Storm Clouds Gather

Bank stock investors have seen their investments soar during the past six weeks. The percentage gains in bank stocks have dwarfed all general market indices.

Citicorp ( C ) stock rose from the ashes of $0.97 per share on March 5th to an inter-day high of $4.48 on April 14, 2009. During relatively the same period, Bank of America
( BAC ) rose from its all-time low of $2.53 to $11.58; J P Morgan ( JPM ) rose from $14.96 to $33.70; Wells Fargo ( WFC ) rose from $7.80 to $19.67, and US Bancorp (USB) rose from $8.06 to $18.01.

Bank stocks initially perked-up when bank officials made favorable comments about their earnings for the first two months of 2009. They really took off, however, when WFC reported robust earnings for the first quarter, which were well above street estimates.

The observed volatility in the bank stock sector reflected the extremes of despair and optimism regarding a financially fragile economy. Nowhere has the battle between market bulls and bears been more evident.

For the past six weeks the voices of Paul Krugman, Nourel Roubini, Dylan Rattigan, Meredith Whitney and others have been muffled as their calls for nationalization were widely dismissed. Of course it didn’t hurt that Rattigan lost his perch, Whitney switched jobs, and Roubini was abroad for much of this time.

These pundits are about to be replaced by the angry voices of people being led to believe that the time for Washington to be reigned in is now. A coalition of commentators who favor small government and balanced budgets has chosen April 15, 2009 as the day to launch taxpayer protests against Federal bailouts. In general, the people leading this movement believe that the United States would be far better off if we allowed banks and businesses to fail.

It is highly likely that this populist movement will gather momentum as the unemployment rate rises and tent cities become more prevalent. Federal Reserve Chairman Bernanke has said that the economy will recover as long as we have the political will. At present, the likelihood of getting another spending bill through Congress is remote. As the anti-bailout movement gathers momentum, the possibility of additional spending packages will disappear entirely as the nation’s political will disappears.

If the current stock rally proves to be short-lived and the anti-bailout forces gather momentum, then the nation will be in for a long, hot summer of discontent and civil unrest. In such an environment, people working for specific organizations could become targets of discontent just as AIG executives have.

Bank Nationalization Fever Wanes

Remarks by Federal Reserve Board Chairman Ben Bernanke allayed fears of the federal government nationalizing major banks. Appearing before the House Financial Services Committee he said the major banks were not in jeopardy of failing and nationalization was not necessary.

Bernanke stated that nationalization is when the government seizes the bank, zeros out the shareholders, and manages the bank; and, they don't have anything like that planned. His remarks caused a significant rally in beaten down bank stocks.

The positive comments by the Fed Chairman came the day after President Obama’s optimistic State of the Union address. Their remarks were the first meaningful statements to effectively offset the cries for nationalization that had been increasingly dominating the print and cable media.

The loud voices favoring bank nationalization have suffered their first major setback. Those opposed to nationalization hope this is the first of many defeats that the talking heads will receive going forward. Baseless rhetoric by inexperienced pundits has simply become too much for the nation to bear.

Bank Nationalization Opponents Need To Thank Greenspan

Alan Greenspan, the former Chairman of the Federal Reserve, who many view as the primary culprit for today’s economic problems, has come out of hiding to express his views on the subject of bank nationalization. Greenspan told The Financial Times “It may be necessary to temporarily nationalize some banks in order to facilitate a swift and orderly restructuring.”

Opponents of bank nationalization should thank Greenspan. After all, who in their right mind would rely on the views of a person weighed down with an admittedly broken economic model. He greased the skids for this slide into the abyss; he does not hold the solution.

Bank Nationalization is Wrong

The clamor for nationalizing big banks grows each day. Those favoring nationalization recommend removing all bad assets from bank balance sheets thereby wiping out, as needed, the equity of common shareholders followed by the interests of preferred stockholders and then the bond owners.

The bad assets would then become assets of the FDIC or a special entity established by the federal government. The new owners could then keep them or sell them to private investors, who are reportedly waiting anxiously to acquire these bad assets.

Proponents of this approach strongly suggest that nationalization is necessary for the nation to end its economic death spiral and begin a recovery. Bank nationalization also has widespread popular appeal, because it supposedly punishes the culprits for destroying the economy and it provides just punishment for making stupid decisions.

Nationalization is neither a necessary nor a sufficient condition to solving today’s problems. The treatment of Continental Illinois in the 1980s and the purported success of the RTC are not appropriate templates to follow. Such actions today could easily aggravate economic conditions by causing further consumer despair and calling into question the value of the U S currency and our U S government debt.

The truth is that de-leveraging by financial institutions, corporations, and individuals takes time. The bad assets on the books of the banks will disappear as they either heal, are liquidated, or are charged off through earnings. The debt of corporations will be reduced as corporations either take bankruptcy or use their cash flow to reduce debt. Individuals will similarly de-lever by either erasing debt through bankruptcy or curtailing consumption. During this period the level of economic activity will be negatively impacted unless the government expands its expenditures and levers its balance sheet. Nationalization of banks will not prevent this process from occurring.

