March 17, 2008 - The center of focus this past week on Wall Street - and indeed, much of the financial world - was whether or not Bear Stearns will go belly-up. As questions arose about the quality of its $395 billion of assets that were carried on only $12 billion of equity, its customers and other brokers became unwilling to accept the counterparty risk that arises from transacting with Bear, while its lenders began worrying about repayment. Being leveraged to that extent, even a small decline in the value of its assets can significantly erode the firm's equity base. But given that Bear is no more than the fifth largest broker in the US, it is a relatively small fish in the financial world.
Let's take a look at the big fish, namely, the commercial banks. In fact, let's look at the biggest of them all to ask: "Will Citibank survive?"
It's a question that would have been outrageous to even consider asking as recently as a year ago. Interestingly, it's a question that was often asked nearly two decades ago during the last banking crisis that eventually led to a bailout in 1991.
Back then Citi - or more precisely, Citigroup Inc. and its banking subsidiary, Citibank - was bailed out by Saudi Prince Al-Waleed bin Talal with a $590 million investment. Citi and many other US banks were nearly ruined by the Savings & Loan crisis and subsequent real estate collapse that plunged the United States into a severe recession.
The tab for losses incurred by the financial system back then was about $100 billion. The final numbers are undoubtedly going to be much higher this time around. Not only is the US more over-leveraged than last time, the impact from the sub-prime morass is being felt globally. Financial institutions worldwide have already come to grips with $140 billion of bad debts.
Commenting upon the recent $200 billion scheme announced by the Federal Reserve this past week, The Telegraph in the UK wisely observed: "The Fed, with its latest $200 billion offer of cheap cash, has provided yet more state aid for errant hedge funds and another Washington-backed bailout for Wall Street bankers…But "as the bail-outs are getting bigger, then clearly the problems causing them must be getting bigger." [emphasis added]
Could what happened to Bear Stearns also happen to Citi and for that matter, other banks? Yes, and it may be happening now because the growing concern about counterparty risk cuts across all sectors and its impact is effecting all financial institutions to some degree.
Commercial banks, however, have some advantages over brokers. They have access to the Federal Reserve, the so-called lender of 'last resort'. Also, banks have an "invisibility cloak" to conceal assets, so it is much harder to discern what is happening to the financial capacity of commercial banks than brokers like Bear Stearns. Brokers do not have "invisibility cloaks" because they are required to mark the value of their assets to market values, i.e., which is the price at which the last trade was made.
Banks argue that the loans on their books are not tradable securities, so they do not have a market value. There is some logic to this argument, but it is disingenuous in many instances. One does not need a market price to know that the value of a fixed rate mortgage will go down when interest rates rise, but banks nevertheless may be carrying the mortgage at book value. Or if a company is downgraded by a rating agency, a bank need not mark its loan to that company as doubtful if in their judgement (and not the rating agency's) the loan will be repaid.
Banks of course also own tradable securities, many of which are probably similar to those owned by Bear and other brokers. But even here commercial banks get a free-pass. If a security in a trading portfolio is not performing as expected, the bank can transfer the security to its investment portfolio to avoid marking it to market, claiming that it intends to hold the security to maturity and that its present market value is therefore irrelevant. This logic is of course nonsense because of one deadly factor - leverage. The use of leverage means that all banks could face a crisis of confidence, like that now being endured by Bear. And in a crisis, again as we are finding out with Bear, potentially all of the bank's assets may need to be sold before maturity.
So while the market is already trying to analyze whether Bear Stearns, Fannie Mae, Lehman Brothers and others are going to make it to the other side of the valley, we also need to ask if the biggest of them all - Citigroup Inc. and its banking subsidiary, Citibank - are solvent.
We can do this by examining Citi's balance sheet. I am ignoring its income statement because in a crisis, future cash-flow is basically irrelevant to a bank's survival and need for liquidity.
The key financial facts are presented in the accompanying table. These numbers are from Citi's quarterly reports from December 2005 through December 2007, the latest report available.
From 2005 to the present Citi's leverage (total liabilities divided by stockholders' equity) has increased in each quarter from 12.3 to 18.2 times. So equity as a percent of liabilities has declined during this period from 8.1% to 5.5%. However, the real picture that I present in the bottom half of the table shows a more significant decline in Citi's equity and corresponding increase in leverage.
Note the increase in Citi's intangible assets and goodwill since 2005. These have essentially no value in a crisis situation, so I have subtracted them from stockholder equity to determine Citi's tangible equity. I then calculated Citi's real leverage by dividing its total liabilities by tangible equity, which is an astounding 41.6-times. Citi only has total equity to total tangible assets of 2.3%.
