Sandy Weill’s “Mea Maxima Culpa”

Sandy Weill, the man who almost single-handedly did more to obliterate Glass-Steagall now admits that he made a most grievous mistake. Those watching him on CNBC on the morning of July 25, 2012 were treated to a rare peak inside a confessional booth as the architect of today’s Citigroup admitted his folly. He now realizes that what he did was wrong and needs to be reversed.

Weill now believes that banks need to return to pure banking, whereby they accept deposits and make loans. Brokerage firms need to return to executing trades on behalf of customers, positioning securities to facilitate those trades, and taking risk positions within the boundary of reasonable leverage ratios.

It is time to begin the process of dismantling these financial behemoths. Citibank, Bank of America, JP Morgan, Wells Fargo, and others can dispose of their nonbank enterprises by simply issuing shares in those nonbank entities to existing shareholders. At the same these financial shopping centers need to reduce or eliminate the use of derivatives that have cast a giant cloud over their financial statements. While the institutions adhere to the belief that their long and short derivative exposures should be can be netted out, the stock market strongly suggests that market participants favor focusing on gross exposures since the counterparties are of questionable financial strength.

Forgive me father for I have sins - as a commercial banker, I discovered a loophole in the law that allowed me to be the first person to establish a brokerage firm as an operating subsidiary of a bank holding company in 1979. My application, regrettably, provided a pathway for others to follow. The loophole allowed limited brokerage services; however, in the 1990s those powers expanded geometrically thanks to favorable legislation and rulings.

People who were not trained as commercial bankers became CEOs of the nation’s largest banks, and they proceeded to transform those entities into unmanageable financial organizations or financial supermarkets. Sandy Weill was the poster child for that era and when he retired he left a crippled organization as his legacy. If the banking industry had a Hall of Shame, he would be a leading candidate to be the first person installed. Too bad it took him so long to get religion and see the truth!

Citigroups Stress Test Blunder

Citigroups ability to transform the latest Fed stress test into a disaster is further evidence of the incompetence of its management. It adds weight to the following tale.

An extremely wealthy man had triplet sons – Jim, John and Joseph, who were born in that order. When they were born he promised his wife that the boys could have anything they wanted when they turned 21.

On their 21st birthday he and his wife invited the boys into the living room to honor his promise. Jim was first born and entitled to make the first choice. When asked what he wanted Jim said he had always liked professional football and wanted to own his favorite team, the New England Patriots. His father immediately called Robert Kraft and made an outrageous offer that Kraft accepted.

The second son, John, was then asked what he wanted. He said that he had always liked professional baseball and wanted to own his favorite team, which was the New York Yankees. His father immediately called Hal Steinbrenner and made an offer that was accepted.

The third son, Joseph, was then asked what he wanted. Joseph said that he had always liked the circus, particularly the clowns, and dreamed of one day owning his own circus. After thinking for a minute, the father called Richard Parsons and offered to buy Citigroup!

Citigroup Exposure To Federal Housing Finance Agency Lawsuit Is Modest

Citigroup once again was on the receiving end of bad press when it was named as one of the 17 organizations sued by the U.S. government over losses in subprime mortgage bonds. The negative publicity was out of proportion to Citigroup’s exposure, which was $3.5 billion. Of the 17 organizations named in the lawsuits only four others were sued for less.

The lawsuits were filed by the Federal Housing Finance Agency (FHFA), which is the government entity that oversees Fannie Mae and Freddie Mac. The lawsuits allege the named organizations sold bonds backed by mortgages that should have never been packaged into securities. The lawsuits cover a total of $196.165 billion in securities.

In contrast to Citigroup, Bank of America was sued for a total of $57.453 billion (BAC $6 billion, Countrywide $26.6 billion, Merrill Lynch $24.853 billion) and JPMorgan Chase was sued for $33 billion.

