The Case Against a Citi Breakup

Before readers start throwing brickbats, let me set forth some general views:

1. I have never thought the financial supermarket was a good idea and have said so for at least 15 years

2. I was opposed to the sale of Salomon to Travelers

3. I was opposed to the merger of Citibank and Travelers

4. I have been saying for over 15 years that that the idea that bigger is better in banking is a head fake that serves only the top executives (bank CEO pay is correlated with the size of the balance sheet). Just about every study ever done of the banking industry finds, contrary to popular image, that the industry has a slightly increasing cost curve once a certain size threshold has been surpassed (the level varies by study, but trust me, it's low). That means that bigger banks, despite the supposed economies of scale, are actually LESS efficient. I can give you my pet theories if you care to hear them.

So how can I possibly be opposed to a breakup of Citi, a behemoth that is barely able to raise capital fast enough to offset the seemingly neverending writedowns? (Other banks are able to play the game of announcing losses and similar sized fundraisings with a tad more dignity ).

Shareholders have every reason to be angry (but really, you should have voted with your feet a long time ago). The frustration at the continued hemorrhaging is a big part of the impetus for the calls for a breakup.

Having worked in M&A and as a management consultant with very large financial institutions (Citi was a client in the 1980s), less is to be gained and more stands to be lost by a breakup (defined as hiving off core business units, such as retail banking or perhaps the credit card operations, to create businesses with much narrower product offerings) at this juncture. One of the dirty secrets of M&A is it's all about timing. Deals make sense when valuations are favorable. This isn't one of those moments.

Mind you, Ciit may still have to do that at a time not of its choosing. But as we will see, it's unlikely to be to its advantage. Consider:

1. Citi's big problem is that (like every large Western financial institution, but more so) it is undercapitalized. Yes, they managed to maintain the fiction of having adequate regulatory capital. But let's face it, banks wouldn't be hoarding cash, clamping down on lending, and going to the Middle East on bended knee if they really thought the credit crisis was over. We may escape further brushes with systemic meltdowns, but (per the post by Satyajit Das on nuclear de-leveraging), more writedowns are in the offing, and more assets will be involuntarily coming on their balance sheets, increasing the need for capital in the absence of business growth.

So the only way a break-up makes sense (in terms of helping Citi through its tsuris) is if you can sell the businesses and show a gain on its book value of those units, or at least come out whole. But who is a buyer of bank assets now? Private equity firms might buy operational units, but for the most part, they don't like regulated entities (with good reason) and have little experience with financial institutions. The possible acquirers of its credit card business are other big credit card players; that raises anti-trust issues and most either are in nearly as bad shape as Citi or, like BofA and JP Morgan, are otherwise occupied. HSBC might have been a buyer, but the chatter today about its latest earnings announcement says that it is in vastly worse shape than the official release indicates. The Japanese and Chinese have the dough, but this isn't a strategic fit (and the issues raised re the credit card ops apply to trying to sell the entire retail business). So who does that leave? Chris Flowers, and he isn't known for overpaying.

The proof of this assessment? The absence of a breakup plan. When a company allegedly has value that can be unlocked via a restructuring or split-up, plenty of people start putting pencils to paper. Someone, say financial analysts, shareholder activists, investment bankers trying to tee up a deal, will publish a breakup analysis. I've seen no evidence that one exists, and any reader that knows of one (a real one, with valuations of the parts versus the whole) is encouraged to speak up.

2. More important, if you believe Citi is a deep dodoo (and I do), you can't simultaneously stabilize the patient and do major surgery. These entities have combined overheads; Pandit's recent move to segregate the credit card business says that even t is fairly well integrated into the retail bank from a managerial and cost perspective.

Breaking up Ciit would a full employment act for a hoard of consultants, accountants, and bankers. I guarantee just producing the financials would be a huge exercise, and the drill would fully consume senior management and prevent them from taking needed action within the businesses.

And where do you get the management talent for these independent entities (if you assume spin outs)? The fact that Pandit has the CEO job says Citi is thin in talent at the top ranks.

Thus, Pandit's plan to offload 20% of the bank's assets isn't as self serving as it might appear. He's hiving off units that (presumably) are sufficiently discrete that they aren't (from an operational and transaction standpoint) ungodly difficult to be rid of them. While Michael Shedlock may assert that this is tantamount to a breakup, disposing of small to middling units and portfolios, even if they adds up to a lot of value in aggregate, is a very different task than separating core units.

