ItsJustMe

Could Citi's Deal Signal a Turnaround?

The fact that Citi is going to take a loss of over $1 billion on short-term debt that was likely on their books at full value isn't what I would call a positive turning point for the banks. If their "good debt" is only worth 90 cents on the dollar 9 months after issue, then what does that say about the rest of their loan portfolio?

Yes, it increases their liquidity but at what cost? Not many borrowers will have the resources of those equity firms to buy back their debt at a discount so I see this as more a move of quiet desperation than a meaningful turnaround model for other banks...

UBS Plan Could Be the Road Map for Financials

PJ568, you're still dealing with market value however. Yes, spinning it off to a new company and selling that company to the general public will get it off their books. That will solve their liquidity problem but not their solvency problem. They will still absorb the exact same loss which is where people are getting confused.

If my $150 million of mortgage loans have a probable write-down of $50 million, then my IPO is only going to bring in $100 million unless you're assuming the public is a bunch of uninformed fools. In 2007, they (we) probably were. In 2008, we're not.

With all the horrible publicity they're getting, their IPO would probably be a disaster and bring in even less than the mortgages are really worth which is why the government will end up buying these bad mortgages.

Then at some point down the road, when workouts have been determined and the bad publicity has settled down, I agree that Newco could go public as a long-term mortgage company...

UBS Plan Could Be the Road Map for Financials

VoR, I was an auditor for over 10 years (currently a no longer practicing CPA). Like most CPAs, I'm well aware of Enron and their cozy relationship with their auditor. It brought down an entire multi-national accounting firm so getting another auditor to turn his/her head to a shell game is not likely in today's environment.

The total estimated writedown of sub-prime loans is $460 billion. That number comes from Goldman Sachs which one would think would have no incentive to drive down their own stock price.

The total estimated writedown of ALL consumer and commercial debt assuming a recession (which is no longer an assumption) is around $1 trillion. The banks are NOT writing down perfectly good paper to zero. They use sophisticated mathematical models based on the current default rate of a group of mortgages to project the future default rate and their writedown is based on that.

I agree with you that the Fed acted to avoid a panic. It was a good move on their part. I disagree that "Joe" is playing into anyone's hands by selling his stock. Joe NEEDS to sell his investment bank stock. The banks and hedge funds have been shorting their own stock (along with homebuilders) for a year now because they knew the housing bubble was collapsing.

That is why you're seeing investment bank and homebuilders surging now because the banks and hedge funds are having to buy that stock back to close out their positions and raise cash. As soon as their positions are closed and their buying has ended, it won't be pretty...

UBS Plan Could Be the Road Map for Financials

scittl, your plan depends on ultimately selling the loans for 100% of full value to "unsuspecting schmucks." That worked from 2002 through 2007. There aren't any unsuspecting schmucks now and even if there were, it's not worth the certain lawsuits that are going to come from even the earlier unsuspecting schmucks...

UBS Plan Could Be the Road Map for Financials

No, you're still missing it Todd. Let's say Wilbur Ross in your article above, wants to buy my $150 million in sub-prime loans. As a sophisticated investor, he knows as well as I do what they're really worth.

He's going to pay me $100 million for them and I'll have to recognize the $50 million loss. I just exchanged a $150 million loan receivable asset for $100 million in cash. The $50 million difference will be a loss on my income statement which then flows through to reduce my owners equity (capital) to zero.

The exact same thing happens if I spin off the $150 million loan receivable to a subsidiary. Instead of a $150 million loan receivable on my balance sheet, I now have a $150 million "Investment in Subsidiary." At the conclusion of that spinoff, nothing has happened to my total assets or equity.

However, since I own 100% of that subsidiary, the accounting rules state that whatever happens to the subsidiary also happens to me. If the subsidiary sells those loans to Wilbur Ross for $100 million, it will take a $50 million loss to its capital and the accounting rules force me to show the $50 million loss on my own books as a writedown of my "Investment in Subsidiary" from $150 million to $100 million.

There is no way for the banks to get rid of these bad loans without recognizing the losses. The accounting rules do not allow you to play smoke and mirrors with your financial statements by setting up subsidiaries. A bad loan is a bad loan and the only way you can get out of swallowing the loss is to either a) pretend it's not a bad loan and leave it on your books at full value which the banks have been doing, or b) sell it to a sucker who doesn't realize it's a bad loan.

