A Quick Valuation of Citi

Warning: this is only another uneducated speculation easily found on, well, the Internet.

The administration announced today to convert the $25 billion preferred shares of Citigroup (C) into common, thus owning 36% of the company. Other preferred holders with a face worth of $27.5 billion will do the same.

If obtaining shareholders’ approval of the conversion (very likely), the ownership structure would be:

 

The conversion price is $3.25, while the market closed at $1.5 (down 39%). C is valued at $70 bn at the conversion price and $32 bn at the closing price.

I will do a quick calculation for justification.

Here’s the balance sheet of 3Q2008 and loss estimation.

Here’s an income statement based on the balance sheet adjusted after loss.

I know, things are missed out and the numbers are highly subjective (and historically conservative). Even though, assuming C will spend first 5 years on the built-up capital base and grow with the economy, it is worth at least $50 billion, or 10X P/E.

What makes it difficult is the known unknowns of what the administration will do to the troubled assets, and how long will the government hold the shares before re-privatization.

Will the administration lose money on this one? I seriously doubt it, or people will be mad and the President unhappy.

If that’s what you believe (i.e., the administration will sell out above $3.25 when the market allows), the answer would be a lot easier: buy the shares, guess when re-privatization will happen and calculate the expected return. For example, if the administration takes it at $3.25 now (why?) and sells after 3 years at par, you will have a 30% annual return.

Conclusion: pile in and expect someone to pull it off.

 

P.S., I can’t explain why the sell-off today. There are a lot of smart guys out there.

 

http://icecurtain.blogspot.com/

Budget 2010

This is a note on the federal budget, a must read for the pro-small-government rich people.

The complete 134-page document can be found here [PDF]. For time-conscious readers, let me show you the summary tables.

Look at the Mandatory programs, totaling $24 trillion from 2010 to 2019, or 60% of outlays. The details:

Social Security: $8.8 trillion outlays on $8.6 trillion social security payroll tax, 2010-2019. It seems balanced, but remembering that it’s pay-go based (paying yesterday’s benefits from today’s income). America is aging.

Medicare & Medicaid: $10 trillion outlays on $2.5 trillion Medicare payroll tax, 2010-2019. This is really, really bad. The president is trying hard to save money and reduce cost on this, but the problem is huge. Since I don’t see the possibility of a benefit cut, prepare for a Medicare tax hike.

Other Mandatory: i.e., veteran benefits and others from the Washington fund family, of $5.4 trillion. Blame the terrorists.

TARP and Financial Stability: $0.247 trillion leftover of TARP and another $0.25 trillion marked as Placeholder for potential additional financial stabilization efforts, or TARP 2.0. If that’s all it is, it will be quite some efforts, indeed.

Geithner promised to level it up to $1 trillion or more to de-toxicate the banks. For the astute investors to accept a price other than the market price (why bother otherwise?), he has to provide some guarantees or loss-sharing agreement. Hope he’s a good negotiator.

Tax Cut: The president kept his promise to cut tax of 95% and raise that of the better off – not a popular decision in a time of recession. The net effect 2010-2019 is $-300 billion, $940 billion cut for the former and $636 billion income from the later.

A quarter million north, don’t be upset. The budget also includes $4.9 trillion interest payment on treasury bills. Invest in America and earn the tax hike back.

 

http://icecurtain.blogspot.com/

Painfully Rich

Would you take a moment to look at this Balance Sheet? It’s of People’s Bank of China, the central bank at the end of last year (in trillion RMB).

Several items make it a bit unusual. For example, there’s a RMB 4.6 trillion bond issuance. Why not printing money instead?

Anyway, that’s not I want to tell.

What really sets it apart is that 2/3 of the assets are foreign assets, mainly U.S. treasury, in amount of $2 trillion.

This is the result of the trade (im)balance that raised much controversy. Some guys whine that the U.S. people borrowing too much from China and living beyond their means. Meanwhile, they complain that banks are not lending. Urh?

Anyway, that’s not I want to tell.