Now in the end, Pandit's plan may all come to naught. Oppenheimer analyst Meredith Whitney, who has been spot on in her calls so far on Citi, says that Citi is too broken to fix:

Citigroup Inc. Chief Executive Officer Vikram Pandit faces an ``impossible feat'' in turning around the biggest U.S. bank as it faces ``seismic'' costs to restructure, Oppenheimer & Co. analyst Meredith Whitney said....

``I think it's an impossible feat,'' Whitney said. ``They don't have the revenue power, they don't have the earnings power in so many of their businesses. Even Stephen Hawking could not pull this off,'' she said, referring to the British physicist.

Whitney said she expects Citigroup, which lost a record $10 billion in the fourth quarter, to post ``de minimis'' profit during the next three to five years. She repeated her prediction that Pandit would be forced to lower the dividend again, and didn't give an estimate for restructuring costs. She estimated a loss this year of 45 cents a share.

While Citi's situation may be as dire as Whitney says (and note that some other analysts disagree), Citi is not going to be permitted to fail. Ironically, if it is as big a garbage barge as she claims, its size and systems issues will keep anyone from taking it on (many an otherwise enticing banking deal has been scuttled due to systems issues; it's a very serious consideration in financial services mergers. The multiplicity of systems would be very troubling for a potential partner, even if one assumed there weren't compatibility issues. After all, Citi is stuck with its mess; anyone else would be electing to take it on).

Thus Citi could continue to be a significant value destroying event for equity holders, yet limp on through this period.

Satyajit Das on Nuclear De-Leveraging

It's one thing when journalists and analysts offer worrisome forecasts about the markets, quite another when someone with good inside knowledge sounds an alarm. Satyajit Das, an expert in derivatives and risk management, best known as the author of Traders, Guns & Money, looks over the financial landscape and does not like what he sees.

Reader CR sent me a copy of Das' latest piece on nuclear de-leveraging, which he also posted at Eurointelligence. Das works thought an example of how deleveraging feeds on itself and discusses how it will progress:

The first phase of de-leveraging is focused on financial markets. Banks have suffered losses in excess of US$200 billion (with more possible). Approximately US$1 trillion of assets have returned onto bank balance sheets.... An additional unknown amount of assets will return onto bank balance sheets as hedge funds gradually de-leverage.

Banks require funding and capital to cover losses and returning assets (christened IAG (involuntary asset growth). High inter-bank rates and the deceleration in bank lending reflect, in part, banks husbanding their cash resources to accommodate the involuntary increase in assets.

They have been raising money both via “helpful” central banks and in the market. Major financial institutions have issued substantial volumes of term debt at very high credit spreads....

Banks will also need substantial new capital to cover losses and the regulatory capital required against returning assets as follows:

Losses: US$ 200 to 400 billion

Additional Capital: US$ 100 to 300 billion (calculated as 10% (the Basel minimum is 8% but few banks operate at that level) of returning assets)

For bank’s operating under Basel 2, probabilities of default in credit models will increase resulting in regulatory capital increases....The capital required is around 15-25% of total global bank capital....

It is not clear how this capital requirement will be meet. Initially new capital was supplied by sovereign wealth funds (“SWFs”) and Chinese banks. Given that most investors have (sometimes) significant losses on their investment, this source of capital is less likely to be available in the near term. Banks have resorted to “hybrid” capital issues such as perpetual preference shares. The major attraction for investors has been the high income. Investors, especially retail investors, may not understand the equity risk in these structures. Rating agencies have expressed concern about the increasing level of hybrid securities in the capital structure of many banks.

Other sources of capital include asset sales. The current state of asset markets makes this problematic. Asset sales will put further pressure on available liquidity and prices.

One bright spot is investment in emerging market banks; for example, investments in Chinese State banks....Many banks see disposition of these shareholdings as an attractive source of capital....

The new capital noted above will merely restore bank balance sheets. Growth in lending and assets will require additional capital. The banking system’s ability to supply credit is significantly impaired and will remain so for the foreseeable future. Credit is clearly being rationed in the global financial system. If the banks are not able to re-capitalise, then the contraction in credit supply will be sharper.