The following is a listing of the 17 named in the lawsuits and the dollar amount (in billions) of securities in question.
• Ally Financial $6
• Bank of America $6
• Countrywide (unit of BofA) $26.6
• Merrill Lynch (unit of BofA) $24.853
• Barclays Plc $4.9
• Citigroup $3.5
• Credit Suisse $14.1
• Deutsche Bank AG $14.2
• First Horizon National Corp. $0.883
• General Electric Co. $0.549
• Goldman Sachs Group $11.1
• HSBC $6.2
• JPMorgan Chase & Co. $33
• Morgan Stanley $10.58
• Nomura Holdings Inc. $2
• Royal Bank of Scotland $30.4
• Societe Generale $1.3
• Total: $196.165

Disclosure: I am long Citigroup

Citigroup’s Technical Pattern Indicates Upside Potential

A review of Citigroup’s (C) closing stock prices for the past 24 months reveals an interesting pattern. In a two month period from 12/17/2009 through 2/12/2010 Citigroup tested a floor price of $31.49 five times. Closing prices were $31.99 on 12/17/2009, $31.49 on 1/26/2010, $31.79 on 2/4/2010, $31.49 on 2/8/2010, and $31.79 on 2/12/2010. Within three months of its fifth test of its low closing price, Citigroup rose to $49.49 on 4/20/2010.

The stock then nosedived and within a month it had fallen to a low of $36.29 on 5/20/2010. That closing low would then be tested four times which were on 6/7/2010 at $36.39, on 6/29/2010 at $37.29, on 8/26/2010 at $36.59, and on 6/8/2011 at $36.81. Like during the earlier period, Citigroup has withstood five tests of its most recent low.

If Citigroup responds to this fifth test of its low as it did the last time then investors can expect C to challenge the $50 price level within the next several months. On four occasions during the past two years Citigroup has approached or exceeded that price. On 8/28/2009 it closed at $52.29, on 10/14/2009 it reached $49.99, on 4/20/2010 it hit $49.69, and on 1/14/2011 it closed at $51.29.

This data strongly suggests that Citigroup’s current stock price offers much more upside potential than downside risk.

Disclosure: I am long Citigroup common stock

Citigroup (C) Declines After Earnings

Before the stock market opened on July 15 Citigroup (C) reported a 21% earnings per share increase in second quarter above the comparable 2010 quarter . Its stock surged $1.37 or 3.5% at the opening to $40.39 . This rise in price was accompanied by heavy volume and seemed to offer a glimmer of hope to long suffering shareholders. By noon, however, Citigroup (C) had lost all its gains. During the afternoon (C) fell as low as $38.12 before ultimately finishing the day off $0.64 or 1.64% at $38.38.

The dispiriting price action for Citigroup was accompanied by price declines in JP Morgan Chase (JPM), Bank of America (BAC) and Wells Fargo (WFC). The percentage decline at (C) was greater than at these other large banks.

It seems clear that in the current environment market participants will always be able to find something disturbing with bank financials that will outweigh any improvements cited by management. In the case of Citi the decline in net interest margin (NIM) to 2.82% in the second quarter of 2011 from 2.88% the previous quarter was particulary unwelcome news. During the second quarter of 2010 Citi had reported a NIM of 3.15%; therefore, NIM declined by 33 basis points or 10.5% in one year. Wall Street hates declines in margins and has a long history of punishing companies and/or industries that experience such declines.

An examination of the decline in net interest margin at Citi reveals it was largely attributable to a very pronounced decline in the yield on its investment portfolio. The yield on that portfolio was 2.79% during the quarter just ended, while it was 3.17% during the first quarter of 2011 and 3.89% during the second quarter of 2010. This is a remarkable and worrisome decline in yield on an investment portfolio that averaged $318 billion during the second quarter of 2011, $320 billion in the prior quarter and $311 billion during the second quarter of 2010.

Adding further selling pressure to (C) was the fact that Citigroup increased its staff by 2% or 3,000 people during the second quarter. The fact that it increased staff while margins were under pressure is a source of concern even though its total staff is the same as it was the year before. Investors generally expect payroll reductions, not additions, when margins are under pressure.

On a positive note it should be mentioned that loans outstanding rose slightly in the second quarter versus the prior quarter and the average loan yield rose 13 basis points to 7.93%. Loans outstanding still remain well below the level of the prior year.

The positive impact that would result from redeploying funds from investments yielding 2.79% and deposits with other banks yielding 1.06% into quality loans yielding 7.93% is obvious. Citi needs to accelerate its lending if it expects to meaningfully increase its income by reversing the decline in its net interest margin, and it must do so without compromising credit quality. If its lending staff cannot generate quality loans then Citi will have to start acquiring fixed and floating rate corporate obligations with the ample funds it currently has available.

