Citigroup: Too Big to Sell - At Least All at Once

Includes: BA, C, GS, JPM
by: Christopher Whalen

"But I'll get back on my feet someday,
The good Lord willin', if He says I may.
I know that the life I'm livin's no good,
I'll get a new start, live the life I should.
I'll get up and fly away, I'll get up and fly away, fly away."

Wharf Rat
The Grateful Dead

First, want to make one and all aware of the event in DC on January 28, 2009, at American Enterprise Institute. Co-sponsored by the DC Chapter of Professional Risk Managers International Association, we have an excellent panel of observers to examine the Bailout to date, including Barry Ritholtz of Fusion IQ, Walker Todd of American Institute for Economic Research, Josh Rosner of Graham Fisher & Co, Tim Bitsberger, formerly of Freddie Mac, and IRA co-founder Christopher Whalen, who serves as co-regional director of PRMIA's DC chapter. Our moderator and host is Alex Pollock of AEI. Click here for more details

Second we have a little treat for the readers of The IRA. After years of searching, IRA's Chris Whalen finally recovered a copy of an artifact from 1993 that is particularly relevant to the current mess and our previous comment, "IndyMac, FDICIA and the Mirrors of Wall Street," where we set the record straight about just how the Fed came to have the legal authority to bailout Wall Street, broadly defined, without going to the Congress. To read the paper published by The Herbert Gold Society almost two decades ago, "Gone Fishing: E. Gerald Corrigan and the Era of Managed Markets," click here.

We've heard from a number of readers who confirm our view of the worsening credit risk situation in the US banking sector. But also from more than a few who feel the worst is over in terms of risk recognition, but the realization remains - unless you have deep enough pockets to just sit with the position.

But if your business is dealing in illiquid assets and securities, times are great. Our friends in the distressed debt and special situations worlds had record years in 2008 measured by volume and profits. And we note that one of the largest mutual funds in the US told The IRA that after months of net outflows, money is starting to flow back in equally fast, but almost entirely into fixed income products.

To this point, we've heard from a few of you asking whether the "F" and "D" banks in the IRA Bank Monitor ratings system are necessarily going to fail. The answer is no. The quarterly ratings we calculate for all banks are tests that change with each period. The ratings are intended to show you which banks are testing poorly vs. the industry, peers, etc. based on their filings with the FDIC. The historical trend of these nominal test results are as important as the results of any one period and must then be compared with the institution's Economic Capital numbers, which are contained in each IRA Bank Report profile.

Alex Pollock likes to say that truth lies in multiplicity of views. We agree. Understanding a bank's safety and soundness means you need at least 1) a nominal and 2) a risk-adjusted perspective on a bank to even begin to fully understand the range of risk possibilities. By synthesizing a bank's risk profile into a Bank Stress rating and a ratio of Economic Capital to Tier One Risk Based Capital, IRA provides professional and retail users alike with the ability to compare different banks in these two dimensions, consistently and without human intervention, each quarter.

But remember that those "F" and "D" institutions, which very well may improve or degrade further next quarter, are the banks that may be excellent value in terms of acquisitions or long-term picks for the long trade. That's why we still see the year ahead as being ultimately a year of both risk and opportunity. Thus JPMorganChase (NYSE:JPM) was rated a weak "A" vs. the Q3 2008 data for its three subsidiary banks, but we stick to our view that the government may need to repeat for JPM CEO Jamie Dimon the open bank assistance now being provided for Citigroup (NYSE:C) later in 2009.

The battered shareholders of Citi have small reason for cheer as Robert Rubin, the former Treasury Secretary and Goldman Sachs (NYSE:GS) CEO, finally announced his departure from the bank's board. After extracting a reported $115 million in professional fees since joining the bank a decade ago, Rubin leaves C as it conducts a fire sale of prime assets to raise cash. The shareholders of C, in our view, should feel every bit as violated by Robert Rubin et al as do the clients of Bernard Madoff. The damage at C was realized slowly, over the course of months and years, instead of being realized in a few days as with the revelation of the Madoff fraud. But both value destruction schemes took years to construct and implement. Besides, the numbers at C in terms of shareholder value lost are far bigger than the Madoff racket and likely will include a loss to the US government.

Remember that while Bob Rubin was collecting those fees, both as a director and a consultant, and was occupying something called the "office of the chairman," he publicly declaimed any operating role - this though his bio says he "participates in the strategic, managerial, and operational matters of the company." Our view: Robert Rubin and other member of the C board literally stood there, took the money and did nothing as one of the largest, proudest global banks wandered leaderless and without the adequate supervision. To us, this bank has not had a serious CEO in years, going back to John Reed and the Raul Salinas mess. By "serious" we mean somebody with primary, hands dirty experience operating and managing banks. Not lawyers, not fund managers or empire building visionaries or stock brokers or consultants, but an honest-to-God operator of commercial banks.

Even if you give Rubin a pass on the issue of an "operating role," he still does not get a pass for botching, in our view, his duties as a director of a bank holding company with publicly listed shares and debt. Start with the normative standards for directors in COSO, then Delaware law, then 12CFR and finally Sarbanes-Oxley. As we've noted previously, the officers and directors of failed banks which cause losses to the Deposit Insurance Fund often face enforcement actions by FDIC to recover part of the loss. The situation in such cases is not unlike that between the victims and Bernard Madoff, where the receiver is using the power of the Court to claw-back assets paid to the parties, in this case the officers and directors of C who contributed to the cost of resolving the institution.