In recent years, off-balance sheet vehicles – ABS CP conduits, SIVs, CDOs and hedge funds (collectively known as the “shadow banking” system) – provided additional leverage. These vehicles relied extensively on bank funding or support. The withdrawal of this support means that these vehicles are also de-leveraging rapidly.

ABS CP conduits, SIVs and CDOs are being gradually dismantled and the assets returning onto bank balance sheets. Hedge funds have been forced to reduce leverage by between a third and a half times. Prime brokers and banks have significantly tightened credit, increasing the level of collateral needed even against high quality assets. Each 1 times leverage reduction in hedge fund leverage represents in excess of US$2 trillion of assets. This accelerates the de-leveraging process.

The next phase of de-leveraging will focus on the real economy....

High quality corporations with maturing debt face face higher borrowing costs. For companies with less than stellar business outlook and credit quality, refinancing may prove difficult. Some US$150 billion + of leveraged loans comes due in 2008. A similar amount also must be refinanced in 2009.

Non-investment grade bond issuance over the last few years was concentrated in the weaker credit categories and is vulnerable to deterioration in economic conditions. Standard & Poor’s rating agency estimates that Two-thirds of non-financial debt issuing companies are junk-rated currently, compared with 50 per cent 10-years ago and 40 per cent 20 years ago. In recent years, around half of all high yield bonds issues were rated B- or below. These borrowers will face refinancing challenges.

Personal balance sheets will also de-leverage. Consumers in the USA and to a lesser degree in the UK, Ireland, Australia and New Zealand have used borrowings (against inflated real estate values) to offset a reduction in real incomes. Falling real estate prices and the reduced availability of “easy” credit will force de-leveraging.

Inflation is also a factor in the de-leveraging in personal balance sheets. Higher prices for the necessities of life reduce cash flow available to support debt....

An economic slowdown will exacerbate the de-leveraging.....In the US economy, the household, housing and financial sectors constitute over half of all economic activity. A (perhaps protracted) slowdown may be difficult to avoid. US demand is a significant driver of global activity. Recent reductions in global growth forecasts reflect these concerns....

There has been a systemic “financialisation” of corporate balance sheets. Changes in financial markets will have a significant impact on many companies that now rely on “financial engineering” rather than “real engineering”. The problems of GE may not be isolated.

For personal borrowers reduced personal income and unemployment will sharply accelerate the de-leveraging. Uncertainty about the future and market volatility will also accelerate the de-leveraging as companies and consumers reduce debt and aggressively save.

De-leveraging in the real economy may result in increasing defaults. Firms and individuals with unsustainable borrowings will fail. This will result in further losses to financial institutions setting off negative feedback loops as both asset prices and the level of aggregate leverage adjusts.

Central banks and governments actions have been directed at maintaining liquidity and (increasingly) directly supporting the financial sector. In the US and Spain, direct fiscal stimulus is already being administered.

These actions are designed to prevent a catastrophic collapse in the financial sector. They are also designed to help maintain a normal supply of credit to creditworthy business and individuals. These actions are designed to help the real economy from slowing down to a degree that the de-leveraging accelerates further. At best, these actions will smooth the inevitable de-leveraging and adjustment to financial asset prices.

How to Leash and Collar the Financiers? (Continued)

The fulminating over what to do about our miscreant socialized unrepentant and as yet unreconstituted financial services sector continues. Since massive subsidies have been extended in the form of help to the mortgage business and an alphabet soup of Federal Reserve facilities, with nary a demand made of the beneficiaries of this largess, it seems that the authorities have perilous little leverage over their wayward charges.

Of course, in reality that isn't so; a determined regulator can, if nothing else, harass a company into submission (the Japanese are masters of this technique) and they have more powerful tools at their disposal. But that presupposes the will to intervene, which despite the crisis, still appears to be sorely lacking.

The collective response resembles the storied boiled frog effect: the heat goes up, or in this case, the public outlays continue, yet legislators, regulators, and the public remain remarkably passive as the expenses continue to rise. Of course, it doesn't hurt that many of these costs are contingent liabilities, so the true damage will come to light only years later, when the perps have moved on to other roles.

But readers beware: the boiled frog is an urban legend. Real frogs have the good sense to hop out of hot water. But in a pot with high enough sides, even a frog that knows it is in trouble will be unable to escape.

