Citigroup: Collateral Damage from Bank of America
Sep/111
This is the second of a three part posting on Citigroup. The first part explored how I own Citigroup and other large banks despite the risk of a systemic collapse if there was a hard Greek default. The final part will review a list of reasons why investors avoid Citigroup and how I overcome these objections.
Bank of America has been in the headlines about its mortgage exposure and capital situation. Its stock is down 42% this quarter through September 23rd, but Citigroup, which I do not believe has similar problems, is also down 40%. In fact, the two stocks seem to be perfectly correlated. It appears that investors are making macro trades against the banking sector without doing fundamental research on the individual companies within the sector. I do not know whether investors are just scrambling to hedge exposures using any bank stock they can find or whether they are expressing their views mainly through sector ETFs. However, good stock pickers appear to have an opportunity within the banking sector since the stocks have moved in such close correlation during the quarter.
I have been adding to my Citigroup position at recent levels. It has a tangible book value of $48.75 as of June 30th, but is trading around $25, or at about 50% of tangible book value. It trades at this discount to book value in spite of reporting profits the last six quarters, having improving credit metrics, building capital, an improving its business mix, and potentially beginning a stock repurchase program next spring.
Bank of America trades at a similar 50% of June 30th tangible book value despite what I perceive as having much higher uncertainty about legacy mortgage costs and having recently diluted common shareholders through the preferred stock and warrant sale to Berkshire Hathaway announced in late August.
It seems to me that Citigroup is being unfairly tarnished by Bank of America’s problems and is a better stock to own at the same valuation. An investor could own Citigroup and short Bank of America as a hedged pair trade. I own both stocks, but my position in Citigroup is much larger than my position in Bank of America.
A Classic Turnaround
I believe Citigroup has all the ingredients of a classic turnaround situation. A large conglomerate with an iconic brand performs poorly because it has become too unwieldy to manage. A new CEO comes in and implements a new strategy to exit non-core assets and businesses. The capital generated from the asset sales has been earmarked for share repurchases. The remaining core businesses operate more profitably and grow faster than before because management can now focus resources on these businesses.
Citigroup’s CEO Vikrum Pandit is executing this turnaround. It has been more difficult than normal because of the difficult economic environment, the need for government assistance at the height of the credit crisis, and the massive size of the organization. That being said, it appears from the outside that things are on track. Management has split the company into two segments: one segment (named Citicorp) holds the company’s three core businesses and the other segment (named CitiHoldings) holds various businesses and assets that Citigroup management has decided they no longer want to own. The assets in CitiHoldings have been declining steadily (see slide 13 on Citigroup’s 2nd Quarter Earnings Presentation.) Although I have thought that Citigroup has given up too much value during some of the asset sales, the management has made steady progress with the asset sales.
I project that Citigroup will generate about $15 billion of excess capital over the next two years. I expect the main source of the excess capital will be from the proceeds of asset sales from the wind down of CitiHoldings. Plus, I estimate that Citigroup will generate more capital than required for growth of its core business. The final piece of the turnaround may come by April 2012 when I expect Citigroup will get approval for a stock buyback program with the excess capital it has generated in 2011. Of course, this approval will be dependent on the operating environment and Citigroup’s results and regulators assessment of Citigroup’s capital and risk positions.
After exiting most of the assets in CitiHoldings and hopefully shrinking the outstanding share count substantially, I believe that investors will be attracted to the remaining Citigroup businesses which are currently in the Citicorp segment. These three businesses are the global retail bank, the corporate bank and institutional securities unit, and the transaction processing business. I believe these remaining three businesses are all good franchises and have the ability to produce attractive growth and returns for shareholders. The corporate structure should be much simpler to understand and analyze.
Global Retail Bank
Of the three core businesses within Citigroup, I believe the global consumer banking franchise is the most attractive business and a unique world-class asset. In my opinion, Citigroup has the only global consumer banking brand with possibly only HSBC as a distant #2. This positions Citigroup for better long-term growth prospects than its U.S.-centric peers (BAC, WFC and JPM.)
The global nature of the Citigroup’s consumer banking franchise positions it for better loan growth than a typical domestic bank. The retail bank benefits from the fast growing economies of the emerging markets. Plus, Citigroup has the option to redirect resources to or from any particular market based on whether that market’s prospects are attractive. With stronger economies outside the U.S., I believe Citigroup’s consumer banking franchise will generate attractive profits and growth and investors will one day give it a premium valuation compared to its domestic peers like Bank of America.
