3 December 2007

The $41B Bomb Citi Doesn't Want You to Know About

Part of our job here is to call “Shenanigans” when we see them. Earlier this week, Citigroup (C) announced that they had cut a deal with the Abu Dhabi state-sponsored fund, AIDA, to pump $7.5 billion into the company. This has since been widely hailed by the media as the reason that the market has begun to rebound.


The market rebounded late this week because, a) it was incredibly oversold; and b) we’ve seen the US Dollar rally, and that has taken some of the air out of oil prices.

If you closely examine the Citigroup deal, you will see that it is executive denial at its finest, and is not in the interest of shareholders… well, maybe Abu Dhabi’s shareholders. After all, they managed to secure 5% of an iconic American bank at multi-year lows for the equivalent of about 5 billion Euros. Oh, and did I forget to mention that it’s a convertible preferred that pays 11% and is convertible into common stock between $31.83 to $37.24 a share?

So, why did Citigroup agree to dilute existing shareholder interests by 5%? Why didn’t they just cut the $10 billion in dividends that they pay each year? More importantly, why wasn’t this deal done with an American institution?

I’ll tell you why. Citigroup didn’t go with an American buyer because any American buyer would have demanded a seat on the board and a voice in righting the ship. Heaven forbid that the company get an outspoken voice for change!

Their foreign friends are apparently quite happy to take their 4.9% stake with no board seat. They took 4.9% so they didn’t trigger the filing requirements of a 5% stake. Mmm, I wonder why? What do they have to hide?

Citigroup is making decisions akin to the executive that gets laid off but wants to keep up appearances. Our laid off exec knows he can’t afford that country club membership and his big Mercedes Benz anymore, but he’s determined not to be embarrassed in front of his peers. Too late, buddy, the problems at Citigroup are just too big to indulge in that type of denial. The company holds approximately 41 billion dollars in direct sub-prime exposure via standby loan guarantees, but they hold it “off balance sheet”.

Remember that the Structured Investment Vehicles (SIVs) borrowed billions by issuing short-term commercial paper at low rates, then went out and bought riskier long-term bonds at higher rates with the proceeds. In order to receive an investment grade on the commercial paper that they were selling to fund their operations, the banks guaranteed that if the SIVs got in trouble they would pay back the commercial paper holders.

Well, guess what? The SIVs can’t pay! The non-payment by the SIVs has triggered the standby loan guarantees. In accounting circles, this is called a “reconsideration event”.

That simply means, "Hey, dummy, the risk of this vehicle needs to be reconsidered! Maybe it's time to put this changed risk on your balance sheet!”

Apparently, the triggering of the standby loan guarantees and a shiny brand new $41 billion liability isn’t a big enough event for the geniuses at Citigroup to acknowledge. These so called “professional money men” are indulging in the worst kind of self-deception, usually seen only among rank amateurs and substance abusers.

I understand why Citi’s doing what they are doing. Their internal Tier 1 capital range is in danger of being violated. Their Tier 1 capital ratio (that’s the ratio of bank capital to outstanding loans) currently stands at approximately 7.5%. The regulators will let you get all the way to 6% before they’ll pay you a visit, but Citi doesn’t want to look weak. Their logic is if they can’t even meet their own self-imposed capital ratios of 7.5%, it's just another reminder of how poorly they have managed their risk.

Here's the wake-up call. EVERY PLAYER ON THE PLANET KNOWS YOU SCREWED UP. YOU ARE NOT FOOLING ANYONE. Like a little boy attempting to whistle away his fear as he passes the graveyard, Citi is running scared, and everybody knows it.

They should take a page out of HSBC’s (HBC) book. HSBC came out this week and formally announced that they would shift two Structured Investment Vehicles from “off balance sheet” status to “on balance sheet” status. The two funds represent about $35 billion in total liability. Here we have a management team doing the tough but right thing, no burying the corporate head in the sand here.

In order for the financials to recover a measure of the lost investor confidence currently plaguing the sector, many more banks must follow HSBC’s lead and come clean about every piece of “off balance sheet” exposure they currently face. The sector will not be a buy until they do so.


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