Estimating the Risk in Citigroup Stock and Bonds
A number of people are beginning to see a light at the end of the Citigroup (C) tunnel. I still have significant doubts. In an article on December 30, 2007, Todd Sullivan pointed out that if Citi is short the $11 billion needed to pay the dividend for one year, that shortfall could be made up by selling an equivalent amount of assets. If we assume that the value before this one time loss made sense, and that $11 billion is the full extent of the loss, then that sounds very reassuring. Collecting 7% from a reliable financial firm, with a 15% tax rate sounds really good. Citi might be very good for my retirement.
Is it correct that $11 billion is all that needs to be made up, and that it's a one shot deal? Does anyone know the magnitude of the losses Citigroup has incurred relating to the incredibly unwise risk in taking on poor quality A.R.M. residential mortgages labeled as AAA creditworthy? I have seen a number of sources saying no one knows the extent of the losses. That surprises me. Financial people can't be making decisions without any analyses or estimates at all. I wonder how would one go about making such an estimate. Can anyone help me with that? I am just a retiree who knows almost nothing about financial evaluations. Then too, off-the-books entities would seem, to my untrained mind, to make it more difficult. But perhaps it's not totally impossible. In the interim, I will take a naive crack at it. Here goes:
We have to start somewhere, so let's try this approach: (Please point out my errors.) Let us assume for the moment that the subprime losses for a large bank are $50 to $100 Billion. Then we will see if that makes practical sense.
Here is how I arrived at that guestimated (engineering jargon) range. A typical number for the loss already admitted to by a number of large banks is in the vicinity of $10 billion plus or minus a few billion. What kind of activity could have generated a loss of $10 billion? It could have been rung up by 40,000 non performing mortgages of $500 thousand each. I am assuming that each property lost 50% in resale value. That means they wrote only twenty thousand non performing mortgages a year in about two full years during 2005, 2006, and 2007. That would translate to about 1700 non-performing subprime mortgages being written per month. What fraction of the actual number of subprime loans written or purchased by Citibank in twenty four full months between 2005 and mid 2007 does that represent? That is the real question. To start, I will assume the fraction is one tenth. Otherwise, why bother with moving risky loans to off-the-books entities? That fraction would mean that 17 thousand loans likely to be in default were written or purchased by Citibank, per month.
Is that number of loans realistic? Let's see. There are roughly ten large banks, and I will assume there were about ten large subprime writing factories and many smaller ones. The key is I am assuming one large subprime loan generating factory per large bank.
How many loan writers were there? Lets leave the many smaller ones aside for now. I seem to recall First Magnus in Arizona had a layoff of something like 200 loan writers when they couldn't sell any more of the clearly worthless loans, even with slicing and dicing tricks. If each bank had about 200 people writing about 4 loans a day, 20 days a month, that allows a $100 billion loss in 2 years. If we assume most mortgages were $250 thousand instead of half a million dollars, that means a loss of "only" $50 billion per bank, everything else remaining the same. What is the effect of all the other low initial rate, ARM, no documentation loan writers? Is a factor between 3 and 10 reasonable? Are these numbers available somewhere?
Since all parts of this first cut estimate are subject to significant variation in terms of the unknown by me) facts, I would be cautious and say the number is likely to lie somewhere between $50 billion and $500 billion per large bank like Citi. Getting to $250 billion is easy with a few factors of two or three, so I will write $500 billion to be cautious. Even $50 billion is not small change, and that assumes only 200 bad loan writers. If there were only ten First Magnus size offices devoted to defrauding Citigroup's investors, we are in the neighborhood of $500 billion dollars of undeclared losses. Five hundred billion dollars represents a significant fraction of Citigroup's total asset value of $2.3 trillion (taken from Todd's article), or $2300 billion. That's roughly 20% of total assets. It doesn't include any other liabilities.
Would that mean the dividend would be cut? That would really hurt the bondholders. The stock would take a significan long term hit I would assume. I am not competent to evaluate the effect of only a fifty billion dollar real loss on the value of bonds or on the stock valuations. What would happen to the book value seems important. I assume it would be difficult to sell financial assets if they are suspected of being tainted by fiscal irresponsibility of the type of Citi itself. Even if they are pure as the driven snow, there may not be enough buyers for the sheer volume of the assets to be liquidated by so many banks at about the same time frame. There may not be enough foreign buyers when we need them.