Comparison to Bank of America
I believe Citigroup should trade at a premium to Bank of America because it doesn’t have the same legacy mortgage and capital issues that I believe have been pressuring Bank of America’s stock in Q3. Here’s a look at some statistics that directly compare the two companies:
| Citigroup | Bank of America | |
| YTD Repurchase Provisions | $352 million | $15 billion |
| Mortgage Servicing Portfolio | $571 billion | $2,003 billion |
| Delinquency Rate in Loan Servicing | 8.1% | 13.7% |
| P/E 2012 | 5.0x | 5.2X |
| P/TB | 50% | 51% |
| Market Cap | $75 billion | $64 billion |
| P/E 2012 | 5.0x | 5.2X |
Source: SEC filings, Yahoo! Finance
I believe that Bank of America’s mortgage issues are an order of magnitude worse than Citigroup’s. Bank of America, including its acquisitions of Countrywide and Merrill Lynch, originated a higher amount of the mortgage loans in the worse vintage years of 2006-2008. Bank of America has realized more mortgage losses so far in 2011 than Citigroup, and it has a mortgage servicing portfolio almost three times the size of Citigroup’s.
Do You Believe the Bond Market or the Stock Market?
The bond market is telling us that Citigroup’s stock is undervalued. Ed Najarian, Head of Bank Research at the ISI Group, wrote an interesting note earlier last week showing the strong relationship between the major banks’ Price-to-Tangible Book ratio compared to where their CDS spreads are trading. Wells Fargo and JP Morgan trade with the tightest spreads and the highest P/TB ratios. At the other end spectrum, Bank of America and Morgan Stanley trade with the widest spreads and the lowest P/TB ratios. In the middle, Goldman Sachs and Citigroup trade with CDS spreads about equivalent to each other. Goldman’s P/TB ratio is perfectly between JPM and WFC on one end and BAC and MS on the other. The interesting part is Citigroup doesn’t have a P/TB close to Goldman’s; rather, it has the same P/TB as Bank of America and Morgan Stanley, which both have wider spread levels.
As of 9/20/11:
| P/TB | CDS Spread | |
| WFC | 1.40x | 126 bps |
| JPM | 1.03x | 127 bps |
| GS | 0.84x | 233 bps |
| C | 0.55x | 231 bps |
| MS | 0.57x | 320 bps |
| BAC | 0.55x | 339 bps |
Source: Bloomberg, SEC filings
As a believer that the bond market is collectively smarter than the stock market, I believe the bond market’s assessment of Citigroup’s risk is more accurate, and Citigroup is undervalued by the stock market.
Citigroup is a classic turnaround. They are selling non-core assets and I expect the management to use the proceeds to repurchase stock at attractive valuations. I believe the core businesses within Citigroup, especially the global consumer bank, appear attractive and could generate high levels of profitability and growth than their U.S.-centric peers. I believe investors are unfairly penalizing Citigroup for Bank of America’s woes.
Disclosure: Long C, BAC, MS, WFC
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.
Updated Thinking on Fannie and Freddie
May/111
This post is an excerpt from the 1st Quarter Investor for my hedge fund. If you would like to receive a full copy of the letter, please send me an email at derek.pilecki@gatorcapital.com.
I have owned positions in Freddie Mac and Fannie Mae (the GSEs) preferred stock since the two firms were placed into conservatorship in September 2008. The shares have been extremely volatile. In the first five weeks of the year, the various classes of Fannie and Freddie preferred stock rose in price from about 2% of face value to about 6% of face value.
There are several factors that contributed to the value increase in these positions:
1. Fannie and Freddie’s financial results are improving – Both companies have improved their operations while in conservatorship. The new loans the companies have guaranteed in 2009, 2010 and going forward will be profitable. The problem vintages of 2005-2008 are being resolved and may be fully reserved for losses. In the meantime, the companies’ mortgage investment portfolios have been very profitable and are throwing off $16 billion of cash per year at each company. I believe Freddie Mac will become profitable in 2011 and Fannie Mae is potentially within 2 years of turning profitable. I believe the regulators have acted wisely in how they’ve managed Fannie and Freddie through conservatorship. Once the companies turn profitable, the nature of the policy debate will change for the better.
