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Citi Makes Loss Look Like Gain

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Accounting for differences of opinion.

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On yesterday's Buzz, Mr. Practical highlighted what I believe may be the most important, yet least reported, element of the proposed sale by Citigroup (C) of $12 billion of leverage loans – 20% recourse to Citigroup.

I raise this, because I believe that we are about to see a flurry of deals which purport to be sales, but which, from a risk transfer perspective, represent nothing more than an accounting arbitrage that ultimately results in expensive financing.

For Citigroup, I believe the decision to sell these loans came down to one simple question, "Is the current market value of these higher or lower than our expectation of loss on the portfolio?"

My guess is that Citigroup concluded that the market value was lower. And by structuring the transaction with recourse, and thereby getting a higher market price from the buyers, Citigroup is now able to record a "gain" on the transaction that represents the difference between the market value and Citigroup's own forecast of losses on the loans– and, by the way, the amount of recourse provided by Citi doesn't matter (10%, 20% even 50%) – the key accounting element for gain or loss purposes is Citi's own forecast of loss.

With recourse of 20%, I would suggest that what Citigroup has fundamentally completed is financial equivalent of the separation of orange juice into water and concentrate – with Citigroup keeping the concentrate and selling off the water.

As I stated above, I have no doubt that we will see a flurry of these deals. With the LBO market closed, and private equity firms struggling to figure out what to do, I expect that they will pile in to buy what they believe are cheap assets.

However, understand that if the current price to be paid for equity is wicked dilution (TPG and Washington Mutual (WM)), the price for asset "sales" will be wicked levels of recourse. But to me, the net of both is the postponement of the day of reckoning.

At the bottom, you can't sell equity at any price and loans are sold (and I mean truly sold without recourse) at firesale prices.

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Position in SKF options.
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