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Subprime Credit Woes Echo with Bad News
At issue are wretchedly named collateralized debt obligations (CDOs), entities that issue securities often backed by subprime mortgages pooled in tranches and sold to investors based on their risk tolerance. These culprits exploded on Merrill Lynch's balance sheet and cost Stanley O'Neal his CEO job, and now at Citi their Chief Executive Charles Prince is expected to offer his resignation.
The critical issue is Citi's exposure through financing commitments to about a dozen CDOs, including three managed by executives of the Bear Stearns (BSC ) hedge funds that cratered this summer amid the subprime meltdown. Citi garnered fees from underwriting these investments, but it also agreed to cover nearly 90% of the financing backing for the CDOs if the commercial paper market seized up... and the asset-backed segment pretty much has.
Just to be clear: This exposure by Citi is a separate matter from other arcane financial products in the news called structured investment vehicles, investment pools that also use short-term funding. Citi has a huge stake in the success of a proposed $80 billion SIV megafund to resuscitate that market. Citi set up many SIVs, yet has no clear legal obligation to cover losses.
However, this dozen or so CDOs in question could cost Citi dearly in the form of writedowns and future earnings hits. An estimate, based on the free fall in asset prices that whacked Merrill's CDOs and the hits some SIVs have taken, suggests Citi could face a $1 billion or so loss. That number assumes that the value of securities backing the $20 billion has fallen 15%. (That's conservative, given the 20% and 30% declines reported by others.) Do the math, and you get a $3billion loss. Citi's commercial paper obligations cover the most senior tranches of these CDOs. Citi is on the hook for any losses above $2 billion, leaving the potential $1 billion exposure.
Citi declined to discuss its CDO exposure. The bank has yet to file its complete third-quarter earnings statement with the Securities & Exchange Commission, a disclosure that may shed more light. It's possible Citi might have hedged some of the risk.
It's not the only firm that may be vulnerable. A handful of other banks, including Barclays (BCS ), WestLB, and Bank of America (BAC ), struck similar financing arrangements. WestLB says its deal problems are resolved. Barclays and B of A declined to comment. In all, there are roughly $100 billion worth of CDOs in which banks are on the line for much of the financing, according to JPMorgan Securities (JPM )... with Citi being the biggest player. "All of [this commercial paper] is probably back on someone's balance sheet," says Kedran Garrison Panageas, a JPMorgan CDO analyst. "My guess is there's going to be some train wreck here," adds J. Edward Ketz, a Penn State accounting professor.
Estimating the value of CDOs is tricky, given that they are complex, opaque, and rarely traded. That's why many people judge them by the credit ratings on their assets, which for Citi's deals were almost exclusively AAA and AA. But "just because a CDO portfolio hasn't been hit with a lot of downgrades doesn't mean it won't in the future," says Douglas J. Lucas, head of CDO research at UBS.
A quick survey of the structured finance terrain turns up bad omens for Citi. In mid-October the Rhinebridge SIV... part of the collection that prompted the rescue fund... reported a 20% decline in the value of its assets in three days, yet some 89% of its holdings had a AAA rating, according to S&P. Meanwhile, Merrill cut the value of its AAA-rated stakes in CDOs by an average of 30%. On Oct. 30, Swiss bank UBS increased its quarterly writedown by $700 million from what it predicted four weeks prior, citing the dropping prices of CDOs and mortgage securities.
Nonpublic trustee reports reviewed by BusinessWeek for two Citi-backed CDOs also offer a rare glimpse into the underlying assets of such portfolios. A close look at the holdings for KLIO II Funding and KLIO III... two CDOs that were run by Bear Stearns... shows that about 40% of their portfolios were invested in securities backed by subprime mortgages. These assets, and KLIO stakes in other CDOs such as Knollwood, Porter Square I, and Commodore II, could be ripe for downgrades in the future. Complicating matters, the two Bear Stearn hedge funds traded securities with at least one of the KLIO CDOs. Now, Citi may have to fight with creditors of the bankrupt Bear hedge funds over the CDOs' assets... just one more cloud over Citi's holdings.
The CDOs backed by Citi may have a better pedigree than those that hurt Merrill. They were assembled mostly in 2004 and 2005, when mortgage lending standards were stronger. However, delinquencies on mortgages from 2005 are starting to climb. S&P recently cut the ratings on 402 bonds backed by mortgages that were issued in the first nine months of 2005. The CDOs that own those bonds stand to be downgraded next... potentially setting off a chain reaction that could knock down Citi's CDOs. For example, 18% of the investments in Saturn Ventures II (a CDO that Citi underwrote in 2004 and one for which the bank agreed to provide backup financing) have been downgraded, according to UBS Research.
Citi earned substantial fees on these structured-finance products. Those KLIO deals that Citi underwrote brought in $22.3 million in underwriting fees. And the bank also collected fees of an estimated $40 million a year for offering backup funding on the CDOs that are now in doubt. Now it's payback time, and this could mean a world of earnings pain for Citi.
Citigroup's board plans an emergency meeting on Sunday, and Chief Executive Charles Prince is expected to offer to resign, according to the Wall Street Journal.
The Journal cited people familiar with the situation. Citigroup spokesmen declined to comment on the report.