2. Realization that continued existence of the GSEs makes the most sense - The Republican success in the election of 2010 makes full nationalization of Fannie and Freddie unfeasible politically. On the other hand, the private market is not capable of providing enough capital to keep the mortgage market functioning smoothly especially at the low prices Fannie and Freddie charge to accept mortgage credit risk. Evidence that the private market is not capable and/or willing to supply capital to the mortgage market is Fannie, Freddie and FHA’s combined 95% percent market share of the mortgage market since 2008. The least risky option is to continue with the current system of the GSEs but impose tighter regulation on the companies to prevent bad management.
3. Recognition that Congress will not resolve the GSE issue soon - Rationality is returning to the GSE policy debate. Cooler heads are voicing their opinions that the GSE model is not broken. We are starting to see this point made from surprising sources such as Steven Roth’s annual letter to Vornado shareholders. The problem with the GSEs wasn’t their hybrid public/private model. The problem with the GSEs was incompetent management that did not recognize the danger of low documentation loans.
4. News that the GSEs asked the Treasury to reduce the coupon on its senior preferred stock – In late January, the Financial Times ran a story saying that management at both Fannie and Freddie asked the Treasury Department to reduce the 10% coupon it receives on its senior preferred stock. Freddie Mac may turn profitable this year even after paying over $6 billion in after-tax dividends to the Treasury. If the coupon rate was lowered, then Freddie could pay back the Treasury that much faster. Plus, the fact that management asked for the reduction confirms that the companies’ financial situations are in the beginning stages of recovery.
Of course, there should be several important changes to the GSE model to protect taxpayers, such as: Fannie and Freddie should not purchase mortgage loans without full documentation of income and assets, should not purchase private label mortgage securities, should step back from the market when spreads are tight and new business cannot meet their return on capital targets, and should restrict executive compensation. A final necessary reform is a requirement that any member of the board of directors be required to purchase an amount of common stock equivalent to a multiple of their annual directors’ fees with their own cash. This would incentivize board members to provide better oversight of management. As a shareholder, I wish all of these changes had been implemented years ago.
As Freddie turns profitable and recaptures some of the capital that is artificially hidden in its accounting statements (marks on private label securities, valuation allowance on deferred tax asset and generous loan loss reserve), I believe the potential exists for them to repay some or all of the Treasury’s investment. Once Freddie regains profitability and begins to repay the Treasury, a whole new set of policy options becomes available. These new policy options would be beneficial to preferred shareholders. It has been a long road owning Fannie and Freddie preferred stock, but the Fund has made a lot of money from the positions and the potential exists for future gains. Although these positions will continue to be volatile, I continue to see several scenarios with further upside.
FHFA implies Freddie Mac will be profitable in 2011
Nov/104
On October 21st, FHFA released projections showing a range of possible additional draws from the U.S. Treasury required by Fannie Mae and Freddie Mac. The report was interesting because it included projections about the companies’ future revenues, expenses and net income. Although the projections are not detailed by income statement line item, they do imply that Freddie Mac will be profitable in 2011 and Fannie Mae will be profitable in 2013 in the base case scenario.
How do you conclude Freddie Mac will be profitable in 2011?
In the FHFA’s projections, the regulator shows a chart projecting future draws from the Treasury for each company. Here’s Freddie’s chart:
By focusing on the base scenario (or Scenario 2 in the chart), we can see that the FHFA projects Freddie Mac to require a $10 billion draw from the Treasury in the 2nd half of 2010, a $3 billion draw from the Treasury in 2011 and no draws in 2012 and beyond. The draws included payments made back to the Treasury for the Zombie Dividends* on the Treasury’s senior preferred stock, which has the usury rate of 10%. The draws from the Treasury are equivalent to Net Income Available to Common Shareholders.
“Net Income” is more useful than “Net Income Available to Common Shareholders” in determining whether Freddie Mac is a viable entity because it is not obscured by the Zombie Dividends paid to the Treasury. I reviewed the reasons why the Treasury should reduce the dividend rate on its GSE senior preferred stock in previous articles.
| 2H10 | 2011 | 2012 | 2013 | |
| Previous cumulative draw from Treasury | -63 | -73 | -76 | -76 |
| Net Income | -7 | 4 | 7 | 7 |
| Treasury Zombie Dividends | -3 | -7 | -7 | -7 |
| Net Income available to Common Shareholders (i.e., current draw from Treasury) | -10 | -3 | 0 | 0 |
| Cumulative draw from Treasury | -73 | -76 | -76 | -76 |
Using the similar information for Fannie Mae, the FHFA implies that Fannie will turn profitable in 2013.
How can you say Freddie Mac will be profitable but still require draws from the Treasury?