Again, this is not my area of expertise, but if this really simple estimation process is reasonable, we have trouble in Citi City.
If the actual loss lies anywhere in the uncertainty range ($50 billion - $500 billion), it could be risky to assume that a 40 percent cut in the dividend is sufficient to fix Citigroup's problem. Cutting the dividend would be a major statement. Is it a correct statement or not? Also, what does this imply for reassessing Citi's actual value? Wouldn't that mean that the current 40% drop in Citi's NAV over the last year is not enough? Would there likely be an additional 20% reduction, or would it be larger or smaller?
If you see one or more flaws in this initial approach, please let me know. Also, please suggest a better one. I am not a financial guru, just a retiree trying to see what are reasonably safe investments, and what are not. I would like to find a way of estimating the real risk. Inflation is a risk I understand somewhat. However, the value and risks of financial paper issued by Citi or of stock in Citi are still a mystery to me. I feel I have just begun to peel away the layers of the onion. I am startled, amazed even, to discover that supposedly mature, knowledgeable, experienced managers, who had a fiduciary responsibility to their institution, purchased highly correlated investments whose outcomes were obviously not statistically independent. Those investments by their very nature had a high probability of failing at around the same time, when "tickler" rates ended. This was an easily reachable and predictable circumstance. What were they thinking? What were they doing in Finance 101 classes? Since their financial actions have not engendered a sense of trust, would their institution be a good vehicle for a DRIP investment or only for a drip down an unstoppered drain? I saw Ben Stein on Kudlow ascribe it to the temptation of having fabulously rich grandchildren overriding fiduciary responsible and I would add honor, honesty, and decency. They were too easily seduced to becoming thieves.
If anyone understands this subject and can suggest other ways of estimating, either deterministically or stochastically, Citi's likely stock and bond values and the associated risks, I would really appreciate your help!
I came across a Forbes article quoting an analyst as saying the immediate loss is $30 billion, with possibly another $100 billion. No analysis was shown. This puts her in my range.
Disclosure: none
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This article has 15 comments:
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vgtwoomph
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4 Comments
My Website
Jan 14 01:16 PM-
dckleins
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3 Comments
Jan 14 04:58 PMThe real issue that Citi (and other banks) have, is that they got caught holding a bag of post-securitized loans in the form of ABS, MBS, and CDOs that no one knows how to value (except for Goldman Sachs, somehow).
Because there's no relationship between the actual sub-prime mortages Citi wrote, and the originators of the underlying mortgages in the ABS's of Citi's proprietary books, you won't be able to back into an estimate of future write offs. You'd need information about the securities in their prop book and more importantly, a database of the underlying mortgages that comprise their ABSs.
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Greg Harris
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54 Comments
Jan 14 05:19 PM-
Richard Shinnick
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103 Comments
Jan 14 06:32 PMRetirees should not invest in Citi. But as far as financial evaluations go, it might make for a great hobby, but as everyone seems to now understand, you can't model this because things have changed so drastically. A lot of people saw the sub-prime probelm coming but they never thought that Citigroup or even Countrywide would be a bagholder, it was just assumed all the junk paper was being peddled overseas.
In the case of Countrywide especially, they simply forgot RULE #1 as noted by scholar and financial genius Biggie Smalls: "Don't get high on your own supply."
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helplessobserver
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411 Comments
Jan 14 07:39 PMa. providing forebearance on regulatory capital requirements
b. supplying all additional capital to allow the bank to continue normal business lending
Its a sham, but it will work.
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Paulo
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70 Comments
Jan 14 07:40 PMPrecision is not possible and when it becomes so, the markets will arrive at an appropriate value. That could be up or down from the present banking sector valuation.
How about buying that sector and using an ultrashort ETF to partly protect the decision ?
Not ideal, but I do no think I want to spend my retirement auditing the banking sector of the developed world in order to correctly time a moment to purchase (not that I think that can usually be done).
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Gob
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39 Comments
My Website
Jan 14 08:58 PM-
Richard Shinnick
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103 Comments
Jan 14 10:56 PM-
dsilisk
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5 Comments
Jan 15 04:23 AMYour 'estimations' are important in underlying that all anyone is working with these days is an estimation. No one knows.