Image that you are a central banker of China, you will be equally painful. The trade surplus has shot up in recent years, almost $300 billion last year. When some toy makers turn in their hard earned US dollars, you have to hand them RMB in return. The good part is that you can just print the RMBs for the dollars, but the bad part is doing it forces monetary expansion, or it is inflationary.

The chart shows the yoy growth of foreign exchange (FRG), total assets (TTL) and reserves (Reserve). Why it has not led to inflation rate as high?

Recoup

This is so weird. China is lending out more money to the U.S. while painfully flooded by more money at the same time? 

What the heck is happening? Where did all the money come from?

Something is wrong. Helps needed. Anyone?

 

http://icecurtain.blogspot.com/

Homeowner Affordability and Stability Plan: A Comment

This is a policy comment, something I hate doing.

The administration recently announced the Homeowner Affordability and Stability Plan. It spends $75 billion to help 4~5 million homeowners for mortgage modification, so that they can keep homes from foreclosure. It attacks the heart of the problem, and it’s a good deed. Anna?

However, I’d like to direct your attention on some of the specifics of the plan:

• Refi for homeowners up to 105% of property value at lower rate, $1,000 per year for on time payment for 5 years
• $1,000 per modification for servicers
• $1,500 per modification for mortgage holders (banks)

The list doesn’t cover all aspects. But let’s look at these from the perspectives of the homeowners, servicers and banks respectively.

Homeowners

There are several types of homeowners in terms of foreclosure. I had a previous post raising the questions and nobody cares answering. Let me reiterate the point considering a homeowner facing the plan.

If you lose your primary income (job), you may not be able to afford it before/after the refi anyway. Taking the refi is a painful decision: grit your teeth while draining your saving account till it turns, w/o knowing when.

If you are a high-income earner bought a house recently, OMG, what a windfall, thanks to the recession. Bizarre, urh?

If you are a speculator that invested in a secondary house, walking away is still the wise choice.

What the plan will really save are the borrowers doped into the absurd 2/28, 3/27 mortgages, which shall not exist except as a tool of predation (or speculation. Yeah, so complicated). The plan will reduce the to-be-reset, higher rate, and allow refi homes down 20% in value.

Servicers

$1,000 per modification? I don’t see how doing a mod requires much more efforts than installing cable.

I guess why it is what it is is that servicers always choose foreclosure, the low cost option for a servicer.

Banks

Refi, reducing income of the mortgage holders (by slowing down the payments? I need some accounting help) notwithstanding, fares better than foreclosure.

If that is the case, the $1,500 per mod is a snuck-in help to the banks ($6 bn in total assuming 4 million mod, a piecemeal for the problem).

http://icecurtain.blogspot.com/

How to Save the Banks

Doing my part to help the economy, I upgraded my TV package and now I have Bloomberg. This is a recoup of watching Bloomberg all weekend.

How Bad It Is and How Much Is Needed

Financial Risks of A Bank

The bank business seems to have more potential troubles. Besides the operating risks like any other businesses, a bank has financial risks of its own kind: namely liquidity risk (funding risk), interest mismatch and credit risk.

We have seen bank runs and bank failures due largely to the funding, which has eased up by the regulators supplies of emergency funding and guarantees.

The main problem today is credit losses – significant market devaluation of MBS, corporate debt, and mortgage and commercial loan losses.

Balance Sheet, Losses and Recapitalization

On the Fed’s Flow of Fund Matrix, the U.S. financial sector at the end of 3Q 2008 has a combined balance of financial assets of over $60 trillion (figure below). Note that hedge funds and private equity funds are not included.

All of them hold big trunks of financial assets, so when the financial markets tumble all of them are in trouble of one kind or the other, depending on the nature of their businesses and what types are on the books.

Here’s an estimated total loss for the U.S. financial sector (shown in the figure below). For convenience, I made up the % loss numbers.

Since banks hold mainly credit instruments, insurance companies treasury and GSE-backed securities, the pension funds (with a heavy portion in stocks) may have hurt the most. But that seems another issue, staying out of public discussion.