The sightings today confirm the difficult of leashing and collaring a complex, sprawling, fast-moving industry. The Financial Times has a comment by Charles Dallara, the head of the Institute of International Finance, an international organization of financial institutions that verges on the sanctimonious. It confidently recites a list of four areas for action and asserts:

Thus, the debate is not about “self-regulation” versus “more regulation”. Instead, there is an emerging consensus on the benefits of reinforcing market-based corrections with improved regulatory incentives and structures.

A consensus among those who'd rather not be regulated, for sure.

Some regulators are getting mad enough to at least threaten action, but it isn't evident that they will be taken seriously. As the Telegraph reports in "EU to launch assault on bankers' bonuses":

A group of key EU finance ministers will today launch an assault on the rewards earned by bankers and top managers in a move that poses a potential threat to the City of London.

A confidential document prepared for the gathering in Brussels finds the "short-term" pay structure of modern capitalism has become deformed, causing firms to take on "excessive risk" without regard to the interests of stakeholders or society.

Note that these discussions do not include the UK.

Now one can correctly point out that this is silly; the main finance centers are not in Europe to begin with, and having the EU adopt even tougher rules will assure even less high powered finance take place there. But don't assume the EU is that naive. I suspect the credit crisis has at least another bad episode or two coming. The Fed has had to coordinate closely with the ECB on recent interventions. The EU may be trying to take intellectual leadership to force the US and the UK, which is also showing signs of financial distress, into taking more radical action. The EU may be taking a tough public posture while privately harboring more limited, realistic aims.

Ironically, the most sensible proposal comes from a US hedge fund manager. As reported by Ira Ross Sorkin in the New York Times:

Kenneth C. Griffin, who runs one of the biggest and most successful hedge fund firms, has a blunt assessment: “We, as an industry, dropped the ball.”

The breakdown happened, Mr. Griffin contends, when big investment banks gambled away money and jobs during the late great credit boom. The bosses let all those young gung-ho traders take far too many risks and now everyone is paying the price.

But the answer is simple, in his view. The entire industry needs to overhaul its thinking and, believe it or not, perhaps even accept greater regulation...

When you read that UBS did not even view parts of its mortgage portfolio as having market risk, it becomes very obvious that a number of firms were not dotting the i’s and crossing the t’s when it comes to risk management,” he said while on the panel [at the Milken Institute Global Conference] to a packed room.

How did it come to this?

A problem, he says, is youth and inexperience — and that’s coming from a former child prodigy.

“Walk across any of the trading floors — they are full of 29-year-old kids,” he said. “The capital markets of America are controlled by a bunch of right-out-of-business-school young guys who haven’t really seen that much. You have a real lack of wisdom.”

On top of that, many chief executives of big universal banks, the ones that combine all sorts of financial services under one roof, “only understand a small part of the business,” Mr. Griffin said, suggesting too many of them come from sales backgrounds. Put those two things together, the traders and the chiefs, and you have the making of an outright debacle.

The problem is compounded further by weak government oversight, he said. “The unwillingness of the Federal Reserve and the S.E.C. to require working capital” limits, he said, only exacerbates the risk-taking environment because the banks are playing the equivalent of no-limit poker. “The sad truth of the matter is it didn’t have to be this way,” he said.

But Mr. Griffin isn’t just a serial complainer. He has thought about solutions.

First, “the investment banks should either choose to be regulated as banks or should arrange to conduct their affairs to not require the stop-gap support of the Federal Reserve,” he says.

But that’s not all. He also wants new government oversight of the arcane world of credit default swaps, a business with a notional value and risk of $50 trillion. “Everyone is missing the elephant in the room,” he said.

It was the interlocking relationships between thousands of investors and banks over credit default swaps that pushed the Fed to help rescue Bear Stearns. In particular, Mr. Griffin wants the government to require the use of exchanges and clearing houses for credit default swaps and derivatives.

That way, instead of investment banks playing matchmaker between parties, an exchange will do it with strict rules in place, eliminating billions of dollars in exposure and creating more transparency.

“It’s not sexy, but it’s simple, it’s cost forward, its straightforward, and it’s what we should have done after 1998,” referring to the collapse of Long-Term Capital Management, a big hedge fund. He added that it “is a very sad commentary on where we are from a regulatory perspective” that such a move hasn’t happened already.

