In my opinion, there were two main factors contributing to the collapse of Enron. The first factor was Enron’s trading of derivatives and complicated financial instruments, which can result in financial destruction when the leverage becomes to great. The second factor was the use of off-balance sheet vehicles, such that all the financial risks of the company were not included in the profit and loss and balance sheets of the financial statements.
Sound familiar? Along with other large financial institutions, Citi (NYSE:C) is making ABS, SIV, MBS, and CDOs famous (or infamous) acronyms in the financial world. These are all example of how Citi has improperly used financial instruments for short-term gains without considering the longer term risk. The former CEO of Citi, Chuck Prince, made famous the quote “As long as the music is playing, you’ve got to get up and dance”. Perhaps only Alfred Hitchcock could produce a more chilling and foreboding statement.
The problem for Citi is that the music has stopped, and they are left holding billions of loans that are not worth nearly their original face value. Many of these toxic pieces of paper were “put” to Citi, meaning Citi was contractually forced to buy these loans in the event the counterparty didn’t want to keep them. This type of transaction is an example of the off-balance sheet risk Citi has used.
Of course, it is entirely possible that Citi will pull through this mess. They have already received billions of new capital from overseas sovereign funds. However, this is a company on the ropes. There market capitalization has been cut in half over the past year. They are writing down assets at an incredible pace. Currently, pure plays on home mortgage loans (mortgage REITS) are getting slaughtered, with Thornburg (TMA) near collapse. It is apparent to almost everyone that we are in a troubling credit crisis…it seems that we are caught in a vicious downward cycle of banks holding bad paper, credit tightens, home values decline, paper gets worse, etc., etc. Unfortunately, Citi seems to have the most exposure (in dollar terms) to all of this.
At some point, there will be some real opportunities to make some money – picking up the scraps from all these distressed loans. I am not sure who will benefit the most – obviously, those with the highest amounts of available capital will have the greatest opportunities. However, that is the subject of a future article.
Disclosure: Author has a short position in C