Today it was announced that a Dubai firm will invest $7.5 billion in Citigroup notes and be paid 11 percent interest, on top of being able to convert the stake to equity in the future. Clearly, these terms indicate how desperate Citigroup has become and should be a wake up call to depositors with large uninsured money market balances at Solomon Smith Barney and other related subsidiaries.
The two primary architects of this debacle are Robert Rubin, Vice Chair of Citigroup, and former Secretary of the Treasury, known in the investment industry as the “Godfather of Hedge Funds” and Sandy Weill, former CEO of Citigroup who made a cool $1 billion in stock options in a single year. Weill, still a “senior advisor” to Citigroup, pictured below, and Rubin both wrote notable books. Rubin was also the primary architect of the deregulation of financial services in 1998, of which Citigroup was the biggest beneficiary. It would seem preposterous to make something this ridiculous up.
The following chart shows Citigroup’s stock trend, compared to Fannie Mae, over the last 6 months.
Few investors realize, however, the true nature of Citigroup’s travails. Here are a few thoughts:
1) Citigroup purchased Associated First Capital, what was known as the “icon of predatory lending” and then proceeded to slice and dice these portfolios of predatory loans into derivatives. Clearly, it just got too agressive and fleeced many of these vulnerable consumers right into default on their mortages. This is the same problem HSBC has, resulting from its purchase of another leading predatory lending firm, Household Finance.
2) The banking system is predicated upon each member having adequate capital, generally defined as 8 percent of assets. If you fall below this level the regulators come in, shut you down and allow other institutions to bid on your remaining assets. That’s how the system works. The formula is simple: take total loans and investments outstanding and multiply them by 8 percent.
3) The value of a banks loan and investment portfolio changes quarterly based upon a variety of factors, including credit risk and the maturity of the loans and deposits. These changes in value must be recognized quarterly per FASB 115 guidelines, guidelines put forth by George Bush Sr. to restore confidence during the S&L crisis, and therein lies the crux for Citigroup. What they had done is an Enron like shell game by creating derivatives and pushing them off their balance sheet, similar to how Enron did the same thing with debt and related interest payments. Now Citigroup is trying to create a market for these derivatives via a special SIV fund when to any honest banker this is nothing but a joke. Perhaps Greenspan put it best when saying it is better for the banks to take the losses now rather than create furthur problems.
4) The biggest risk to Citigroup is rising interest rates than would require them to mark down the value of their loans and investments already on the books, as required by FASB 115. It is really simple math. If the 10 year treasury increases from 4 to 6 percent, the loss is 18 percent on comparable maturity loans and investments and a direct hit to capital. The formula is change in rate, in this case, 2 percent, times the remaining term. And this doesn’t even consider the notion that they have large investments in Fannie Mae and Freddie Mac that now have their own credit quality issues and could also require writedowns independent of those required due to the interest rate scenario.
Back in 2001 Bloomberg Markets did a cover story titled “A Tale of Two Cities.” In the article Sandy Weill looked rather smug, having just pocketed $1 billion in stock options, and highlighted its strengths. I was featured telling the other tale while playing a classical guitar while standing on a stone wall in Washington Park overlooking Portland. My tale was focused upon credit quality issues associated with predatory lending in addition to excessive derivatives and numerous other issues. I always thought it was rather gutsy of Loren Steffy to do that article for Bloomberg, once again highlighting why Bloomberg is such a premier source for financial information.
The good news is that there are many outstanding banks out there including Northern Trust, US Bank and many other regional and local banks. At this point, however, for the system to repair itself we’ll first need to rid it of the cespools of unproductive greed and corruption as exemplified by Citigroup. Or in more mundance terms, simply require Citigroup, a leader in structuring the most egregious Enron related partnerships, to follow the rules and take the required FASB 115 writedowns on its derivatives, loans and investments. Anything short of that will only harm the higher quality more important financial institutions we depend on.
*** Updating Note on January 17, 2008. The following link is a 9 minute podcast posted on youtube with more detailed observations on Citigroup and the federal reserves response to it and other related events.
Disclosure: I do not own any financial interest in Citigroup although 3 clients do own a small amount of shares that were owned previous to engaging me as their advisor.