Disclosure: I am long C

CitiFinancial Sale Weighs on Citigroup

For several months, Citigroup has been seeking a buyer for CitiFinancial, which is the largest consumer finance company in the US. CitiFinancial is reported to have a book value of about $2 billion and some $13 billion in assets. The delay in getting this transaction done is weighing on Citigroup’s stock.

This unit of Citigroup is one of the many trophies Sandy Weill acquired as CEO when he paid $31 billion in Citi stock for Associates First Capital, CitiFinancial’s predecessor. In 2010 Citigroup closed more than 300 CitiFinancial branches, stopped making loans at another 184 and rebranded the remaining 1,500 outlets OneMain Financial.

Four groups had been rumored to be among the interested bidders. One group was comprised of private equity firms Warburg Pincus LLC WP.UL and KKR & Co LP. It was supposedly aligned with Spain's Banco Santander and BlackRock Inc.

A second group of rumored bidders included Brysam Global Partners, Blackstone Group LP, Carlyle Group CYL.UL, Thomas H. Lee Partners THL.UL and Wilbur Ross' WL Ross & Co. Brysam is run by former Citigroup executives, including former COO Robert Willumstad and former Global Consumer Group CEO Marjorie Magner, who know CitiFinancial well.

Other rumored bidding groups had included Apollo Management APOLO.UL and J.C. Flowers; and Clayton Dubilier & Rice and Onex Corp.

Disposition of this troubled consumer-lending unit has dragged on to the point where it appears to be getting shop worn. Terms keep changing as Citigroup attempts to avoid a significant loss on any sale, while at the same time it unloads troubled loans.

On May 4 the New York Post, citing people close to the transaction, reported that the Brysam Group and the Apollo Group have both dropped out of the bidding.

The Revenue Growth Fixation

Financial analysts have been focusing their attention on revenue growth because of a general belief that companies need such growth to fuel earnings at this stage of the business cycle. While this focus certainly has merit for most businesses, it is far less applicable to financial firms.

Revenue at the major commercial banks is a mixture of interest income and noninterest income and is not identical to sales figures reported by nonfinancial firms. The former is determined by the level of interest rates and the volume of earning assets. Increases in rates and volume of earning assets will be accompanied by revenue growth.

Analysts were quick to point out that gross revenue at Citigroup was down 22% in the first quarter of 2011 versus the first quarter of 2010. Few, however, mentioned that the decline in assets at Citi Holdings was a prime contributing factor.

Citi Holdings is effectively the “bad bank” Citigroup created to house its worst assets during its near death experience. The assets in Citi Holdings fell by $166 billion or 33% from the end of the first quarter of 2010 to the end on the first quarter in 2011. Concurrently, revenue declined 50% to $3.3 billion and that accounted for 57.9% of the decline in Citigroup’s total revenues.

As of March 31, 2011 Citi Holdings had total assets of $337 billion, which is down from a peak of $827 billion reached during the first quarter of 2008. Citigroup management has clearly stated it considers the businesses and assets contained in Citi Holdings to be nonessential to its core business going forward. The remaining assets are to be liquidated through business divestitures, portfolio run-offs and asset sales.

A continued reduction in Citi Holdings assets will weigh on Citigroup’s gross revenues; however, it should continue to lower Citigroup’s risk profile. Citi Holdings reported losses of $36.5 billion in fiscal 2008, $8.8 billion in 2009, $4.0 billion in 2010 and $0.6 billion during the first quarter of 2011.

Disclosure: I am long Citigroup (C)

Tough Comparison For Citigroup (C)

Citigroup (C) is scheduled to release its first quarter earnings on April 18. It is important to note that the first quarter of 2010 was, by far, the most profitable quarter last year for Citi. In that quarter it earned $4.428 billion.

The first quarter of 2010 was followed by progressively worse quarters as it earned $2.697 billion in the second quarter, $2.168 billion in the third quarter and $1.309 billion in the fourth quarter. This trend of declining quarterly earnings is unacceptable, weighs of the stock price and must end in 2011. Bank earnings should be relatively consistent throughout a year.

