Citi’s dirty pool of assets

August 12, 2009

Hard as it may be to believe, shares of beleaguered Citigroup are on fire.

The stock of the de facto U.S. government-owned bank is up some 300 percent after it cratered at around $1 back in early March.

The over-caffeinated stock maven Jim Cramer keeps calling Citi a “buy, buy, buy” on his nightly CNBC television show. Even the more sober-minded writers at Barron’s are pounding the table a bit, predicting Citi shares could double in price in three years.”

Time out! It’s far too soon for anyone but stock flippers and fast money hedge funds to buy Citi right now.

That’s because there’s still a world of hurt for Citi in the $83.2 billion in subprime mortgage-backed securities, corporate loans, home loans and commercial real estate mortgages that the bank’s finance team has stuffed neatly into something called the “Special Asset Pool.”

But there’s nothing special at all about these assets. This cesspool of toxic securities and floundering loans is the worst of the stuff that’s been stinking up Citi’s balance sheet.

And these rotting securities and loans represent a good chunk of the $300 billion in problem assets the federal government is guaranteeing under its bailout of the giant bank.

Yet what the cheerleaders for Citi sometimes forget is that the struggling bank must absorb up to $39.5 billion of the “first loss” on those troubled assets. To date, Citi says it has incurred $5.3 billion in losses on this pool of toxic assets — meaning the bank has another $34 billion in losses to soak up before the taxpayers start footing the bill.

And the way things look today, Citi is looking at a good deal more losses to come from its Special Asset Pool.

For starters, Citi still sits on a rather sizable portfolio of subprime-backed collateralized debt obligations — the dubious securities that helped spark the financial crisis.

At last count, Citi valued its CDO portfolio at $9.6 billion, a 56 percent decline from the value the bank placed on those securities last summer. To protect itself against a potential default on those CDOs, Citi has hedged its exposure with some $4.5 billion in credit default swaps.

But unfortunately for Citi, it didn’t buy those insurance-like derivatives from American International Group, another big bailout recipient.

If Citi had been shrewd enough to have done business with AIG, it would have been able to sell its CDOs at face value to an entity set up by the Federal Reserve, just like Goldman Sachs, Deutsche Bank and Merrill Lynch and other big banks did. In a flash, Citi’s CDO problem would have disappeared.

Citi, however, had the misfortune of purchasing its CDS from Ambac Financial Group, a bond insurer that many see as being on its last legs. The bond research firm CreditSights says Ambac “may run out of capital sometime in 2013.”

Many others think Ambac’s demise could come much sooner. On August 7, Ambac, which trades around $1, reported a larger than expected $2.4 billion second-quarter loss.

A collapse of Ambac would render the CDS that Citi holds on its CDOs all but worthless. (For related news click here).

To date, Citi, which declined to comment on its CDO exposure, has written down the value of those insurance-like derivatives by more than $1 billion, according to regulatory filings.

Even if Ambac survives in some fashion, Citi is likely looking at additional write-downs on those contracts, and potentially on the underlying CDOs they are supposed to insure.

Citi also could take more hits on some $6.2 billion in private equity investments and $8.5 billion in loans that financed debt-laden buyouts. The bank also reports having some $10 billion in Alt-A mortgages — a home loan that’s a step above subprime — and $8.3 billion in still largely untradeable auction-rate securities.

To be fair, Citi has been aggressive in writing down the value of its $10 billion in so-called Alt-A home loans to $1.7 billion. The bank has been equally aggressive in reducing its exposure to commercial real estate loans. The bank has marked down the bulk of its $28 billion in commercial real estate-related assets to $5.1 billion.

So it would require substantial defaults in both categories of loans for Citi to incur large losses.

But to say Citi isn’t going to suffer any more losses in this pool of toxic assets is way premature. And none of this analysis has focused on the $183 billion in loans to cash-strapped consumers on Citi’s books that could still go bust.

In short, the safest bet on Citi shares is still a short one.


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