Why was Citi so irresponsible? Why did so many highly-paid portfolio managers take on so much risk? Because their paychecks are just as fat either way. These are not the Harvard MBA business elite--they are ex-frat boys who were all drinking buddies together in college 5-15 years ago.
When I was at college studying economics and mathematics, it was not the smart, hardworking, analytical students who were in the business program hoping to be bankers. The best business minds go on to be economists--but economists don't make decisions. In conclusion: we have idiots running our financial institutions, because banking is a frat.
Also, we saw Citigroup shares rise by 1.75% today. HELLO? What are people thinking! Citi is about to announce dividend cuts, a deal-that-never-was with China, & 10-30 billion in write-offs (don't you love how they can just get out of this with a 'write-off' while the individual investor loses 40-60% of his retirement savings?) The correction for their losses has not been built into the stock price already.
To whomever is bullish on Citi: Warren Buffet's No. 1 rule of investing is, "Never Lose Money." Stop taking the same miscalculated on Citi that Citi took on ARM's. Save your money, so that my taxes don't have to support your broke, stupid butt when you get wiped out.
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Paulo
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70 Comments
Jan 15 03:54 PM-
chicbee
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6 Comments
Jan 17 09:57 PMYour approach to avoiding having to time the banking systems is quite interesting, and makes tactical sense. Today's percentage changes in KBE and SDS almost cancelled each other out. SDS did better. So it worked today.
Is the net effect of doing that to lower the return of the dividend in the dividend paying instrument to something like half of it's stated rate on the day you bought it?
I don't see the banking shares coming back over the next few years, until they sell off sufficient assets to cover these enormous, real losses that they are revealing to the public a little at a time. In addition, they are issuing and selling new shares of preferred stocks to new investors. Even if they are not fools, and have good reasons for taking control of a shell, the new preferred shares they receive do dilute your investment for the reasonably foreseeable future. The funds they put in are not additional asset purchasing funds, and just cover already incurred losses that were hidden.
That all seems to mean that the NAV on Citigroup, and other financial institutions with similar problems, will be gravitating to a significantly lower number about which it may fluctuate. That will be true until they almost start to make profits. Whoever buys them is buying damaged goods which could be hard to resell near where you bought them... for a long time, possibly ever.
In your strategy, what happens when Nasdaq turns upward, SDS starts declining, and the banks still struggle in their downward spiral, like a star orbiting a black hole? That seems risky to me. Fortunately, we are not locked into KBE, since commissions are very small. I am confident there are less volatile, safer, dividend paying stocks that do well in bear markets. Consumer necessities such as milk, soap, soda, baked beans, and beer are a few examples that come to mind.
Arguing against my own position, Sandy Weil is apparently investing in this rescue effort, and he is brilliant. The article seemed to say it was his own money. If that's true, I would like to hear his reasons. I would love to talk to him. I would hate to bet against Sandy Weil.
As dsilisk pointed out, Warren Buffet's first rule of investing is "Never lose money."
Thanks for sharing your strategy. I bought some SDS, and just a few shares of KBE, so like RNP, it's now on my radar screen.
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chicbee
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6 Comments
Jan 18 04:13 AMThanks for that news alert. I assume there is a lot of disagreement within China about how to handle this hot potato.
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chicbee
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6 Comments
Jan 18 05:51 AMYou seem to really know the banking business.
Paragraph 1: I found your first paragraph very interesting. I will have to research the Basel requirements. The paradigm shift you refer to may make the banking industry an unsafe investment tool for retirees, except in the higher risk portions of their portfolios.
On the other hand, no paradigm shift should entail making very elementary mistakes and taking obviously correlated risks with a built in rapid escalation of almost guaranteed non-performance in three years. That makes the risk in three years over 90% and possibly 99.9%. That's a poor investment for anyone at less than some interest or dividend rate over ~30%. And that's just break even.
That sounds a bit like the paradigm shift in the dotcom bubble. That had two main components. The first was the more money you spent, without any earnings, at all the better because it meant you were gathering market share. The second was that investing in ten "uncorrelated&quo... ideas improved your probability of success. They also missed the correlation implicit in the first component. Also, Psuccess_n_bad_ideas=(... The more bad ideas they came up with to pour money into, the more toxic the paradigm.