Of course, most big investment banks would hate such a plan, he acknowledged by telephone last week. “The investment banks and commercial banks benefit from the lack of transparency because they are the intermediary,” he said. (It also has the effect of making Mr. Griffin’s firm more money by cutting out the middleman.)

But he also wants to warn against going too far. “It may be a moment in time where there is quite a bit of fervor to put in place significant regulatory regimes that in my opinion could set this nation way back on the playing field,” he said.

He’s particularly nervous that excessive regulation could send more jobs overseas. “I see thousands and thousands of jobs at Canary Wharf and in downtown London, jobs that should have been in America in financial services. Derivatives really were developed in America and because of regulatory uncertainty left America.”

Note that, as readers have pointed out, moving CDS to exchanges isn't quite that simple. New contracts with different and more standardized features could be exchange traded; the current types don't lend themselves well to that. So the worrisome and potentially wobbly overhang of outstanding CDS would have to run itself off over time. Still, any progress on that front is welcome.

And to Griffin's point about regulatory arbitrage; that's where the EU's foray might prove useful. The idea of an international regulation, or failing that, greater international harmonization, is getting traction. But it will take a push, which may come in the form of another leg down in the credit crisis, for that to happen.

Links 5/13/08

Scientists probe recent coyote attacks in California PhysOrg

The First Genetically Modified Human Embryo: Advance or Abomination? Wired

Why Did the EPA Fire a Respected Toxicologist? Mark Thoma

Car and Driver: Plummeting auto sales teach a lesson in the value of putting a price on carbon Washington Post

Bernanke Lunched With Dimon, Rubin Before Bear Rescue Bloomberg

MBIA Reports Scary Earnings; NEGATIVE Revenues Ben Bittrolff

Why legal barriers are not critical to deterring immigrants Drew Keeling, VoxEU

Net Exports, Oil Imports, and Implications for GDP Menzie Chinn, Econbrowser

Spacial Price Index Spencer, Angry Bear

London Suffers Most Widespread House-Price Declines Since 1994 Bloomberg

Antidote du jour:

"Investor says HSBC undervalued loss by $30bn"

The Times of London reports that activist investor Knight Vinke accused HSBC of failing to mark down its subprime assets (due to its ill-fated 2003 acquisition of Household Financial) adequately, leading to its greatly understating its first quarter losses. Vinke isn't alone in being skeptical of HSBC's latest earnings release.

Amazingly, HSBC's denial was weak, arguing that the losses were in consumer loans and therefore weren't required to be marked to market. In other words, if HSBC kept its books on the same basis as a US bank, its losses would indeed be much higher. However, HSBC is also claiming to have only moderate delinquencies on its mortgage book.

From the Times:

Knight Vinke, the activist investor, launched a fresh attack on HSBC yesterday, accusing Europe's biggest bank of flattering its US sub-prime losses by failing to write down $30 billion (£15 billion) worth of mortgage assets.

The broadside came as HSBC revealed a $3.2 billion first-quarter writedown on loans by its US business to poor Americans.

HSBC's investment bank also took a $2.6 billion writedown on credit investments for the first three months, pushing the group's total losses on sub-prime to $25 billion.....

Knight Vinke said that HSBC should have been gloomier about its own prospects. The fund manager, which has been agitating for HSBC to sell HFC, said that the group was the only large bank not to make a fair value adjustment on its loans to customers and other banks.

If HSBC accounted for the loans at their market value, they would be worth almost $30 billion less than $1,218 billion book value that the bank ascribes them, Knight Vinke said. Of that loss, about $23 billion comes from HFC. Taking the writedown would have pushed HSBC into a $5 billion loss last year instead of a $24 billion pre-tax profit, the fund manager said.

Other problems at HFC include the need to refinance at least $80 billion of its own loans in the next 30 months and a potential $10 billion goodwill impairment, which Knight Vinke said would force HSBC to pump in extra capital. HSBC has spent $60 billion on buying and supporting the US bank.

Douglas Flint, HSBC's finance director, said that Knight Vinke's claims were based on a misunderstanding of accounting rules. He said:

“Customer loans are accounted for differently to trading assets. We wouldn't be permitted by current rules to account for our loan book in the way Knight Vinke suggests we should.”

