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Sunday, 27 January 2008

Citigroup – Opportunity or Death Rattle?

Citigroup – Opportunity or Death Rattle?

It’s not very often you will find me focusing on one share but something rather important has happened to Citigroup [C]. Firstly let me explain I am not, most assuredly not, recommending any position in Citi. I don’t “do” recommendations and as most of you who read my articles know, I prefer to look for the longer term effects. Think of this article more along the lines of a follow up to A beginners Guide To Credit Default Swaps and CDS, An Example in Real Time.

Citigroup is in serious trouble. It’s not the first time Citi has been threatened but it may be the last. Too many risks have been taken without adequate protection or examination. Whilst previous episodes of credit collapse were eventually seen off, with a little outside investment help, this time the problem may be just too big. If Citigroup does start waving a white flag, the repercussions will be enormous.

I am going to rule out a takeover/buyout similar to the Bank of America / Countrywide deal. That deal was not, in my opinion, about a grab for cheap assets. I believe BoA had too much invested in Countrywide to allow it to file for bankruptcy. I also suspect BoA may also have been exposed to large counterparty agreements that would have cost much more than BoA have paid to absorb Countrywide. Essentially BoA have covered their own position.

Citigroup will not get such kind treatment. Instead of it being “too big to fail” I think it may be “too opaque to sell”. Firstly, here is a chart of Citi, it is telling us what the market thinks:

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It's a weekly chart going back to 1997. I have circled the 4 important lows: 1998, 2002 x 2 and current. Citi is now valued at the 2002 low price, including any inflation or $ devaluation effects. This is one ugly share to own if you are not a US based owner. Notice the subtle difference between the current low and the previous 3. Previously Citi spiked down into its low and then rebounded rapidly.

The current low is different, a sustained period of selling continues whilst the oversold condition persists. It is the opposite condition of continued buying whilst in an overbought condition as seen in 1999/2000. Unless a financial miracle occurs Citigroup is going lower, 1998 anyone? If my suspicions come to fruition then the price may well end up quoted in cents.

Can I relate fundamentals to the chart view? Yes I can. Even with the announcement of the capital injections, staff layoffs and the dividend cut:

“Citigroup reported a fourth-quarter loss of $9.83 billion, or $1.99 a share, which included $18.1 billion in subprime-related writedowns, and a $4.1 billion increase in consumer-related credit costs. Citi also said it would sell $14.5 billion in convertible preferred securities, including $12.5 billion to private investors. Citi also said it would cut its quarterly dividend by 41% to 32 cents a share from 54 cents a share.”

So to offset $22.2bn credit losses in the 4th Q , Citi called on profits of $12.43Bn from its other activities to post a headline loss of $9.83Bn. What does this tell us? Simply put the losses on the credit side of the business are not yet over. Either more are expected or have yet to be calculated or fully acknowledged. Why else would Citi require a further capital infusion of $14.5Bn in convertible securities that pay interest at junk status, job cuts and slashing the dividend?

Combine the above with the warning that delinquencies are rising on its $200Bn+ home loan portfolio and that credit card and auto loans are increasingly going bad. We can see the problems are not over.

It gets worse. The SIV problem has come home to roost. With the destruction of M-LEC ( Mr Paulson mentioned it once, saying it was good that it wasn’t needed! ) all the toxic paper has to come onto the balance sheet. I suspect it’s still being examined and most of the losses are not yet in the open. Further, Citi has yet to come clean about its derivative positions. We still do not know what counterparty risk Citi is liable for. Did Citi carry out proper risk analysis on any CDS it wrote or was counterparty too?

Even worse, we still do not know who is liable if Citi has a default or credit event. Like subprime, the Citi situation is not going to be isolated. Contamination from toxic paper is guaranteed.

What can ensure the spread? This:

NEW YORK (Thomson Financial) - Standard & Poor's lowered Citigroup Inc.'s long-term counterparty credit rating to AA- from AA, and on Citibank N.A. to AA from AA+, citing the financial services company's "severe losses." The outlooks for the ratings are negative. The short-term counterparty credit ratings of A-1+ were affirmed.

"Our downgrade also takes into consideration that Citigroup's performance could be rocky in 2008 amid prospects for a continued difficult operating environment for U.S. banks," said S&P credit analyst Tanya Azarchs. "More writedowns of mortgage-related securities cannot be ruled out."

Observant readers of “Credit Default Swaps – An Example In Real Time” will remember the implications for being placed on a negative outlook.

Oh yes, I nearly forgot. The opportunity with Citi lies with its bonds. If it has a credit default event that triggers payouts on CDS, bonds have to be delivered before payment is made. I would not be surprised if there was a large shortage of bonds in such circumstances, thus raising the price.

Maybe the opportunity arises as the death rattle begins?

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