Below is a missive from Minyan Peter, who has become quite popular around the 'Ville with readers and professors alike with pieces like A Bird's-Eye View of the Credit Conundrum and Brave New World for Debt Issuers.


Judging by the market’s reaction to Citigroup’s (C) news yesterday, all of the company’s problems are behind it. In the interest of suggesting that there may be another side to the story, here are some of my observations from Citigroup’s tape message.

First, I think it is important to recognize that while the point of maximum pain was in August, the writedowns that Citigroup announced yesterday are a combination of actual losses realized during the quarter as well as changes in asset valuation from the beginning to the end of the quarter. In other words, a large part of the writedowns reflect values as of last Friday, not in the middle of August. In all likelihood, the market to market losses in August were considerably worse than what Citi reported yesterday.

Second, Citigroup stated that forecast earnings for the quarter will be down 60% from the third quarter of 2006. By my math, that suggests Citi will earn roughly $2.2 bln. Even disregarding Comprehensive Income Losses (which I anticipate and will flow through capital) Citi’s earnings this quarter will not cover the dividend - $2.7 bln. As a result, stockholders' capital at the end of the quarter will likely be lower than at the beginning. This is particularly troubling when you read that “[Citi] will have additional assets as some portion of our leveraged loan commitments, and drawn liquidity facilities that we have for CP conduits, will remain on our balance sheet.”

Over the past four quarters, Citigroup’s balance sheet has grown by 36% (roughly $600 bln) while capital has grown by only 11% ($12.4 bln). Further, a significant part of the build in Citigroup’s equity base came through the issuance of trust preferreds. In fact, total trust preferred rose from $6.2 bln to just over $10 bln. Needless to say, based on Citigroup’s forecast, Tier 1 capital will likely be less than the 7.9% reported at the end of the second quarter, and well below the 8.6% reported a year ago.

Further, in going back through Citi’s prior period balance sheets, it appears that the bulk of the funding for the $600 bln in asset growth over the past year came not through deposit growth (up $127 bln), but through short term borrowings (up $92 bln from $72 bln to $167 bln) and long term debt (up $100 bln to $340 bln). Citigroup’s reliance on the institutional credit markets is as high as it has ever been.

Third, I found Citigroup’s comments regarding its securitizations of particular concern:

“First, we [Citi] expect a downward adjustment in the valuation of the residual interest which gets marked to market that we hold on our credit card securitizations. This was driven primarily by an increase in short-term funding costs as commercial paper spreads widened significantly during the quarter. Second, the receivables securitized this quarter were of higher credit quality and therefore had lower yields than those securitized in last year’s third quarter, resulting in lower securitization revenues in the current quarter.”

While I can appreciate the fact that LIBOR based borrowing costs have squeezed credit card excess spreads, the comment on adding higher quality assets to Citigroup’s securitizations is a red flag and raises the question as to why Citi may feel compelled to shore up its credit card deals at this point.

Which brings me to my last comment. In its discussion of reserves for its Consumer credit portfolios, Citi stated:

“First, our reserve increase reflects a change in our estimate of losses inherent in our portfolios, but not yet visible. For example, if a mortgage customer is making payments a few days later than normal or even into the grace period, this behavioral pattern can be correlated with future delinquency and future losses. Our reserve build this quarter reflects such behavioral patterns that we are observing in our portfolio as well as an enhancement to our loss estimation process.”

Clearly Citi sees something of concern in its portfolio, and while it has not (and may not) manifest itself through traditional delinquency statistics, based on what it sees, losses are going to rise.

While I will readily accept that Citigroup and others in the industry have come clean on the earnings impacts of August’s credit market “thunderstorm”, I firmly believe that the deterioration in consumer credit is just beginning. And when you combine that with the heightened leverage and “hot money” funding that most of the major financial institutions have come to rely on, I find it difficult, based on Citigroup’s own words, to believe that the whole storm has passed.

Too bad Citigroup got rid of the umbrella logo a few months ago. It's going to need it.