The bank said yesterday that 5 per cent of its US mortgages were two or more months overdue at March 31, compared with 4.2 per cent at the end of last year. Bad credit card debts rose from 5.8 per cent to 5.9 per cent.

Frankel, Dimon Say Recession Has Arrived

A very good (as usual) post by Jeff Frankel takes issue with Council of Economic Advisers chair Ed Lazear's assertion that the economy is not in recession:

It is true that the Commerce Department BEA’s advanced estimate of first-quarter GDP growth was still above zero (+0.6%). But there are three reasons not to take this too seriously.

(1) Revisions in these numbers are usually substantial, so the final number could easily turn out to be negative — or twice as high.

(2) Even if the +0.6% number were to hold up, it can be entirely accounted for by measured inventory investment. In other words, real final demand fell rather than rose in the first quarter. It is plain that this inventory accumulation was not the outcome of deliberate decisions by bullish firms to add to their inventories in anticipation of a booming economy. Rather it was almost certainly unintended inventory accumulation, as goods sat unsold on store shelves and in warehouses. This overhang makes it more likely that inventory accumulation will be negative in the 2nd quarter. (Admittedly, rising exports from the weak dollar and rising consumption from the tax rebate checks could outweigh that particular factor, and we could scrape along the ground for another quarter at near-zero growth).

(3) As Martin Feldstein has been pointing out, it is a misinterpretation of the GDP statistics to say that growth remained positive within the first quarter. Rather GDP for QI as a whole was estimated to have been 0.6% higher as compared to QIV as a whole. The Commerce Department does not report monthly GDP estimates, but MacroAdvisers does, and these data suggest that monthly GDP has been declining since January.

There are other reasons as well to consider it likely that a recession started in the first quarter. The NBER Business Cycle Dating Committee, which declares when recessions start, looks at lots of data. But the most important information, alongside GDP, is the jobs data from the Bureau of Labor Statistics. Employment, like GDP, offers a comprehensive measure across the economy, but it has the advantage of being available monthly and with shorter lags. The employment data suggest that the recession may have started in January.

And Jamie Dimon has joined the fold (hat tip reader RK via Calculated Risk), Note the CR post picked up on an earlier Reuters headline, which was that the recession was "just starting"; the current version omits that quote and instead emphasizes that the recession could be severd:

JPMorgan Chase & Co Chairman and Chief Executive Jamie Dimon on Monday told bank investors that while the current credit market crunch may soon be over, the U.S. economy could still face a deep and extended recession.

The slump in mortgage and corporate loan markets could bottom out this year...Yet the economy may face a longer-term challenge even as financial markets begin to function again, the "slower burn" of a recession that may rival the severity of the 1982 contraction, he said.

Carlyle's Rubenstein: Banks Still Have "Enormous" Unrecognized Losses

David Rubenstein of Carlyle Group doesn't have anything to gain by saying bad things about banks, and he is well connected, so odds are good he is on to something (hat tip reader Abdul).

He also repeated a theme that we've heard earlier: don't count on sovereign fund rescues. While they were active buyers in the first round of bank fundraising, they've been burned, and will hold back until they have clearer indications that the worst is past.

The article notes he was far more bullish on April 28. Wonder what he learned in the meantime?

From Bloomberg:

U.S. and European banks and financial institutions have ``enormous losses'' from bad loans they haven't yet recognized and may have a harder time wooing sovereign-fund rescuers, Carlyle Group Chairman David Rubenstein said.

``Based on information I see,'' it will take at least a year before all losses are realized, and some financial institutions may fail, Rubenstein said at a breakfast meeting of the Institute for Education Public Policy Roundtable in Washington. He didn't name any companies.

``The sovereign wealth funds are not likely to jump into the fray again to bail out these institutions,'' Rubenstein said. ``Many financial institutions aren't going to be able to survive as independent institutions.''...

On April 28 at a conference in Baltimore, Rubenstein said financial institutions and financial assets are ``the single greatest investment opportunities'' in the U.S. and ``a lot of private-equity firms like ours are going to try to make investments in these firms.''....

Rubenstein said today that the industry and broader economy aren't likely to turn around until early next year.

``The truth is, we're in some kind of economic slowdown,'' Rubenstein said. ``I don't think it's going to be over for quite a while.''