Commentaries

Geithner of Oz

Earlier today I wrote that Sheila Bair is one of the few financial regulators who gets it. And by getting it, I mean not sucking up to the banks and the big money interests on Wall Street. You know, the guys (and most of them are guys), who got us into this financial mess. Tim Geithner, on the other hand, is a regulator who just doesn’t get it.

It’s not that the Treasury secretary isn’t smart–he is. And it’s not that he’s not up to job–he is. It’s that Geithner is too much of a politician and his views have been molded by people who work on Wall Street.

So, that’s why we have Geithner telling The Wall Street Journal today that Wall Street isn’t reverting back to its old ways–even though everything indicates that’s exactly what is going on. In Geithner’s world, things are getting better and the banks are becoming better citizens:

I don’t think the financial system is reverting to past practice, and we won’t let that happen. The big banks are running with much less leverage now, much more conservative liquidity cushions. There has been a significant shrinking of their balance sheets, getting rid of bad assets and cleaning up. And the weakest parts of the system don’t exist anymore.

But Geithner lives in the land of Oz. A land where we should ignore the man behind the screen and all the toxic assets that still line the balance sheets of the nation’s banks.

The trouble is the rest of us live in the real world where the roads aren’t paved with gold bricks.

Citi’s dirty pool of assets

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.

Trust still matters

Trust is one of those touchy-feely words that gets thrown around a lot, but whose true value isn’t felt until it’s lost.

The Congressional Oversight Panel’s latest report on the troubled assets still embedded in bank balance sheets reminds us that one of the first casualties of the credit crisis, trust, is still up for grabs.

Those toxic assets that started the whole mess, culminating in last fall’s financial market meltdown, are still there — they’re just harder to see.

This is so even after the government has pumped trillions of dollars into the financial system, including the $700 billion of funds initially targeted at removing those assets, but redeployed to vulnerable financial institutions themselves.

Trust is one of those things that bind financial markets together. When it’s breached it can get ugly, with last year’s maelstrom one of the worst examples.

While it’s unlikely we’ll see again the likes of the mayhem last fall, the persistence of toxic assets on bank balance sheets means some financial institutions remain vulnerable should they lose the trust of the investors and taxpayers who have kindly supported them so far.

For the moment, the markets don’t seem too worried, since euphoria about the expected rebound in the economy means few are thinking too much about the niceties of whether bank executives or policy makers can be trusted to do right by shareholders and taxpayers. (UPDATE: The stock market decline Tuesday and climb in Treasury yields, however, shows how fragile confidence in the recovery and the financial sector is, however.)

Toxic bonuses, Credit Suisse’s one hit wonder

At the height of the financial crisis, Credit Suisse came up with a clever idea to offload dodgy assets without having to sell them at knock-down prices. It stuffed $5 billion of them into a bonus pool for its bankers.

The Swiss bank’s scheme — which includes leveraged loans and commercial mortgage backed securities — exposed 2,000 senior Credit Suisse bankers to the value of those toxic assets. They were given 70-80 percent of their equity compensation in the form of so-called “partner asset facility” (PAF) units linked to the performance of the assets. The rest of the bonus was in the form of share units.

Under the PAF scheme, bankers receive semi-annual coupon payments (of LIBOR plus 250 basis points) on the initial award value. And they can look forward to annual cash payments — depending on the performance of the assets — after five years.

This was smart PR by Credit Suisse, which paid bonuses to its senior staff without attracting quite the odium that other banks did. That was because it was felt to have lumbered the bankers with some of the toxic dross they were collectively responsible for originating, rather than leaving it all in the laps of the shareholders.

Despite some griping at the time, it now looks as if the bankers haven’t done so badly either. Thanks to a partial recovery in credit markets, the PAFs are worth more than they were when the bank dropped them in the pool. The Wall Street Journal is reporting that the toxic assets have returned 17 percent since January.

Of course, had the bankers been paid fully in Credit Suisse equity, they would have done far better. Its shares are up around 83 percent over the same period.

CEO Brady Dougan and investment bank boss Paul Calello are probably relieved that the fund has so far come good given the dangers of bankers being lured elsewhere. But PAFs are likely to be a one hit wonder, after all banks won’t want to make a habit of having large, illiquid portfolios to find a home for.