Citigroup posted a 57% profit drop in the third quarter after taking billions of dollars in write-downs of debt tied up in the tight credit markets and defaulting mortgages. Speculation about whether Prince would leave has been swirling in the market since then.
Many investors expect Citigroup to take similar, or perhaps even larger, write-offs in coming quarters.
Analysts have downgraded Citigroup and other major financial institutions in recent days because of concerns about their debt holdings and potential write-offs.
Deutsche Bank analyst Mike Mayo estimated in a note late Thursday that the investment banks will need to take an additional $10 billion in write-downs in the fourth quarter, and that Citigroup's share would amount to $4 billion.
Citigroup's stock has lagged its peers in the four years Prince has headed the bank. Citigroup closed down 78 cents, or 2%, at $37.73, but pared even steeper losses on the report that a meeting might be held.
After Citigroup warned in early October that the credit squeeze would hurt its bottom line, the bank combined its investment banking and alternative investments businesses into one unit led by Vikram Pandit, who had led Citigroup's alternative investments unit. Tom Maheras, co-CEO of the investment banking unit, left.
But at the time, Citigroup executive committee chairman Robert Rubin and Saudi Arabian Prince Alwaleed bin Talal... Citigroup's biggest individual shareholder and once a critic of Prince... expressed their support for the bank's embattled CEO.
Chuck Prince’s future as chairman and chief executive of Citigroup hung in the balance on Friday as directors of the financial services giant prepared for an emergency meeting on Sunday.
The board is expected to decide on Mr Prince’s future after being briefed on the futher losses it faces on holdings of mortgage-backed securities and other investment that have been hit by the credit market turmoil.
One large investor said: “They may call for his head or accept his resignation. Or they may give him one last chance.”
Mr Prince’s critics hope that the board has become emboldened by this week’s ousting of Stan O’Neal as chairman and chief executive of Merrill Lynch, following an $8bn writedown on its mortgage-related holdings. But some fear the directors will continue to resist the calls for Mr Prince’s removal.
Robert Rubin, the former Treasury secretary who sits on the board as Mr Prince’s closest adviser, is expected to play a key role in the meeting. He is highly respected by other directors and could serve as a temporary replacement for Mr Prince.
Citi’s shares fell 11 per cent this week as analysts increased their estimates of the further losses it is facing on mortgage-backed securities and some speculated that the company might even be forced to cut the dividend to preserve capital.
The dividend has been the main support for the share price in recent years as Citi’s earnings have stagnated. The shares are now down 32 per cent this year and have fallen 19 per cent since he was appointed chief executive four years ago.
Mike Mayo, analyst at Deutsche Bank, on Friday predicted that Citi could be hit with another $4bn of write offs in the fourth quarter.
Speculation about Mr Prince’s future has mounted since the company announced a 57 per cent slump in third quarter earnings after $3.3bn of writedowns and credit trading losses together with increased reserves for future consumer loan losses.
The losses were particularly embarrassing for Mr Prince who told the FT in July that Citi was “still dancing” in the leveraged lending business even as the crisis in subprime mortgages was turning into a broader credit squeeze.
Like Mr O’Neal, Mr Prince has lost the confidence of many senior executives. Athough most believe his strategy is right, particularly his determination not to split the up group, there is enormous pressure for change internally.
At Citi there are also relatively few potential long-term successors. Vikram Pandit, a former senior Morgan Stanley executive who was recently appointed head of all Citi’s institutional businesses, is thought the most likely internal candidate. But he has been at Citi for only six months.
A Citi spokeswoman declined to comment.
Update:
Citigroup, reeling from its exposure to billions in assets backed by volatile home loans, has appointed a triage team led by one of Wall Street’s best-known fix-it men.
Citigroup is expected to write down as much as $11 billion in subprime-related assets next quarter and is seeking a new chief executive to succeed Charles O. Prince III, who resigned over the weekend.
The situation is not quite comparable to the collapse of Long-Term Capital, which lost $4.6 billion and had to be bailed out by a coalition of banks brokered by the Federal Reserve Bank of New York.
But Citi is facing a free-falling stock price and rumors that the company could be broken apart.
Citigroup’s stock, which reached a four-and-a-half-year low on Monday, fell further today, closing at $35.08, down 82 cents, or 2.3 percent.
Stuckey will run the Sub-Prime Portfolio Group, which the bank formed after saying on Sunday it would write down $8 billion to $11 billion in subprime losses. Chief Executive Charles Prince also resigned on Sunday.
Citigroup has $55 billion in subprime exposure, including $43 billion of "super-senior" collateralized debt obligations (CDOs) for which there are no buyers. These securities were once thought safe despite being linked to lower-quality mortgages.
The bank said its projected write-down might reduce net income by $5 billion to $7 billion, equal to three or four months of profit. It said the write-down might grow larger if market conditions worsen.
Citigroup shares closed down 82 cents, or 2.3 percent, at $35.08 on the New York Stock Exchange. The 24-stock Philadelphia KBW Bank Index (.BKX: Quote, Profile, Research), which includes Citigroup, rose 2 percent. Citigroup shares are down 37 percent this year, while the KBW index is off 17 percent.
Merrill Lynch & Co Inc (MER.N: Quote, Profile, Research) last month took an $8.4 billion write-down largely caused by mortgage exposures. That prompted the October 30 ouster of its chief executive, Stanley O'Neal.
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