Just to make sure we are all on the same page, C is operating under "open-bank assistance," supported by a combination of loss sharing with the FDIC and investments by the US Treasury, with a former fund manager as CEO and a Board of Directors as dysfunctional as any found in a large cap public company. Owing in part to this Rubin-inspired vacuum at the top, we've predicted that the government will need to eventually take control of C (and several other large banks) and liquidate their assets into a slowly improving US banking sector over the next three years or more. The proximate cause of that unhappy result will be record levels of losses for C and other large banks, but the years of mismanagement and/or no management at C set the stage for the present calamity.

A lender which focuses on risky lending, even subprime lending as in the case of C, does not need to fail, even in a deflating bubble economy. In fact, for many years C managed to take more risk, with higher spreads over a shorter period of time and thereby managed to generate billions of dollars in profit per month. But when you combine an above-peer risk profile, with low tangible capital levels, a complex portfolio of on and off-balance sheet trading book risks, retail banking operations around the world, and a weak CSUITE, the situation is unstable and unmanageable, it's just a matter of time as to when this fact is realized.

And there are political concerns. Rubin, it seems, had to leave C's board immediately because of his role as chief string puller in the about to be Obama Administration. We hear that the former GS banker spends so much time on the telephone with Treasury-Secretary designate and Rubin minion Timothy Geithner, sometimes three or four telephone calls during the course of a workday, that he could not possibly have any time for other duties such as sitting as a director of a public company.

Americans everywhere should feel safe and secure knowing that Bob Rubin is about to do for all Americans the same fine job that he just finished doing on C shareholders. We hope that when Richard Shelby (R-AL) fires up the barbecue pit for the Geithner nomination hearing later this week, he saves some time to ask the FRBNY president about his owner/minion relationship with both Rubin and outgoing Treasury Secretary Hank Paulson. Boys and girls, don't you wish you had the subpoena power of the Senate Banking Committee right about now?

Our guess is that C sells some assets over the next few months and that the government must convert its preferred shares into common by 3Q 2009. If you look at the loss rate estimates for C in the IRA Bank Monitor, or recent comments by our colleagues in the analyst community like Meredith Whitney at Oppenheimer and Charles Peabody at Portales Partners, it is hard to escape the conclusion that C is going to consume all of the TARP money and then some as the credit cycle troughs.

While the depositors and customers of C probably have nothing to fear, the equity and debt holders of troubled banking conglomerate need to start assessing just where the FDIC is going to draw the line as and when the time comes to pull the trigger and resolve C's subsidiary banks. By then, it is possible that Banamex and other bank units will be gone or far smaller than today, but the remaining entity may well end up in a carefully managed liquidation with the Fed and FDIC sitting shiva.

Ultimately, President Obama and the Congress must decide that the bailouts are over and the resolution process is begun. Rejecting bailouts and embracing resolution requires political courage of a sort not yet visible in Washington, but the number may dictate the least-cost solution required by federal law. Consider the comment of Eugene Fama of the University of Chicago on the "bank debt overhang problem" and how to get rid of it:

"Suppose no private buyer steps up to buy a failed bank, and suppose, for whatever reason, the Fed and the Treasury decide they want to inject equity to allow the bank to meet its capital requirement. The FDIC approach can still be used to solve the debt overhang problem, so taxpayers get their money's worth, that is, so equity financing ends up as equity financing rather than as a shift of taxpayer wealth to the bank's debt holders. To achieve this goal, the FDIC can draw a line in the bank's liability structure, with debt holders and stockholders below the line getting nothing. The line should be drawn so that the market value of the bank's assets covers the liabilities above the line. (This is what the FDIC does when the new equity comes from a private investor.)

"When this prescription is followed, the bad news is that the failed bank has been nationalized (I hate nationalization), but the good news is that nationalization is accomplished without a taxpayer subsidy to the bank's debt holders. I suspect the Fed and the Treasury think they avoid nationalization (or at least perception of it) if they inject equity capital into a bank without solving the debt overhang problem. This is an illusion. The bank has been nationalized, but in a more expensive way. The additional expense is the subsidy to the old debt holders because of the debt overhang problem.

"The FDIC's powers are written so that taxpayers should not have to pay when a bank goes bad. The logic is that the bank's stockholders and its lower priority debt holders get the benefits when the bank does well so they should pay the costs when it does poorly. Stockholders and lower priority debt holders should be pushed out of the game until the value of the bank's assets are sufficient to cover its remaining liabilities. My view is that this blueprint should be followed when the subsequent injection of equity capital that a failed bank needs to survive comes from the public sector (the Treasury or the Fed), as well as when it comes from the private sector. It produces all the benefits of a recapitalization without a taxpayer subsidy." -EFF

So if we take the advice of Professor Fama and draw a line through the liability structure of C, how high does the line go? We see common equity as being toast along with the preferred - all the preferred. The prospective sale of the SmithBarney unit of C is, to us, confirmation that the open-bank assistance put in place last quarter is moving to management and other changes. There is already speculation in the media about a new CEO. Our view is that this is a traditional "open bank" sale process a la Continental Illinois, but with more sophistication. Since nobody but Uncle is going to buy C's equity for now, the sale process must occur in as many as a dozen pieces over a period of months or years.

Our view on 2009 seeing a 2x 1990 loss rate peak has not changed, which means C's loss (charge-off) rate could double in next two quarters. Same for many other large banks. And Charlie Gasparino of CNBC is right; JPM is next on the wall of worry.

But we remind one and all, as the Global Armageddon crowd get ready to do their victory dance in 2009, there are opportunities aplenty in US banks. Two-thirds of the banks in the US are rated A+ or A on our IRA Bank Monitor system. These banks are over-capitalized, under-risked and waiting to lend somebody money -- with collateral!

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