Recent appearances and comments by Chairman Richard Parsons and CEO Vikram Pandit suggest that Citi has turned the corner. The forthcoming April 18 report will either reinforce that view and be well accepted by shareholders, or Parsons and Pandit will be confronted by a hostile crowd at Citi’s annual stockholders’ meeting on April 21.

The fact is that it will be difficult for Citi to report earnings above last year’s first quarter and that is why Citi call options are so quiet. Things could change quickly if Citi reports an increase in reported earnings and they then forecast even better results for the rest of 2011. Today, few market participants seem willing to bet on such a favorable scenario unfolding in the next few weeks.

Disclosure: I am long Citigroup (C)

What is Citigroup (C) Worth?

Belief that credit quality at the largest lending institutions is improving continues to gather adherents. As bank balance sheets heal from their near mortal wounds it is time to look ahead and ask how much these banks can earn so investors can determine how much a share of stock is worth. In this regard it seems appropriate to focus on Citigroup (C) since it came so close to financial death, has a unique worldwide franchise, and did not acquire other troubled institutions during the financial meltdown.

Credit quality is clearly improving at Citigroup (C) as evidenced by the fact that non-accrual assets at the end of 2010 were 37% ($12.2 billion) lower than they had been at year-end 2009. This improvement helped Citigroup report net income of $10.6 billion for 2010 versus a loss of $1.6 billion in 2009.

Citigroup's board recently approved a base salary of $1.75 million for CEO Vikram Pandit. Pandit had vowed in 2009 to receive an annual salary of $1 until Citigroup returned to sustained profitability. This recent board action is therefore particulary interesting.

Given the implied belief that sustained profitability has returned at Citigroup, investors now need to ask how much Citigroup can be expected to earn going forward and how much of a dividend will it pay to shareholders. Future earnings and dividends will largely dictate price movements in C.

An appropriate way to determine future earnings is to focus on a bank’s return on total assets (ROA). This measure has always been a generally accepted, standard metric used to compare the relative profitability of banks. For example, high-earning banks typically earn more than 2% on their assets, while low-earning banks earn less than 1%.

The SEC filings of Citigroup during the relatively halcyon period from 1997 through 2006 revealed that its ROA ranged from a low of 0.79% in 1998 to a high of 1.66% in 2005. Its average ROA for that decade was 1.33%. Its dividend payout during this same time period ranged from a low of 13.98% of net income in 1997 to a high of 48.19% in 2004. Its average dividend payout from 1997 through 2006 was 27.95%.

At the end of 2010 Citigroup reported total assets of $1.915 trillion, more than 12% below its 2008 asset peak of $2.187 trillion, but up slightly from the end of 2009. It is likely that Citigroup is in the early stages of expanding its asset base; however, its rate of asset growth should not be expected to equal or exceed the 8.09% annual average achieved from 1997 through 2006 when its total assets grew from $680 billion to $1.484 trillion.

In a book I wrote for the American Bankers Association titled Asset/Liability Management I noted that high-earning banks had higher earning power ratios, which I defined as the ratio of interest earning assets divided by interest paying liabilities (EA/PL). Other things being equal, the bank with the highest earning power will be more profitable as measured by ROA.

A particularly healthy sign at Citigroup is the fact that its earning power is once again rising. From 1997 through 2010 Citigroup’s earning power (EA/PL) ranged from a high of 125.18% in 1999 to a low of 107.88% in 2008. Importantly, Citigroup’s earning power reached 113.59% in the fourth quarter of 2010, which is the highest reading since 2000. The recent increase in this important predictor of bank income reflects improving credit quality at Citigroup as loans return to accrual and the continued jettisoning of non-earning assets.

A conservative forecast using the above data suggests that Citigroup’s total assets can be expected to grow by 6% per year. Its ROA in 2010 was about 0.50%. Accordingly, it is reasonable to expect that Citigroup’s ROA should return to the 1% area in the near future and that it could comfortably payout 20% of net income in common stock dividends.

The application of these assumptions yields earnings per share for Citigroup of about $0.66 per share for 2011 and a dividend of about $0.12. By 2015 earnings per share should reach $0.85 and dividends $0.17.

