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Citigroup: A Bet Against the End of the World

This is the first of a three part posting on Citigroup.  The second part compared the opportunity in Citigroup to Bank of America.  The final part will review a list of reasons why investors avoid Citigroup and how I overcome these objections.

Betting on the End of the World by shorting the major U.S. banks is not a winning strategy.  This is not to say investors should blindly depend on policy makers to bailout the financial system every time there is an issue.  We have clear, recent evidence from September 2008 that bailouts do not always come for investors.  Also, I fear we will have a repeat of September 2008 in the future as anti-bailout proponents continue to gain power in Washington.  However, the current financial policy makers (Geithner and Bernanke) will not repeat the mistakes of September 2008, so shorting the major U.S. banks now is a losing strategy.

The sellers of bank stocks at these levels fear the financial system will collapse if there is a hard default by Greece.  Their thesis is if Greece defaults, major European banks will take losses directly and suffer additional counterparty losses from the failure of smaller banks.  As the European banks take losses, risk aversion will rise and liquidity will drain from the system.  Lower levels of liquidity will drive asset prices lower causing losses in both U.S. and European banks.  These additional losses may cause a major a European bank to fail, and U.S. banks will suffer additional losses as a result.  If the losses for the U.S. banks rise to a high enough level, we may see a major U.S. bank have to fire-sale assets and/or raise capital at dilutive stock prices.

I disagree with several parts of this thesis.  Most important, I believe the current policy makers learned an important lesson from September 2008 and will not compound a crisis by letting their financial institutions fail due to a lack of liquidity.  Plus, the major U.S. banks have liquidity and capital levels that will allow them to survive a severe downturn in the financial markets.  I have been expressing my view by adding to my position in Citigroup.

My preferred way to implement my view that the financial system will not collapse is to own shares of Citigroup.  I believe all of the large banks are attractive, including JP Morgan Chase, Bank of America, Goldman Sachs, Morgan Stanley and Wells Fargo.  I own most of them, but my largest position is in Citigroup.  My preference for Citigroup is due to its low valuation and its ongoing corporate restructuring which is generating excess capital.

I do not think the financial system is going to collapse due to the current European crisis.  Political leaders have learned important lessons from the Lehman Brothers bankruptcy that orderly wind-down of major financial institutions is needed.  I believe the distress in the financial system in September 2008 is etched on the minds of Geithner and Bernanke.  They will not allow a major financial institution to fail due to a shock from Europe.

Treasury Secretary Tim Geithner consistently shows in his speeches and interviews that the lessons learned from September 2008 are well in grained.  On September 19^th, Geithner said in a Bloomberg interview, “I think you’re going to see them draw on the lessons of our crisis, draw on the lessons of things that worked here in the United States. I think you’ll see that reflected in some of the choices they make.”

In the end, I believe the European leaders have learned these same lessons.  They will protect their own country’s banks from losses.  It may be bumpy trip, but we see evidence that  European political leaders are starting to get it.  Merkel and Sarkozy released a joint statement saying that they “are convinced that Greece’s future is in the eurozone.”  At the recent G7 meeting, the finance ministers stated their support for the banks, “We will take all necessary actions to ensure the resilience of banking systems and financial markets,”

In addition to the support from political leaders, I believe Citigroup is approaching a potential Greek default with much more solid liquidity and capital positions than.  Here’s a look at the high level numbers:

These are clearly stronger numbers and position Citigroup to handle a stressful environment better than 2008.  In addition, Citigroup has spent the past 3 years reducing risk within its loan book.  With the credit quality metrics declining, I get the sense that management has a much better sense of its balance sheet and the risks than it did 3 years ago.

I believe Citigroup is well positioned here to survive a stressful period in the markets due to a Greek default.  With the stock at 60% of tangible book value, I believe it is an attractive stock.  The reason it is at these low valuation level is the potential for potential problems in the financial system due to a Greek default.  I do not believe

Disclosure: Long C, BAC, WFC & MS

Disclaimer: This is not investment advice. This intended to be a window into my thinking when analyzing Citigroup.  Please do you own work before making an investment. My positions listed in the disclosure may change without further update.