The fact that “vulture investors” are among the most vocal supporters of nationalization testifies to the fortunes they made when the government engaged in widespread closures of financial institutions in the 1980s and 1990s. They can’t wait to once again be the beneficiaries of a large transfer of wealth courtesy of the federal government.

While fans of the RTC cover it in accolades, the beneficiaries of its largess chuckle. Here is what one person had to say about the RTC, “When working on a mortgage-backed trading desk back in the '80s, the RTC went to the street to solicit bids for the assets that they had taken over from the insolvent thrifts. We made a killing. It was an unadulterated field day. We bought the stuff at a discount to the projected cash flows and resold it within hours for huge profits. In anticipation of once again earning huge profits, the likely beneficiaries are doing their best to drive banks off the cliff so they can once again buy distressed assets at fire sale prices. It is the way of the street.”

Bank nationalization proponents claim that the only proper way to value banks is on the basis of liquidating value or tangible common equity. Such an approach is understandable, because that is in their best interests. Valuing banks on a going concern basis has no place in their playbook. Calling these investors “vulture investors” gives vultures a bad name!

Unwittingly, regular citizens, including the unemployed, have joined forces with these people to form an unofficial bank nationalization coalition. The fact that these disparate groups increasingly favor nationalization is disturbing and requires examination.

There are two issues that merit careful consideration before being swept up in this drive for nationalization. First, who determines what “bad assets” need to be excised from a bank being nationalized? Second. who determines the price of a bad asset at the time of its removal?

In the case where a loan is determined to be a bad asset and is transferred to another entity that borrower loses their right to renegotiate that debt with the original lender. This puts the borrower in a less favorable position than they would otherwise be, since the new holder of the loan would either be unable or less likely to lend more money, extend the term, and/or lower the interest rate. Borrowers and the local economy are better served by loans staying where they are originated.

Recent events with securitization prove beyond a reasonable doubt that original lenders have a greater likelihood of getting repaid. Accordingly, the intrinsic value of a bad loan on the balance sheet of a bank that made it is greater than the intrinsic value of that loan when it is housed and administered elsewhere. Furthermore, an original lender is far more likely to advance additional funds to borrowers, thus extending the economic life of a borrower.

Similarly, it can be argued that the intrinsic values of securitized assets held by a bank are greater than the comparable values if they are held by most private investors. This is so because banks benefit from having a much lower cost of funds, especially today. Banks also have more secure and virtually unlimited funds available thanks to expanded FDIC coverage, which removes the fear of bank runs, and an aggressively accommodative Federal Reserve. The intrinsic values of assets on the balance sheet of a bank today are understandably greater than what non-bank investors’ claim.

We cannot afford to experiment with nationalizing our banks. It is not necessary, especially in view of the fact they do not face deposit runs; their cost of funding is plummeting; they have very favorable interest spreads; and, their earning assets exceed their paying liabilities.

The truth is that almost all of the banks and savings and loans that were closed during the past 30 years would have survived if they had today’s deposit guarantees, deposit rates, and were given some time. The exceptions are those institutions that were caught by persistent negative interest rate spreads when interest rates soared and those banks closed because of fraud and malfeasance.

The federal government needs to ignore the cry for bank nationalization. This is not like the 1980s or 1990s.

Citigroup’s Stock Action For Week Ending February 6th

Volatility in the price of bank stocks returned last week with renewed vigor as bears and bulls clashed over the Obama administration’s failure to release its bank rescue plan. Rumors regarding imminent nationalization focused especially on Citigroup ( C ) and Bank of America ( BAC ) and caused those stocks to plummet on Thursday morning. Citigroup traded as low as $3.20, which was still above its $2.80 low of January 20th. BAC, however, was really taken to the woodshed and collapsed to $3.77, which was a 25 year low.

Members of the Obama administration must have been watching the deterioration, because news began to leak regarding the forthcoming bank plan. The leaks were all attributed to unidentified sources close to the discussions and revealed that this administration was not hell-bent on destroying the last remnants of common equity in the large banks.

As that news spread, the shorts ran for cover, the longs said “gotcha,” and the market in bank stocks improved dramatically along with the rest of the market. At the close on Friday, Citigroup was trading at $3.91. In after hours trading it traded as high as $4.07. The market seemed to gather momentum at the close so there is hope that Citigroup will be able to challenge its January 28th high of $4.33 as early as Monday, February 9th.

Pandit Wiffs The Ball

In the meantime someone needs to school CEO Vikram Pandit on how to properly answer tough questions. He missed a wonderful opportunity on January 27th to dispel rumors of Citigroup’s nationalization during and after his formal address at Citi's 2009 Financial Services Conference.

He did not address the subject of nationalization in his speech. Then, in the Q & A session following his presentation, he was pointedly asked what was the possibility of Citigroup being nationalized.

You could hear the audience gasp as the question was asked. I thought the question was planted by Pandit himself and I was prepared for him to say something such as there isn’t a snowball chance in hell, or, something nicer like, that is simply not in the cards. Instead he went into a verbose discussion about the nature of democracy. I was stunned.