At a current price of $4.82, Citigroup shares are valued at 7.3 times expected 2011 earnings and 5.7 times 2015 earnings. By comparison the S & P 500 and KBW bank indexes are both trading around 15 times earnings.

This brief analysis suggests that a significant increase in Citigroup’s stock price is possible as the turnaround at Citigroup gathers momentum and it returns to financial health. A doubling in the current price of C would put its price earnings multiple on par with other large corporations in its peer group and should not be ruled out.

Citigroup Undervalued

Valuation of common shares in bank holding companies has become a challenge as the amount of data released in SEC filings has increased. Analysts have responded by narrowing their focus to selected metrics such as the current share price divided by tangible common equity per share and net interest margin. An examination of these measures for six (6) of the largest bank holding companies shows significant variation and suggests that at the present time some are undervalued relative to others.

The bank holding company trading at the greatest premium above its tangible book value as of the close on January 21, 2011 was U.S Bancorp (USB) at 2.89 times. At the other extreme, Bank of America (BAC) and Citigroup (C) trade at the smallest premium to their tangible equity, 1.10 times. The second largest premium observed was for Wells Fargo (WFC), which trades at 2.34 times its tangible equity. It was followed by PNC at 1.65 times and JP Morgan (JPM) at 1.49 times.

Net interest margin (NIM) is the difference between interest income and interest expense expressed as a percentage of interest earning assets. It is normally presented on a taxable equivalent basis and is a measure of relative profitability of a banking franchise. An examination of the fourth quarter net interest margins reported last week in the SEC 8-K filings for the above six companies showed WFC had the highest at 4.16%, followed by PNC at 3.93%, USB at 3.83%, C at 2.97%, JPM at 2.87%, and BAC at 2.66%.

This brief analysis suggests that at the present time BAC and C are undervalued relative to JPM, while WFC and USB are overvalued relative to all the other bank holding companies examined.

Back From The Brink

The financial media is awash with speculation about major bank holding companies increasing dividends and/or buying back shares. While regulatory authorities have acknowledged that bank balance sheets are healing, those same regulators need to remember how difficult it was to raise bank capital within the past few years. Similarly, bank holding company board members need to carefully balance the care and feeding of shareholders with the need to re-establish sound dividend policies that will not have to be reversed.

An overly aggressive dividend policy runs a serious risk of financial embarrassment in the event that a dividend has to be cut in the future. A better option would be for a bank holding company to pay modest quarterly dividends and then augment them with a year-end extra dividend based on the full year results.

A review of the financials for Bank of America, JP Morgan, Citigroup, Wells Fargo, and U.S. Bancorp for the period from 2005 through the third quarter of 2010 suggests that none of them are strong enough to buy back shares. They all remain highly levered financial institutions that have benefited from a period of artificially low interest rates.

These five bank holding companies have significant amounts of goodwill on their balance sheets as a result of acquisitions and accounting treatments accorded by U.S. GAAP. Goodwill is represents the excess of the purchase price of an acquired entity over the fair value amounts assigned to assets acquired and liabilities assumed. Even though goodwill must be tested for impairment every year, its true value is very questionable and excluded from tangible common equity and Tier 1 capital calculations.

As of September 30, 2010 goodwill accounted for 35.60% of Bank of America’s common equity, 32.21% of U.S. Bancorp’s, 29.35% of JP Morgan’s, 21.35% of Wells Fargo’s, and 15.65% of Citigroup’s. Given the significant amounts of goodwill, the degree of financial leverage among the five aforementioned bank holding companies was gauged by reducing their common equity by goodwill and then expressing that more tangible amount as a percentage of total assets. This methodological approach revealed that Wells Fargo had the lowest degree of financial leverage at 7.49%, while JP Morgan had the highest at 5.48%. In between were Citigroup at 7.01%, U.S. Bancorp at 6.53% and Bank of America at 5.85%.

This brief analysis strongly suggests that it would be folly for the major bank holding companies to buy back shares of their common stock and/or establish large dividend payouts so soon after perching on the financial abyss. The general public, as well as shareholders, would be better served by these companies using their earnings to support loan growth. This generation of bankers needs to understand that the public’s appetite for bailing out banks has been satiated for the foreseeable future. Banks must therefore be operated with more common equity and less financial leverage.

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.