This 2.3% number is vitally important to determine whether Citi is solvent. And here is where we get into the inevitable subjective judgements. The "invisibility cloak" that commercial banks use to conceal assets makes it impossible to determine the quality of those assets. But there is one escapable cold, hard fact. Given that Citi's tangible equity to tangible assets is 2.3%, we know that if the value of those assets is 2.3% less than their reported value, then Citi is insolvent. Citi may continue operating because it is liquid, but it would be operating as an insolvent.
The question therefore becomes, what are Citi's assets worth? As explained above, we can't accurately answer that question, but here is some information to ponder.
(1) Citi has $133.4 billion of Level 3 assets. Here's how MarketWatch recently described this category when reporting Citi's Level 3 assets: "Level 3 assets are holdings that are so illiquid, or trade so infrequently, that they have no reliable price, so their valuations are based on management's best guess." In an analysis of Bear Stearns, Barron's prudently observes: "Of particular concern are Bear's so-called Level Three assets, which stood at $28 billion as of November and by definition are illiquid and valued on the basis only of the firm's own estimates. Any buyer might be worried about the need to mark down the value of these assets, and the value of Bear's large book of financial derivatives." What's more, Bear's so-called "large book" of derivatives pales in comparison to the size of Citi's book. According to the Comptroller of the Currency, Citi is counterparty to financial derivatives with a notional value of $34.0 trillion (sic). We should keep in mind Warren Buffett's warning from 2002: "Derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal."
(2) Last week JP Morgan warned that the Street is facing a "systemic margin call" on subprime mortgages that alone might deplete $325 billion of capital. Citibank alone has about 10% of total bank capital in the US, so if it were to incur 10% of that loss projected by JP Morgan or $32.5 billion, only $17.2 billion of tangible equity would remain. Note that Morgan's analysis ignored all of the other paper now being called into question, which could mean even bigger losses for the banks. For example, on February 29th Bloomberg reported: "Citigroup Inc. helped create at least $6.9 billion of securities insured by Ambac Financial Group Inc. that have tumbled in value and may require the insurer to pay claims." Apparently these are some "of Ambac's most troubled CDOs", i.e. the one's most likely to incur large losses. Given that Ambac's future is being questioned despite its recent injection of capital, Citi may end up with losses on these CDOs, not to mention other firm's CDOs of inferior quality that it helped write. It is worth noting that Citi already took more than $20 billion in credit-related losses in the last half of the year, and conditions are worse this year given that the US is now in a recession. Bank losses almost always worsen in recessions.
(3) When I started working for a bank in the late 1960s after graduating from college, normal bank leverage was considered to be 6-to-8 times equity. But let's assume that the 21.4-times real leverage presented in the above table for Citi in December 2005 is adequate. To reduce its leverage and bring its capital ratio back to its December 2005 level, Citi needs to raise $46.9 billion in equity, nearly doubling its capital base. This calculation of course assumes that Citi has no further charge-offs and doesn't expand its total assets by making new loans - both of which seem improbable.
(4) Alternatively, Citi can sell assets and reduce its leverage by repaying debt. But this alternative does not seem practical given the huge amounts involved and present market conditions. To reduce its leverage back to its 2005 level on its current capital base, Citi would need to dispose $384.1 billion of assets. Sales of that size in all likelihood could only be done with significant asset price destruction, causing losses that would further erode Citi's capital base.
(5) The real Achilles heel is that banks lend long and borrow short. In other words, they fund long-term loans with checking account deposits and 90-day loans. These funding sources can evaporate overnight, as Bear Stearns found out. This imbalance in asset/liability management has killed countless banks throughout history.
So is Citi solvent? We just don't know. But there are reasons to be concerned. We are in one of those recurring periods when the solvency of banks is doubted, like the late 1980s when the S&L crisis was brewing. Or perhaps it is more like 1974 when the failure of Herstatt Bank in West Germany set off banking crises throughout the world, culminating with the collapse of Franklin National Bank in New York City. The problem is leverage. Too much debt has been extended on too little capital, so even a small decline in the value of a bank's assets can significantly erode its capital and make it insolvent.
In any case, it looks like the financial crisis already upon us will get worse before it gets better, and I am not alone in that thinking. David Rubenstein, co-founder of the Carlyle Group told The Wall Street Journal last week: "This is the tip of the iceberg. People are looking at our situation and saying, 'There but for the grace of God go I.' There are others out there hanging on by their fingernails."
He should know. His group managed Carlyle Capital, which recently defaulted on its loans to Citi and other banks, and whose stock price is shown in the above chart.
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