Friday, January 16, 2009

Citigroup: Ward of the State

Remember when Obi Wan Kenobi lept up from that bottomless pit on Naboo and sliced Darth Maul in half? That's what comes to mind when I think about today's Citigroup news.

Citigroup's recent woes are a perfect reminder of what investors in corporate bonds and preferred stock are up against in 2009. Yes, government support is nice. But it isn't everything.

First the chart on Citigroup's credit default swaps (CDS). Higher CDS rates (also called the spread) indicate a higher price to insure against Citigroup defaulting.

We see the CDS fall drastically on October 13-14, when the Treasury initially made TARP investments in Citigroup and several other banks. The spread then rose to nearly 500bps in late November before the government made another injection into Citigroup that weekend. Once again the spread plummeted, settling in the mid to low 200's before rising in recent days. The chart doesn't show it, but today's announcement from Citigroup caused CDS to drop another 50 bps to +275.

The trading pattern is that Citi goes wider, the government steps in to help. So why worry? The Treasury is telling you that Citi is too big to fail right?

Step back and ask yourself why Citi is too big to fail. Its because of the interlocking nature of the financial markets. Its because Citi is a major counter-party to all stripes of derivatives. Its because Citi is a major market-maker in the financial markets. Etc. etc. It isn't because Citi bond holders or preferred stock holders need to be protected.

Another way to read the CDS chart above is that Citi would have been bankrupt not once, but twice if it hadn't been for government support. Now, I fully expect the government to continue to support Citigroup, but what is this new good bank/bad bank split going to look like for bond investors? Debt holders aren't likely to be backed entirely by the good bank, because that bank would be over-leveraged. Some of the debt is going to go to the bad bank. It could wind up where the bad bank does some sort of tender and re-issue, and existing bond holders turn out just fine. But we don't know that.

There was talk that Citi could be nationalized. Again, the simplistic investor is assuming this would be good for debt holders. But in a nationalization, the government would probably move to break up the bank even faster than what is currently underway. If Citi breaks into three pieces, which piece would bond holders be tied to? Before you make a guess, remember that if the government gets involved, anything can happen.

I've heard many times a recommendation to "buy what the government is supporting." But I suggest investors take an alternate but similar approach. In the bond market, buy what the government is supporting to maintain liquidity, not what the government is supporting to avoid insolvency. There is now, or may be in the near future, strong government support of several bond sectors that would be money good anyway, but are trading cheap because of poor liquidity. Student Loan-backed bonds, municipal bonds, GSE-backed mortgages, etc. Why are people buying Citigroup bonds at around 6% yield with so much uncertainty surrounding it?

Citigroup is clearly a declining situation. It may well be that with government support, Citi survives and eventually becomes a thriving company again. But its also distinctly possible that in a break-up, bond holders are left with something less than full government support. Buyer beware.


PNL4LYFE said...

While I think C equity (and probably BAC and others) is almost certainly worthless, I think the debt is very likely safe. As it stands, banks are still able to raise debt via government guaranteed CP and TLGP bonds which are about to be extended from 3 years to 10 years. If there is any perceived weakness in these guarantees (i.e. if Citi debt was not made whole), the government would become the sole provider of both debt and equity financing to banks rather than just equity. Citi alone has over $570bn of short term borrowings which they clearly could not roll without government backing. Their balance sheet is much bigger then LEH's and the market disruption caused by a liquidation would cause many other banks to either fail or require government assistance. It seems much cheaper in the long run to maintain the illusion that Citi is solvent. The 20, 30, or 100bn more of equity that will have to be injected will be small compared to the cost of letting all the dominoes fall.

I think preferreds are the fulcrum here. Will the government continue to inject preferred capital while still allowing existing preferred dividends to be paid? I think they probably will at least until the 2nd tranche of TARP money is gone. If they have to go to the well again, all bets are off.

The common will be worthless because all this government preferred will eventually have to be refinanced with massively dilutive common offerings after things return to 'normal'. I think most of the big banks will still be around when all is said and done, but the current equity holders will be a small piece of the pie by then.

cap vandal said...

What do you think about something BML-H. This is a MER floating rate $25 par that is selling for $6 and yielding 10%+.

If the bank is really bailed out, and if part of the process includes a suspension of preferred dividends, you would still have a shot at par and with a healthy dose of inflation in the future, you have the floating rate.

I'm not seriously considering this issue, since I need more exposure to leveraged financials like a hole in the head. Also, I suppose that preferreds are a notch down the food chain from bonds and more likely to get wiped out.

Letting the preferred go would have serious knock on effects, since a lot of financial firms hold this stuff -- similar to the GSE preferred.

In Debt We Trust said...

Read paragraphs 5 and 6. These are Bernanke's latest plans. Nothing you don't already know but Bernanke is making if official.