Sir Win FTW at Lloyd’s Banking Group

It’s good to hear that Win Bischoff has a list of priorities in his new role as chairman of Lloyds Banking Group <LLOY.L>. Reviewing the position of chief executive Eric Daniels is apparently not at the top of it.

So what should he be doing when he formally takes the chair on Sept. 15?   The first thing is to accelerate the integration of HBOS into Lloyds. The group needs to stop dribbling out restructuring announcements (a few job losses here, a few there) and come clean about what it needs to do to secure the synergies that were promised from this ill-starred transaction.

True, promising to cut tens of thousands of jobs in the middle of a recession would be politically unpopular. But it would allow Bischoff to argue that Lloyds is doing what needs to be done in the interests of taxpayers, who own a large chunk of the bank. More importantly, it’s the single most direct thing he can do to drive up the share price.

Second, he needs to shepherd Lloyds through the European state aid process more or less intact. If the Commission forces it to make significant disposals, Bischoff needs to ensure that the group has plenty of time in which to make them.

Third, he needs to nail down Lloyds’s participation in the UK government’s asset protection scheme. The details still aren’t known even though it was announced months ago. Finalising the APS would allow Lloyds to segregate all the nasty HBOS corporate loans and other junk into a bad bank and run it off. Shareholders will know the basis on which they have been backstopped.

Eric Daniels may not be top of Bischoff’s list, but he should at least be fourth. Daniels has lost the confidence of shareholders. It isn’t just a question of the disastrous HBOS merger which occurred on his watch; Daniels has since become an invisible man surfacing only occasionally to make eccentric remarks, such as his observation to a parliamentary committee that his salary of more than 1 million pounds was “relatively modest”. Bischoff should start looking for a replacement.

Next, he should find a new owner for Scottish Widows, the insurance group Lloyds bought for a staggering 7 billion pounds in 1999. The group has retained Widows because it is allowed under current regulations to double-count the insurer’s embedded value towards its own capital. That will run out in 2012, leaving Lloyds with another hole in its balance sheet. If it’s to find a buyer at an acceptable price it needs to start looking well before that drop dead date.

The Citi dump

City landfills aren’t pretty places. Much the same can be said for Citi Holdings, the newly formed dumping ground for Citigroup’s most ailing and malodorous assets.

Earlier this year, the de facto government-owned bank created Citi Holdings as a repository for assets that it either planned on selling or would simply have a hard time giving away. In truth, Citi Holdings really isn’t a distinct company. It’s merely part of a PR strategy to get investors to focus on the businesses that are going well at Citi and which are housed in a so-called good bank called Citicorp.

But Citi Holdings holds the key to gauging just how long the bank will remain a ward of the state.

Now technically, things looked good at Citi Holdings in the second quarter, according to the results released today. But that’s only because Citi Holdings benefited from the closing of the Smith Barney joint venture with Morgan Stanley.

Strip away the $11.1 billion in pre-tax dollars from that deal and you get a good look at the problems that persist at Citi.

One of the biggest lines of business dumped into Citi Holding is the bank’s North American consumer lending operation, which includes homes, auto, student and personal loans. And the numbers for consumer lending are plain ugly. The group accounts for 83 percent of the $9.85 billion that Citi Holdings has set aside to cover losses on all credit and loan losses.

Particularly troubling is that the percentage of home loans to North American borrowers that are now delinquent is up to 6.52 percent. At the end of the first quarter the percentage of home loans past due was 5.9 percent and a year ago it was a little over 3 percent. Those numbers don’t suggest much improvement in the housing market and raise the prospect of ever higher delinquency rates as the unemployment rate creeps higher and higher.

A Tale of Two Citi’s

Here’s a summer quiz: Identify the following two US banks:

1. This institution has been profitable throughout the credit crisis. Last year, it reported net income of $6bn on revenues of $60bn, despite taking big hits in its consumer operations in North and South America in the fourth quarter. At the end of the first quarter the bank had total assets of $958 billion, supported by a healthy deposit base of $660 billion.

2. The second institution lost a massive $36 billion last year. Even net revenues were negative to the tune of almost $7 billion. This bank had a $662 billion balance sheet at the end of the first quarter, but deposits of just $88 billion.

The answer: they’re both Citigroup.