I am most focused on whether Freddie Mac can report profits before dividend payments to the Treasury. I view the net income line item of Freddie Mac as the best indicator of the profit earning capability of the corporate entity. I view the senior preferred stock issued to the Treasury as an expensive form of capital that can be restructured if the underlying company is profitable. For example, if Freddie restructured the Treasury’s stake in a similar manner to the AIG restructuring, the Treasury’s senior preferred would be converted in common stock and the Zombie Dividends would be eliminated.
What happens if the scenarios in the FHFA’s projections are too optimistic?
If anything, Freddie’s results might be better than the base case scenario of these projections because the assumptions behind these projections are conservative. Here are the possible areas of conservatism:
1) Zero growth in credit guaranty business – Although growth in this business has been negative single digits for the past year, this will not always be the case. With the housing market weak, mortgage debt outstanding has been falling. Plus, the FHA has recently raised prices, so I would expect for more market share for the GSEs in the short-term. The private-label mortgage securities is years away from becoming a competitor again. Growth in this business will resume with the continued recovery in the housing market.
2) No additional retained portfolio business – Although this business is mandated to shrink, I believe this assumption is more aggressive than the mandated decline in the mortgage portfolio. The portfolio is the main way the GSEs are generating revenue right now. These revenues are offsetting the losses in the credit business. I think it is foolish to shrink this business since the FHFA itself has said most of the losses came from the credit business.
3) No recognition of Deferred Tax Asset value – Based on the limited information in the projections, it does not appear as though the GSEs are given credit for a revaluation of their deferred tax-asset once they demonstrate a return to sustained profitability. Recognizing this asset will create capital in the near-term to allow an accelerated payback to the Treasury.
4) 5% drop in ABX and CMBX – This assumption has already proven false since we know these markets have been strong since the June 30, 2009 start of the projections.
5) Regulator has incentive to be conservative – Government projections have been consistently conservative coming out of the financial crisis. No one at the FHFA has any desire to raise expectations and have to reverse course down the road.
Conclusion
Fannie and Freddie are not endless black holes of losses. The total loss is becoming clear with passage of time. Eventually, the Treasury may get paid back for its capital investment into the companies. Profitable companies with poor capital structures lead to restructuring opportunities.
The point of this article is there a potential restructuring opportunity in Freddie Mac’s capital structure because the corporate entity will turn profitable in 2011. The potential reform of Freddie Mac and Fannie Mae will be near impossible as liberals want a full nationalization of the companies and conservatives want complete privatization. Neither scenario is pragmatic. The clearest path is to do no damage to the housing market and modify the current form of Fannie and Freddie. This is the path of least resistance politically and the least risky option economically.
Possible options for modifying Fannie and Freddie are to improve their business practices: 1) prohibit low doc and no doc lending, 2) prohibit investment in private label mortgage securities, and 3) give the FHFA authority over both housing goals and safety and soundness with a priority on safety and soundness.
Disclaimer – Please do not buy the common stock because you read this article. I believe the common stock does not have much upside because 1) the Treasury owns an 80% warrant on both companies, 2) there is a potential for additional dilution through a preferred for common swap to restructure the Treasury’s senior preferred stock, and 3) one or both of the GSEs could be put through receivership and wipe out common shareholders entirely.
* – Zombie Dividends – I call the dividend payments on the Treasury’s senior preferred stock Zombie Dividends because Treasury Secretary Paulson wanted the GSE’s dead at the time he put them into Conservatorship. He forced them to pay a 10% dividend rate to the Treasury on its senior preferred stock investment. No other financial institution has had to actually pay to the government a 10% rate like the GSEs have. The commercial banks pay a 5% rate on the TARP preferred stock. AIG initially had to pay a 10% rate, but it was restructured into a non-cumulative preferred stock and AIG Board of Directors has chosen not to pay the dividend since early 2009.
Disclosure – long Freddie Mac preferred stock and Fannie Mae preferred stock
Fannie and Freddie Model from Bronte Capital
Aug/091
John Hempton of Bronte Capital has written a fascinating series of articles on Fannie Mae and Freddie Mac. He models Freddie’s credit losses and revenues and comes to the conclusion that the company will earn its way to paying back the Treasury. He concludes that the way for investors to position themselves is to buy preferred stock in Fannie and Freddie.