As for the banks, GSEs and brokers/dealers, the accumulated loss is $1 trillion something. The loss is worldwide thanks to global financial integration. Bloomberg reported that until January 26, 2009, total bank writedowns was $792 bn, and replenished capital $826 bn (including $380 bn public money).

The credit loss will escalate up to $2.2 trillion (a Mark-to-Market number), according to IMF’s Global Financial Stability Report (GFSR) Market Update, as of January, 2009.

“The worsening credit conditions affecting a broader range of markets have raised our estimate of the potential deterioration in U.S.- originated credit assets held by banks and others from $1.4 trillion in the October 2008 GFSR to $2.2 trillion. Much of this deterioration has occurred in the mark-to-market portion of our estimates (mostly securities), especially in corporate and commercial real estate securities, but degradation is also occurring in the loan books of banks, reflecting the weakening outlook for the economy.”

How Much is Needed

If only talking about what is required to save the banking system, it is still a hard-to-know since the number depends on the design of the rescue plan, though it seems at least $1 trillion will be necessary.

Objectives, Issues and Challenges

The objective is to establish a capital base solid enough to restore the confidence of capital adequacy as well as encourage the banks to provide adequate credits to the economy. To achieve this, several issues must be solved or taken full consideration.

· Trust / Valuation

I see the phenomenon in large part a valuation issue. Facing a troubled bank, the first thing is to go through its book and assess the situation, but it is said to be an impossible task.

There are several factors. First, as they say that the financial statement is an opinion, it is more so for a financial institution because the future earning streams have to be estimated. Secondly, if you resort to market price (thus the Mark-to-Market accounting), some say that the market price is depressed today and doesn’t reflects the true asset value (which no one knows for sure because of so much other macro uncertainties), if a comparable market price is available. Besides, the innovative financial instruments (CDOs, CDS, etc.) have increased the difficulties many folds. It takes the rating agencies’ super computer running two days to rate a structured product.

The obscurity (plus the malpractices) leads to a lost of confidence that deters the much needed private capitals from financial institutions.

· Investors’ interest vs. tax payers’ money

How to balance these two seems the paradoxical issue the government is facing. On the one hand, any sign of a loss of tax payers’ money would be a disaster (instead of considering the dedicated government resource a necessary support, the public takes it more like a spending, gone already), but a gain that would be realized much later would not be an achievement; On the other hand, it takes a fair answer to the existing bond holders and shareholders of the banks at hand, who would rather prefer a liquidation.

All these becomes near impossible considering the valuation issue above. Any approach may very much produce a result that leaves each party equally unhappy.

· Moral hazard

As important as it is, the moral hazard issue is increasingly a side issue.

· Fairness: one big vs. A hundred small

The so called too big to fail. I don’t know how to play on this one. One thing is certain: the average size of banks will become bigger.

The Alternatives

Based on the stated objectives, here are the ways to go:

· Common, Preferred and Guarantees

To inject equity (common or preferred) or provide guarantees to bank assets is to reestablish the capital base and secure funding. Preferred and guarantee (and warranty) have been the common practice till today. I believe the reason that purchasing common shares has not been used is because of pricing/valuation talked above.

In other words, the authorities want a clear exit strategy, trying to prevent unexpected loss and stay out of the management process. The existing bond/equity holders are thus protected, though after taking significant loss.

The key question is how much money would be needed. Will another $1 trillion be enough?

· Nationalization

To nationalize major banks is based on the view that it is really, really bad – banks are deep under and it needs much more than $1 trillion. Still, the question of where the money comes from needs to be answered.

Think for a minute on how the government would nationalize and run a nationalized bank. Shareholders would probably be wiped out; management replaced by a banking czar, as well as some or all of board members; massive accounting writedowns are also expected.

But how the bank would be managed differently is another issue. Also, the government needs to figure out how to do an IPO after recovery.

· Aggregate Bank, Good Bank/Bad Bank

I don’t know exactly how this one works, but I believe the gist is to take the so-called bad assets off from the balance sheet into another (aggregated) bank, so that: a) it makes the cleared banks more transparent, safer and cleaner, and b) the established asset pool will be held to maturity and realize a better value than what the current market price declares them to be.

