Citigroup, Merrill Lynch, Citadel: Earnings Troubles All Around

Includes: BAC, C, MER
by: Roger Ehrenberg

I started last Thursday bright and early at Fox Business News' studio, discussing Citigroup's earnings and its ramifications for the market. Around the same time as Citigroup's (NYSE:C) release Merrill reported (MER), missing consensus by a mile. And then we had the news of Citadel's troubles. If I had more time on the show I could have blathered on for hours, but seeing as how I had about 60 seconds there is a whole lot more I wanted to say. Here are a few themes:

Citigroup's earnings - Who Knows, Who Cares?

Can anybody tell me - Bueller, Bueller? -  what their numbers really mean? In the absence of transparency around their illiquid asset portfolios, both on- and off-balance sheet liabilities and contingent commitments (bank revolvers, liqudity backstops, LBO debt, etc.), how can we really know? This was one thing I did get to say on FBN. To this day I am mystified by the arguments over mark-to-market accounting in light of the current crisis. While can have a long, theoretical discussion about what should be (though I've argued quite strenuously that the treatment of asset values should be related to a firm's liability structure - if you can hold an asset for the long-term, hold it at cost less permanent impairment, otherwise, mark it to market), a meaningful contributor to the stock and credit markets' swoon is an utter lack of trust. Banks don't trust each other. Consumers don't trust banks. Banks don't trust the Government. This is a problem, people. Why would any rational investor buy Citigroup knowing what we know about their financial position, which isn't that much given the extent and complexity of their enterprise-wide exposures?

Bottom line, the sequencing of the bank-related elements of the rescue plan is all wrong. Here is a five-step plan for getting investors interested in and excited about investing in banks once again:

  1. Tighten, don't loosen, accounting rules for financial institutions, making them mark-to-market financial asset portfolios that specifically cannot be held on a long-term basis. Also clarify rules around consolidation of off-balance sheet vehicles, forcing all but the most clearly dissociated entities to be recorded as on-balance sheet obligations.
  2. Have banks mark-to-market illiquid assets that it cannot fund with term liabilities (core deposits, subordinated and senior unsecured debt, etc.). This will cause massive hits to equity that will render many banks insolvent from a regulatory capital perspective.
  3. Have banks sell these assets at market value to an RTC-type vehicle, which will finance them and work them out over a long period of time. The expected return on the investment in the vehicle would be expected to be positive and perhaps quite attractive.
  4. Have the Treasury provide the senior preferred stock investment that has been proposed, in amounts sufficient to top banks up to the point where they are in compliance with regulatory capital guidelines.
  5. Watch private investors inject fresh capital in the banking sector now that balance sheets and off-balance sheet liabilities have been cleaned up and their financial positions are once again comprehensible.

Controversial? Yes. But who cares. Equity holders will moan. Bank managements will whine. Deal with it. The stakes are incredibly high. If we want the crisis to drag on indefinitely and the overhang on our financial services sector to persist (which means keeping a damper on the non-financial economy as well), then we're doing a great job. $25 billion into Citigroup? This could be burned through in one quarter. Why not find out what the right number is to support a stable, healthy franchise? This can only be gotten through transparency and clarity around bank financial statements.

Merrill: The Fed and Treasury Are Holding Their Breath

Merrill is cool because they're going to be taken over by BofA (NYSE:BAC). Right? Well... Sure, as we stand today the deal is likely to happen, notwithstanding the 12% spread between Merrill stock price and the offer price. But last week's horrid earnings report can only re-awaken Ken Lewis's fear and trepidation over the transaction.

Like Citigroup, even in light of the steps John Thain has taken to shore up the balance sheet and offload troubled assets, there are still question marks over if and when another big hit is going to be taken.  And couple this with retail sales falling off a cliff, an indebted and morose consumer and sheer panic among retail investors towards the equity markets, that "golden goose" - the retail network - might not be as golden as once thought. So if retail is weak, banking is in the doldrums and the portfolio has lots of question marks, does this not pose an execution nightmare to BofA, which is still digesting the not-so-pretty Countrywide acquisition? That arbitrage spread is so wide for a reason. Because if BofA wakes up and walks and the stock craters, we are looking at a very ugly sequel: Lehman 2.

Citadel - Even the Smartest Men in the Room Can Be Cowed

Make no mistake - Ken Griffin dropping 30% is big news. Huge news. Less because Citadel is going bust (which it's not), but because of what it says about the state of the hedge fund industry and the financial markets in general. Sure, I can see Phil Falcone and Harbinger being up 80%, down 40%, etc. because of the concentrated nature of his strategy (kind of like David Tepper and Appaloosa, which has had historically great compound annual returns but with vomit-inducing levels of volatility). But Ken Griffin? That is not his game. But clearly his credit positions, both stand-alone and as part of his convertible arbitrage strategies, had to have gotten hit, and hard. Equities as well. But being a man of math, I'm sure he also understood his factor exposures pretty well, and got clubbed over the head when historical correlations broke down and everything started to move in lock-step. So it's not surprising that we're seeing just awful returns across most hedge fund strategies, because so many of those purported "hedges" simply haven't worked.

Mr. Griffin and several of his brethren have accumulated cash piles the likes of which haven't been witnessed in this generation, and are battening down the hatches against both renewed market volatility (which Mr. Griffin expects) and redemptions (which everyone expects). The bright side is that with all this cash having been accumulated, a significant amount of selling pressure has been taken off the market. That said, there is still plenty of fear, margin calls and unhappy unwinds to take place over the next 12-24 months. My friend Paul Kedrosky also penned an interesting piece on this topic, and it is worth checking out.

These next few months should tell us a lot about the next few years. Either we can take our medicine now and gag or we can take it later and perhaps be in ICU. While gagging is never fun, it might just be the best option we've got.

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