The Citigroup Rescue: Exit Financials Under State Capitalism

Includes: AIG, C, XLK, XLP, XLU, XLV
by: Rakesh Saxena

The government’s Citigroup (NYSE:C) bailout does indeed show resolve. But that resolve has now become part of an ideology (state capitalism), and investors need to figure out how to trade, and make money, in an era where interventionist policies are rendering traditional valuation methodologies, for both equities and bonds, totally irrelevant.

The Citigroup package leaves a number of unanswered valuation-related questions, since there is no assurance that the $300 billion worth of guarantees for Citigroup’s toxic assets tackle core balance sheet considerations in any comprehensive manner at all. In fact, it is obvious that the term sheet jointly issued by the Fed, the Treasury and the FDIC late Sunday does not appear to be premised on a thorough understanding of the size or nature of the problem; it is just ridiculous that the $10.61 per share strike price for the warrants Citigroup will issue has been calculated on the 20-day market average (ending November 21) rather than on any verifiable corporate valuation guidelines.

Besides the implied upside cap created on Citigroup’s share price by the strike price for warrants, for an aggregate amount of US$2.7 billion, investors need to be concerned with other aspects of the Citigroup bailout. In addition to the $300 billion guarantee, the Fed has agreed to finance Citigroup’s remaining assets at OIS (Overnight Indexed Swap) plus 300 basis points. Citigroup will pay an 8% dividend rate for $7 billion of preferred stock. To complicate the package, the government will assume 90% of portfolio losses, beyond the $29 billion benchmark to be absorbed by Citigroup itself.

Where all this leaves investors is highly uncertain, at least from a valuation perspective. But it is exactly this type of uncertainty relating to the value of private capital that the state-capitalism ideology essentially destroys. Those who target Citigroup at $1 (or lower) may be trapped by more rescue-related announcements. Those desiring to go long run the risk of adverse disclosure on the quantum of toxic assets (e.g. AIG).

In the broader context, investors need to bear in mind that the US government has already committed a total of $7.4 trillion of American taxpayer dollars (half of everything produced in America last year) in its bid to repair the financial system. According to Bloomberg (November 24, 2008), this $7.4 trillion figure incorporates the $2.4 trillion support program for commercial paper and $1.4 trillion in FDIC guarantees for bank-to-bank loans. Fiscal conservatives are clearly distressed by the outlook for deficits. But, of greater and immediate concern should be the erosion of the foundations of free market capitalism, and the consequent impact on trading and investment perceptions.

As Russia and China prove, state capitalism has little regard for the intricacies of stock-price forecasting, since government intervention can, at short notice, destroy the very assumptions which drive forecasting in the first place. Therefore, one may ask, is it the right time to stop trading financial stocks altogether? Take note that the key dynamic of state capitalism is the avoidance, at all costs, of systemic risks, specifically the risk of a collapse of the financial system.

Is it now prudent to exit stocks which are inextricably linked to potential systemic upheavals, and to focus on ETFs which will actually benefit from the Obama stimulus package (due to be detailed this week), particularly sector ETFs dedicated to health care (NYSEARCA:XLV), consumer goods (NYSEARCA:XLP), technology (NYSEARCA:XLK) and utilities (NYSEARCA:XLU)? Remember that there is no need to agree with the stimulus concept; the best investment ideology today is to dispense with ideology altogether.

This writer is not recommending buying anything at this juncture. But a deleveraging-induced 15-20% retreat in equities (S&P 500) should make a highly compelling case for selective sector-ETF longs. It is imperative that one trades in business segments where the influence of the state-capitalism ideology, in the context of equity valuations, is minimal, at best.

Disclosure: no positions in the above-mentioned stocks.