In Debt We Trust said...

Sorry, the page borders cut off the link. Here is the right repost:

Accrued Interest said...

Here is a tiny url for Debt's piece.

PNL: You are probably right, but particularly with Citi, I've got little confidence. Its one thing for someone like me to trade preferreds in BAC. I know I'm taking an awful risk. But I think there are a lot of joe blow investors who think that government support=no risk for debt holders, and that's just not correct.

Accrued Interest said...

Cap: I just bought some CFC preferreds personally, but I am speculating. Think about it as a speculative play, not as an investment. I also shorted BAC out of the money puts. Again, totally speculative, thinking that BAC isn't really insolvent and therefore the equity vol will calm down. But I believe I have a good handle on the risk I'm taking (100% loss!) And I know how to build a portfolio with varying risks. And I'm sure a lot of AI's readers are sophisticated enough to handle this kind of trading too.

But a lot of investors are getting fooled into taking more risk than they realize here.

alex said...

In an earlier post you commented on Anally. Do you feel that with short term rates so low there is only one way to go-the question is when- and when it happens this stock will suffer because the dividend will go down. Also your previous description of lack of upside potential for MBS as spreads tighten serves to effectively cap the appreciation potential for NLY.

Jake said...

Accrued Interest-

Which series of the BAC pfd did you buy? I am holding the L series, 1m par value, convertible. It is convertible into twenty shares at 50... I know there is almost no value to the the option but it's a 72.50 coupon on a 480 current price, it was the best yield I could find.

Don said...

"Remember when Obi Wan Kenobi lept up from that bottomless pit on Naboo and sliced Darth Maul in half?"

Darth Maul is my favorite Star Wars character. Please, do not ever mention this scene again. It makes me want to weep.

Don the libertarian Democrat

PNL4LYFE said...

Jake: The BAC L is an interesting one. Many of the banks issued convertible true preferreds in late '07 and early '08 before the extent of the problem was realized. These are interesting because they have recently been trading at significantly higher yields than similar straight preferreds. I think the main reason is the nature of the large holders. Convertible arbitrage has been the worst performing hedge fund strategy and there has been a lot of forced selling. Also, because many holders hedge these converts by shorting stock, the market tends to nuke them down whenever the common falls even though the option is way out of the money.

Another type of security that's interesting for those seeking long dated yield are the 'trust preferred' securities issued by banks. These are technically junior debt of subsidiary entities, but they can be partially treated as equity capital in leverage ratio tests which is why they were attractive for banks to issue. The key distinction is that they are cumulative, and the 'dividend' is actually interest. This may be worse for some investors from a tax perspective, but it should be much be difficult to suspend the dividend.

Accrued Interest said...

I haven't been playing in converts for exactly the reason that PNL mentions... lots of deleveraging there.

I bot CFC A.

PNL4LYFE said...

Timely discussion... pfds are cratering today. BAC L -14 pts to around 36. 20% yield... This new UK bailout plan is not helping. Also, FBR note today saying BAC will need $80bn in capital.

Lockstep said...

Hey guys,

I agree with PNL and AI, gov will keep the illusion that C is solvent for the populace.

As for spec plays, I have been in GS-A since July. I think at the right price GS will be scooped up like PIMCO was a while ago and held as the high risk arm of a major asset manager (i.e. insurance, SWF, commercial bank)

I am also in BAC-E.

Getting the floating preferreds is a must even though I don't see inflation kicking up for a few years.

Jake said...

I think the PFDs in general are WAY undervalued. I think the prob of much in the way of major bank equity going away is very low...

I realize that there are all sorts of reasons why they are all going to zero, but I believe that the banks will beat the FASB.

In Debt We Trust said...

You guys are missing the big story - British banks are going bankrupt left and right. The resulting "rescue" by the UK authorities just means an opportunity to short gilts. Unlike the US, the UK is NOT too big to fail. In fact, you can say the same thing about the peripheral EU nations too - Ireland, Greece, Portugal, etc. Short all their govt bonds.

Basic game theory says that the EU faces a massive coordination problem in aligning member states' incentives to buy each others' debt. Why should they when the incentive to "cheat" or buy their own bonds is much MUCH stronger. The problem is compounded exponentially by the lack of sovereignty over interest rates - instead they surrendered that over to a distant, bureaucratic council in Brussels more interested in blaming each other than solving the problem.

PNL4LYFE said...

Another interesting thing I noticed related to the bank pfds is Pimco's PHK closed end fund. It's normally a high yield fund, but as of 12/31/08, it's top holdings are all bank pfds. It's NAV has fallen off a cliff in the last two weeks while the fund is still rallying. It now trades at 55% premium to NAV. Probably a good time to get out if you own this one.