 earnings. That in addition to the Qingdao Whale exposure makes me wonder what other unknown risks are lurking within Citigroup's operations.
The Qingdao Whale exposure highlights the fact that neither Citigroup nor its shareholders are being rewarded for the risks undertaken by the company. Exposures to fines by the DOJ or commodities lending in China are too much given the company's flat earnings. I recommend that investors avoid the stock.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.