Unfortunately, there aren't any suckers left which is why the large banks have reached desperation status. Quite frankly - and most people are stunned by this - if the projections of $1 trillion of write-offs by the end of the recession are accurate, the entire US banking system is insolvent.

That means that the losses will ultimately be more than the capital of ALL our banks combined. That doesn't mean that every single US bank is insolvent, but it does mean that the ones who are holding all of these NINJA and liar loans have significant negative equity.

That is why they are racing to raise capital. That is why Bernanke is making Fed moves unprecedented since the Great Depression. It's also why Bernanke looks scared to death and the politicians are asking what they can do to help rather than grilling him for risking billions of dollars of taxpayer money.

This is a VERY serious crisis and if the US banks start setting up subsidiaries, it is probably the prelude to a government takeover of those subsidiaries (at pennies on the dollar) rather than a means to get out of swallowing the losses...

UBS Plan Could Be the Road Map for Financials

A follow-up to my comment above. As a CPA, what seems common-sense to me about financial statements isn't always clear to non-accountants so I'll elaborate a little more on why UBS' spinoff strategy is just window dressing that won't change anything in terms of their capital problems.

Let's say I manage a bank which has $50 million in capital (owners equity) and $150 million in bad loans of which I think $50 million will eventually be totally noncollectable. If I admit to all the bad loans and write them all off, I'll have ZERO left in capital and a LOT of angry shareholders - and worse, frightened depositors.

However, let's say I take UBS' approach. I try to hedge and say that only $25 million is noncollectable so I write that off and spin the remaining $125 million of debt into a separate company. I'll now have $25 million in remaining capital and an asset on my balance sheet called "Investment in Garbage Subsidiary." (Okay, I'll probably name it something less honest to fool investors).

That investment asset will be on my books for $125 million, but guess what? When the auditors come in at year-end, they're going to audit the books of that subsidiary just as they audit my own books and they'll force the $25 million writedown in my subsidiary investment. I'm now left with ZERO capital and angry shareholders.

That is why UBS is out raising capital. The subsidiary idea is just window-dressing to get the garbage loans out of sight. No one is going to buy their new subsidiary for the same reason no one is lining up to buy their garbage loans now.

Don't be fooled by accounting tricks. The UBS spinoff is pretty meaningless...

UBS Plan Could Be the Road Map for Financials

Todd, there is no magic pill to get bad assets off your balance sheet to "preserve capital." Whether you spin them off or sell them, the resulting writedown is going to wipe out your capital and you will be forced to either go bankrupt or raise additional capital to keep operating. UBS is raising additional capital now and they'll likely have to do it again this year.

ALL of the investment banks will have to raise additional capital this year in order to stay solvent. It doesn't matter if they spin their bad loans into a separate company, sell them off one by one or build a pretty wrought iron fence around them on their balance sheet.

A bad loan is a direct charge against a bank's capital no matter what type of accounting wrapping you put on it...

Meredith Whitney Threatens Severe Deflation For Your Portfolio

Philip, I'm aware that the market is forward-looking. Citi isn't going back and adjusting prior years for the losses they're about to swallow and give refunds to prior investors.

I used the last 5 years for comparison purposes to show you the income pain that is about to occur for the NEXT 5 years. The losses began coming off last year and they will come off this year, next year and the years after.

Also, dividends are paid out of equity and have no part in calculating income or loss. And yes, when they report their losses for the next few years, they'll get tax refunds from their previously reported profits. However, tax refunds are usually an irritating consolation for the investors who weren't expecting the depth of the losses...

Meredith Whitney Threatens Severe Deflation For Your Portfolio

Also, I forgot to add that another way of valuing Citi is to look at the hit to their equity. As of 12/31/07, they had equity of $113 billion with 5 billion shares outstanding for a "book value" of $22.60.

If we subtract $80 billion in bad debts off their $2.1 trillion of assets, that leaves them with equity of $33 billion against 5 billion shares. In other words, a book value of $6.60 per share versus the current market value of $20.83.