If anyone was still wondering why Vikram Pandit is planning to split the ailing megabank in half, Citi’s restatement of its historical financial data provided the answer.

Citicorp, which includes the retail, commercial and transaction banking businesses, is a financial powerhouse. Citi Holdings, which owns the consumer lending and brokerage businesses – as well as a huge pile of toxic assets - is a financial dumping ground. No prizes for guessing which half Pandit will be focusing on when Citi reports second-quarter earnings on July 17th.

Unfortunately for shareholders, shortly to include the US government, the split is pretty meaningless. No matter how well Citicorp performs, it will count for little as long as it’s still attached to Citi Holdings. If these figures are any guide, the two will be conjoined for a very long time.

The shuffle Citi needs

Citi CEO Vikram Pandit keeps moving around the deck chairs, but the one chair he still won’t move is his own.

The latest management shuffle at Citi seems more designed to appease the federal government–the bank’s largest shareholder–than anything else. Moving people in and out of jobs gives the appearance that Pandit is really shaking Citi up. (Here’s a report from Reuters on the latest management shuffling).

But the reality is things can’t really change at Citi until Pandit leaves the stage. Of course, the problems at Citi long predate Pandit’s arrival. But it’s hard to see how Citi will revive itself without an entirely fresh management team and board.

Frankly, what Pandit should be more focused on right now is cleansing the bank’s balance sheet of toxic assets. Citi should be one of the biggest sellers of toxic assets to the dramatically scaled back PPIP.

It also would be nice to see Pandit take up my idea of donating toxic assets to needy charities–a move that could allow the bank to offset some of the inevitable writedowns with a tax break.

On that score, the most puzzling shakeup is the departure of Gary Crittenden, Citi’s former CFO, who earlier this year became chairman of Citi Holdings. That’s a new entity set up by the bank to essentially become the holding company for some $300 billion in toxic assets and other operations the bank is looking to spin-off.

In the press release, Pandit says Crittenden is leaving the bank to move to Utah to spend more time with his family and pursue other interests.

The PPIP let down

Details on the government’s PPIP program – the one designed to suck out the venomous assets still coursing through bank balance sheets – is out and the amount of money dedicated to the task looks underwhelming.

From the joint statement issued by Treasury, the Fed and the FDIC.

Under this program, Treasury will invest up to $30 billion of equity and debt in PPIFs established with private sector fund managers and private investors for the purpose of purchasing legacy securities.

Reuters is reporting the plan is to purchase $40 billion of assets, so presumably the private sector will kick in $10 billion.

Compare this with the initial hoopla announcing the plan in March:

Using $75 to $100 billion in TARP capital and capital from private investors, the Public-Private Investment Program will generate $500 billion in purchasing power to buy legacy assets – with the potential to expand to $1 trillion over time.

When the tough gets going, securitize!

The FT has a report that banks are looking to slice and dice risky assets on their balance sheet so they can unload some of the capital-gobbling securities to investors. The banks argue that this type of securitization is different than those CDOs that helped suck the financial system into a sinkhole since it doesn’t rely on leverage and it’s more transparent.

The appeal for the banks is obvious. From the FT:

BarCap’s structures involve the pooling of assets from several clients into a secured financial product that can be sold on to other investors and rated by a credit rating agency, potentially reducing the capital allocated against the assets by between 10 per cent and 50 per cent.

Not sure branding it “smart securitization” as Barclays Capital does is the best tactic, however, given investors’ wariness of all things labeled “smart” or “sophisticated.”  Clever financial engineering, after all, brought the global financial markets to the brink last year.

Moreover, I don’t think re-securitization of problem assets is the way to go for the long haul since it simply shifts the risk around again. It also doesn’t stimulate new lending since it’s not packaging new loans, but just repackaging old ones.

But increasingly, this seems to be the way big banks are attacking the problem of unwanted assets. Securitization of old structured products, or re-Remics, in the commercial mortgage-backed securities market has been gaining momentum since Standard & Poor’s warned about pending downgrades for highly-rated CMBS tranches in late May. Still, the deal sizes have been relatively small, with a recent deal, the CGCMT 2009-RR1, totaling just $87 million, according to IFR.

Just how much appetite is out there for repackaged assets is still a big question mark. How regulators will view the latest innovation from Wall Street could also be an issue.