That bubble taught me to be wary of the words "paradigm shift" regarding investments. When I hear those words I think of Professor Harold Hill in "The Music Man"; To paraphrase... 'shift' rhymes with 'berift' (of value) and it means 'we have trouble in City Citi'. (Of course, in the show, the students succeeded. Aren't musicals wonderful?)
Paragraph 2: I have to disagree. They didn't get caught with stuff they intended to unload. Everyone made money investing in the same junk ( see Rich Shinnick's later comment) ABS, MBS, and CDOs they were selling to their customers. No one wanted to have less success than their competitors. Goldman Sachs was lucky. One of their analysts figured out they would do much better with much less risk by selling the bad stuff short. I read they had a long acrimonious meeting regarding whether or not to sell short. I wonder if the person who steered them correctly and saved their lunch is now highly regarded or viewed with suspicion?
Paragraph 3: Yes, I agree totally! Realizing that early on led me to try a different approach to bounding their likely range of losses. Since I don't have access to that "database of underlying mortgages that comprise their ABSs," I had to come up with another way. I simply asked myself..."self, how many bad mortgages did they buy assuming they were buying?" I assumed they were buying, because otherwise they would not have ever growing estimates of loss. Think about it, the estimates of loss are still growing and they are scurrying around to raise ever growing funds to cover losses, and selling "non core related assets." If they were not buying to hold, I believe the losses would have actually been "contained and manageable" (or words to that effect) as they asserted early on.
Actually I got the idea when I heard the very first $3 billion estimate. I remarked to my wife when we were watching NBC's Nightly News, that this had to be a gross understatement. A quick mental "back of the envelop calculation" showed the stated number was only a few days or hours worth of writing loans, at $500 million a bad loan. This isn't rocket science. When their estimates kept going up, I asked myself how I might get a bound on the problem? The lower number, $50 billion, is probably pretty good. The upper bound has large uncertainties, as pointed out by a knowledgeable friend, and also by a very knowledgeable Cousin, due to unknown leverage so I multiplied it by a comfort factor of 2. That could be way too low.
By the way, if we had the details in the database, of the structure of the "tranches" purchased and the leverage used in the hedging swaps, we could model it quite accuracy, with a fair amount of precision. I assume the analyst with brains in Goldman did just that.
As an aside: The higher the precision the more significant digits can be calculated. We do not actually need "high" precision, since we only need 1 or 2 significant figures and the order of magnitude. But I digress.
Thanks for the education, and for pointing out what I did not say in the article. I appreciate it.
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chicbee
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6 Comments
Jan 18 06:43 AMThanks for your interesting questions.
Re Question 1: I did read the latest 10-Q quarterly report available when I did my trivial analysis. I just didn't believe what I read. I did my calculations as sanity checks of what they wrote, or at least of what I understood it to mean. I quickly realized that if the books told the whole story, Citigroup wouldn't be in the mess that was, and still is, relentlessly unfolding. I did it a few weeks before submitting it here.
Did you read "what's on the books"? Did you come up with a prediction of a worsening crisis for Citi on that basis? If you did so without a method similar to the one I used, I would appreciate hearing how you did that! I love to learn alternative methods.
Re Question 2: SEC filings require patience and a concentrated, skeptical mind. Realizing what they do not contain, and what the crisp wording might mean, is interesting to say the least. Is it rocket science? I think not. Does the SEC review it for completeness and honesty?
I suppose it's fair to say I "make stuff up". In my profession it's called using what-if scenarios. I try to check any assumptions. I varied the values of parameters (parametric variation) intentionally to explore the range of possibilities. It also helps in identifying "worst case scenarios". It's part of a reasonable assessment of risk. I recommend it.
It's valuable to use independent methods and to make sure they agree, or to understand why they differ. I would like to learn about any alternative methods. Especially so, if you know of a better, simpler, cleverer, more reliable approach.
I am not in love with my approach. I use it because it tends to uncover discrepancies, incorrect assumptions, and evaluate risks. I continue to use it only because I don't know better methods.
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Pooch
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1 Comment
Jan 20 06:22 PM