Ignore total assets Philip. Banks love to measure themselves by total assets but the only things that really matter to a bank are equity, income and consumer trust. Citi is vastly over-valued on the first two and is desperately trying to salvage the third. And if they lose that battle, the first two numbers become irrelevant as Bear Stearns learned...

Meredith Whitney Threatens Severe Deflation For Your Portfolio

Okay Philip, now I see where your analysis is getting screwed up. You point out that even if Citi's share of the mortgage losses is $46 billion, that is still only a tiny fraction of their $2.1 trillion in assets.

That is correct. However, it is a HUGE percentage of their bottom line profits for many years to come. Did i mention the word HUGE? Over the last 5 years (2003 to 2007), Citi has reported net income of $83 billion dollars.

Now take your $46 billion in mortgage writedowns and add in an additional $20 to $30 billion in commercial and consumer writedowns due to the resulting recession and you have a bank that realistically hasn't made a profit in 5 years and is trying desperately to delay confessing that catastrophe to investors.

I happen to agree with you that our country isn't in a doomsday scenario because the overall banking system will survive a trillion dollar writedown. However, certain institutions like Citi and the investment banks own a much bigger share of that problem than other banks like Wells Fargo.

Quite frankly, I happen to disagree with Meredith Whitney that the troubled banks should just confess their losses all at once. I agree with both them and the Fed that it could spark a worldwide panic that would do much greater harm than good.

I see what Citi and the investment banks are doing with their long, drawn-out "disparage and then beat" income strategy and I would do the same thing in their shoes. Playing for time while they swallow their medicine is their only chance at survival and I'm sure the "Plunge Protection Team" is blessing it.

Ms Whitney is a thorn in their sides and heeding her advice could be catastrophic. But that doesn't mean her analysis is incorrect. Ignore her at your peril...

Meredith Whitney Threatens Severe Deflation For Your Portfolio

Philip, as I mentioned above, Citi's quarterly financials in 2 weeks will tell us nothing. Last week, I was long on Citi, this week I went short and I'll switch to long again before they report.

The reason? All of the rating agencies - not just Oppenheimer - are giving earnings warnings on Citi and with mark to market, Citi can pick a few more of their assets to write down and still easily beat expectations.

However, it's all a game. Long term, Citi is struggling for survival. I'm not sure where you're getting your worst-case debt scenarios, but GS just estimated home mortgage write-offs alone to be $460 billion (only a quarter of that has been written down so far) and other analysts I respect because they've proven right so far have projected that commercial debt writeoffs and credit card writeoffs will gradually push the total credit catastrophe to well over $1 trillion over the next 2 years.

Citi has a very unhealthy chunk of that slow-grinding catastrophe and advising your clients to go long on Citi because you think they've hit bottom only 8 months into a real estate collapse which will take years to unfold is a real good way to lose your clients...

Meredith Whitney Threatens Severe Deflation For Your Portfolio

By the time the banks confess to all of the losses sitting on their balance sheets, Citi's profit for the last 3 years will be completely wiped out. I believe that would make Ms Whitney's 2004 statements accurate.

Warren Buffet warned years ago to be wary of investing in banks because they can easily hide huge problems. As a CPA who is somewhat familiar with bank accounting, I can tell you that he was accurate (as he usually is).

Right now, the financial industry is playing a game with their income statements in order to make their price collapse occur in slow motion over a couple of years rather than in a single panic-inducing drop which Ms Whitney is suggesting.

They are sending out earnings warnings on each other to slowly drive their price down and then producing income statements which "beat" those reduced expectations in order to prevent a total collapse.

All companies play this "lower the expectations and then beat them" game, but with mark-to-market accounting where "market" is a guessing game, the banks can pretty much name their bottom line to be whatever they need it to be. If their stock price is falling too rapidly, the banks will reduce their write-offs and beat the expectations.

That is why the Fed - and the banks - were desperate to prevent Bear Stearns from going bankrupt and having to sell their assets on the open market. Everyone in the industry knew they were worth significantly less than what Bear was showing (see Chase's market valuation of BSC) and a sale would have produced a KNOWN market value for mortgage backed securities rather than the INFLATED value all of the banks are carrying them on their balance sheets...