Part I – Introduction and Where Losses Came From
Part II – Write Downs on Private Label Securities
Part III – Default Curves
Part IV – Estimates of Lifetime Defaults by Loan Vintage
Part V – Net Interest Margin
Part VI – Putting the Model Together
Part VII – Answering Criticsms
Part VIII – Risks
Not surprisingly, I completely agree with his analysis. I own a substantial amount of GSE preferred stock in Gator Financial Partners. In fact, it is, by far, my largest position.
Make Fannie’s Deal No Worse Than TARP
Aug/090
Given Freddie Mac’s recently report profitable 2nd quarter earnings report, it is time for Treasury Secretary Geithner to amend the terms of Fannie Mae and Freddie Mac’s Senior Preferred Stock Purchase Plan with the Treasury to be comparable to the preferred stock purchases the Treasury made in commercial banks last October under TARP.
Reasons to Change Fannie and Freddie’s Deal with the Treasury
1. Fannie and Freddie should not have a materially worse deal than the banks just because their deal was cut 4 weeks before TARP.
2. Fannie and Freddie are critical to the domestic economy as they have been the only source of mortgage capital for the past 12 months.
3. The mortgage market will need private capital in the future and cannot rely on government support forever, so Fannie and Freddie will have to raise more capital in the future. If the GSEs are going to raise capital in the future, the Treasury is going to have to treat existing capital better than its current deal with the GSEs.
4. Fannie and Freddie incurred higher expenses because they were team players and supported the Obama Administration’s economic recovery plan. Changing their deal would be a small payback for the support they have given the country and the Administration.
5. Recognition that placing the GSEs in conservatorship was a political attack by led by former Treasury Secretary Paulson.
6. Recognition that former Treasury Secretary Paulson caused a decline in the GSEs stock prices by not outlining the terms under which he would provide capital to the GSEs in the July 2008 legislation. Sec. Paulson then used circular reasoning in claiming that the GSEs had to be taken over because they had low stock prices and couldn’t raise capital. In fact, they couldn’t raise capital because he would not state the terms of a potential future Treasury investment.
7. Paulson’s reasoning for the harsh treatment of GSE shareholders was that shareholders had to pay for the poor risks taken by the companies’ management teams. I disagree since many shareholders were giving advice to the respective managements to raise capital and reduce risk. Rich Pzena was the most outspoken shareholder on this point. Plus, Paulson reversed his position on this issue once he was proven wrong with his handling of the Lehman situation and treated the bank shareholders on much more friendly terms.
8. Eliminating the dividend on Fannie and Freddie’s preferred stockholders was a failed experiment on the part of Sec. Paulson and destroyed the new issuance market for preferred stock. It also hurt many small banks that held Fannie and Freddie preferred stock in their portfolios.
9. GSE preferred stock is still primarily owned by small banks. When dividends are restored, the value of the preferred stock will increase by 10x. This will add approximately $30 billion in restored capital to the commercial banking industry. If banks levered this capital 12x, this raises industry lending capacity by $360 billion.
10. The losses by the GSEs since entering conservatorship have been inflated because a) they are mostly write-downs of deferred tax-assets which the companies still retain and b) the credit reserve build was bigger than expected because Sec. Paulson sent the economy into a tailspin by not providing an orderly wind down to Lehman Brothers.
Terms to Change
1. Lower Preferred Stock Coupon to 5% from 10%. There is no justification for the GSEs to pay a higher coupon than the banks.
2. Change the Treasury’s warrant from 79.99% of the GSEs’ equity to terms identical to the warrant deal received by the banks under TARP. Similar to the preceding point, there is no justification for the GSEs to give the U.S. a higher equity stake for than the banks did.
3. Make the Treasury’s preferred stock pari passu with existing preferred stock. This is another move to equal the banks’ deal under TARP
4. Eliminate asset size restrictions on Fannie and Freddie’s mortgage portfolios. This provision proves my Republican conspiracy theory for placing the GSEs into conservatorship. There is no reason to shrink the GSEs at this point. We need the GSEs to expand their balance sheets. The Fed has temporarily stepped into the breached left by the GSEs not growing. But, what is going to happen when the Fed steps back from the mortgage market? We need the GSEs to support the market as the Fed reduces its balance sheet.
The GSEs deal with the Treasury Secretary should be updated to be similar to the deal the banks received under TARP. Based on the nobler GSE housing mission, there is an argument that they should be treated better than the banks. The banks have no legs to stand on because the FDIC insurance they receive from the federal government is a larger subsidy than the implicit guarantee Fannie and Freddie enjoy.
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