Responding to a rhetorical “What does a bank do?” question at a Town Hall meeting last November, Citigroup (NYSE:C) CEO Vikram Pandit explained that “a bank takes deposits and puts them to work by investing and making loans.” But the phenomenal exposure to derivatives on Citigroup’s books has nothing whatsoever to do with either taking deposits or making loans. As of June 30, 2008, the notional value of Citigroup’s derivative contracts exceeded a whopping $37 trillion; the ultimate fate of those contracts far outweighs the positives detailed in the Town Hall presentation.
Barely a week after Mr. Pandit’s assertion that a leaner and meaner bank was firmly on the agenda, the Treasury, the Federal Reserve and the Federal Deposit Insurance Corporation were forced to put together a massive rescue plan for Citigroup. So certain key components of the slide show which formed the basis of his presentation (available on Citigroup’s website) are now either hopelessly outdated or simply irrelevant. But given that 95% of Citigroup’s derivative contracts are grounded in the over-the-counter market, it is unclear whether those drafting the Citigroup bailout truly grasped the sheer size of the problem.
For that matter, those buying Citigroup’s shares today are also perhaps unaware of the fact that, as of June 2008, Citigroup’s exposure to credit derivatives stood at $3.2 trillion (notional value), and a fair proportion of its swaps (currency and interest rates), forward contracts and options incorporate settlement references to third-world currencies, thus implying a much higher degree of pricing, counterparty and valuation risks than those commonly found in dollar-to-dollar, euro and yen transactions. A detailed analysis of the substantive downside of engagement in illiquid and undeveloped financial markets is beyond the scope of this article; but, most certainly, the rescue plan fails to address the potentially disastrous impact of a crumbling derivatives portfolio in the face of a rapidly deteriorating global economic environment.
Citigroup has raised $50 billion through public and private offerings since the third quarter of 2007. In 2008, the US government invested $45 billion in Citigroup, and guaranteed $306 billion in toxic assets. But the capital inflow and the guarantees have only addressed, in part, loan loss provisions in sub-prime and consumer lending. The risk on the derivatives portfolio appears to have been ignored, perhaps in the hope that the end of the recession, at some point in the foreseeable future, will bring a semblance of mark-to-market rationality to thousands of “off balance sheet” trades concluded with international banks, hedge funds and corporate entities in 70-plus countries.
Those Wall Street analysts who are recommending long-Citigroup positions should bear in mind that derivative contracts originating in the developing world are also at risk of political intervention. Senior finance ministry officials in New Delhi, for example, are considering the cancellation of swaps, futures and option contracts in circumstances where such contracts are adversely affecting (a) exporters of agricultural commodities and manufactured goods and (b) importers of machinery and equipment for use in infrastructure projects. Neither Citigroup nor other significant providers of derivative contracts are hedged for “political risk”. However, for what may prove to be a blessing in disguise, JPMorgan Chase (NYSE:JPM) and Bank of America (NYSE:BAC), with total derivative contracts (notional value) of $91 trillion and $40 trillion respectively, never managed to achieve the global reach of Citigroup.
Vikram Pandit’s deposit-to-loan concept runs contrary to everything which Citigroup stood for, thus far. But even if one assumes that Mr. Pandit will be able to convert his concept into reality, the earnings-per-share and capital-adequacy outlook remains dismal. The 30-day high of $8.50 is an excellent short-Citigroup target price. If you are short, stay short. This stock can slide to its November 21, 2008, low of $3 fairly rapidly on the back of bad news, from the global economy or from within Citigroup’s balance sheet.
Disclosure: Author holds short positions in C, JPM