Senator Schumer Favors Guarantees

Bloomberg and the Financial Times report that Senator Charles Schumer in a CNBC interview today said he favored the guarantee of troubled bank assets rather than the establishment of a so-called “bad bank.” His views carry weight because he is a leading Senate Democrat and member of the influential Senate Finance Committee.

If Schumer's view prevails the guarantee of $301 billion of Citigroup (Citi) assets in November 2008 might very well serve as a template for any such guarantees. In that deal the U.S. Government agreed to "ring-fence" $306 billion (later modified to $301 billion) of loans, investments, and commitments. These assets remain on the books of Citi; however, it is responsible for only the first $39.5 billion loss plus 10% of any losses greater than that. Citi's total exposure on these toxic assets is therefore $65.65 billion.

In return for this guarantee, Citi issued $4.034 billion in 8% Cumulative Perpetual Preferred Stock to the U.S. Treasury and $3.025 billion in the same 8% preferred to the FDIC as a "fee". Citigroup also issued to the U.S. Treasury a warrant for an additional 66,531,728 shares of common stock at the $10.61 strike price, which was the average of the closing prices of Citigroup common stock for the preceding 20 trading days.

Interestingly, the arrangement is really like Citigroup buying an insurance policy with an initial non-cash premium of $7.059 billion, which is the sum of the awarded preferred stock, and a quarterly cash premium of $141.2 million. As the insurer the U.S. Treasury is also given an equity kicker via the warrant.

Citigroup (C) is a Buy

For the past few months I have been listening to pundits who confidently assert that Citigroup (C) is on its last breath and near either outright failure or nationalization. These fearless forecasts have generally lacked meaningful supporting data; therefore, I thought it was time for independent research that would shed light on the condition of Citigroup.

My research included a review of the income statements and balance sheets of Citi for the last 8 quarters including the recently released December 31, 2008 quarter. I also reviewed the notes to those financial statements and charts showing Citigroup's recent price history.

In conjunction with that review I also reviewed the the terms of the U.S. Treasury's October injection of $25 billion in TARP funds (TARP 1) and the more recent November injection of $20 billion in TARP funds (TARP 2). Citi issued 5% Cumulative Perpetual Preferred Stock for TARP 1 and 8% Cumulative Perpetual Preferred Stock for TARP 2. By the way, despite what Barney Frank says, Citi cannot redeem those issues for at least 3 years.

Warrants awarded to the U.S. Treasury for TARP 1 allow it to purchase 210,084,034 common shares at a per share price of $17.85. Warrants for an additional 188,501,414 common shares at a strike price of $10.61 were awarded to the U.S. Treasury for TARP 2 funds.

At the time of the TARP 2 transaction, the U.S. Government agreed to "ring-fence" $306 billion (later modified to $301 billion) of Citi loans, investments, and commitments. These assets remain on the books of Citi; however, Citi is responsible for only the first $39.5 billion loss plus 10% of any losses greater than that. Citi's total exposure on these toxic assets is therefore $65.65 billion. In return for this arrangement, Citi issued an additional $4.034 billion in 8% Preferred to the U.S. Treasury and $3.025 billion in 8% preferred to the FDIC as a "fee". Citi also issued to the U.S. Treasury a warrant for an additional 66,531,728 shares of common stock at the $10.61 strike price.

As a result of these two TARP transactions the U.S. Treasury has the right through it warrant ownership to purchase 465,117,176 shares of common stock at prices well above the current level. Exercise of those warrants would increase the equity of Citi by about $6.5 billion and the U.S. Treasury would then own less than 8% of Citi.

As of December 31, 2008 Citi had 5.45 billion shares of common stock outstanding and its equity book value was $80.1 billion. Accordingly, its book value was $14.70. This measure of equity excludes the $49.034 billion in preferred stock owned by the U.S. Treasury and the $3.025 billion in preferred stock owned by the FDIC. It also ignores the fact that Citi had $29.616 billion in its reserve for loan losses at the end of 2008 and that represented 4.26% of its outstanding loans.

The threat of a deposit run has also been taken off the table by the Federal Reserve's open discount window policy. Citi's greatest strength is that it has been under the microscope longer than any of its competitors. It has, therefore, been forced to shore up its problems earlier than other banks, which acquired severely troubled institutions like WAMU, Wachovia, Merrill Lynch, Bear Stearns, and Countrywide. Citi will likely turn the corner before these other banks.

The appointment of Richard Parsons as Chairman of the Citi Board is important given the fact that he was a member of President Obama's economic advisory team and standing alongside Paul Volcker onstage when that team of advisors was introduced.

Given all of the above, talk of nationalizing Citi is absurd. The U.S. Government has already played its cards and decided to protect all depositors. It has already bailed out Citigroup. To paraphrase Mark Twain, fear of Citigroup's imminent demise are greatly exaggerated.

Based on the above analysis, I initiated the purchase of Citigroup (C) common stock on January 26, 2008.