Several key issues need to be addressed. First, pricing or pricing mechanism (e.g., auctioning). Again it is a valuation issue and I doubt any pricing mechanism would work better than what is available. Second, what are qualified bad assets? When the economy is in a downward spiral, nothing is completely safe except treasury bills (which are questionable according to some). Third, it seems it would take a lot more money. It is purchasing the assets outright vs. covering the loss (part of the asset value).

What to Expect

Regardless of the rescue approach, we should expect that:

· Many banks have failed, and many more will.

I don’t want to repeat the list of the failed, but to make a prediction of the incoming wave I would refer to the Saving and Loans Crisis in the 80s and early 90s in the United States: 1617 banks (9.14% of total) with assets of $206 bn (8.98% of total) failed.

Whether we should compare now and then or if so whether it is worse this time is for you to answer. It is bad enough if the same happens today.

· A lot of public money has been spent, and a lot more is necessary

I don’t have to repeat the public record of the public money already involved, but I would say at least $1 trillion more would be needed. I was surprised when Geithner spelled out the 1 trillion number, now I wonder if it is going to be enough.

· Regulatory resources would be under serious pressure

All that said, take a look at the balance sheet of Department of Treasury, Fed, FDIC, and PBGC…

 

http://icecurtain.blogspot.com/

Sirius XM, an update

I had on the record an thesis on Sirius XM. Today, the teetering company got a mortgage of $530 million from Liberty Media.

As I have expressed earlier, the business requires maybe $2 billion more to survive, under even optimistic assumptions in the whirlwind.

Anyway, the stock price gained 50% today, still showing a high probability of bankruptcy. I can cash in and buy me a life-time supply of oat meals, or I can hold on and get diluted away.

 

http://icecurtain.blogspot.com

The Forbidden City’s Pension

Suggest some opportunity for improvement on Beijing’s newly published pension plan.

The Plan

In summary, it works like an alternative saving account. You choose a ceiled amount each month to deposit into the pension account, accumulating at an interest rate of banks’ long-term saving rate. When retired, you receive RMB 280 (from Beijing local government) plus a preset monthly payment on your accumulated pension amount till you die. The principal amount will be in your will.

The interesting point is it allows you to choose retirement age, and monthly payment rate ascend toward later retirement. The schedule:

Retirement Age	Monthly Payment Index	Equivalent Annual Interest
55	170	7.06%
56	164	7.32%
57	158	7.59%
58	152	7.89%
59	145	8.28%
60	139	8.63%
61	132	9.09%
62	125	9.60%
63	117	10.26%
64	109	11.01%
65	101	11.88%

Good for You?

How much you save thru the account is an impossible decision. You have to estimate, for example, how long you will live, and the expected long term interest rate / stock market development. Anyway, it’s a safe choice (sometimes pension funds implode, private or public), and not a bad one.

Possible Improvement

What’s more important though is a policy consideration – why not subsidize the low income?

Its correspondent in the U.S. is Social Security trust fund, which collect 12.4% of salary (50/50 from employer and employee). Benefit payment,  starting at age 65, bent toward the low income (meaning poor people get a higher return on the money).

This is my suggestion to the Beijing government. Don’t let capitalism beat socialists on socialism, or we may lose the race. There are two ways to do it, after some necessary adjustment: either increase the fixed portion (what can RMB 280 buy?) or fix the payment index for the benefit of the low incomers.

 

http://icecurtain.blogspot.com/

Satellite Radio

I bought some penny stocks of Sirius XM – it’s a recession. This is an investment thesis.

Background

TV replaced radio, like a century ago. Now newspapers seems at sunset, thanks to the Internet – the free Internet. It happened even before the recession. Call it human progress.

That said, it may well surprise you that some guys opened some radio stations and collect money from listeners. They launched satellites for broadcasting.

There were two operators, Sirius and XM. It was a cage fight from the very beginning. After 10 years, both of them never recorded a single profit, but the stock price shot through the roof until the tech bubble busted. So the two decided for a merger last year. The new name is naturally Sirius XM.

How it works

They signed up Rush Limbaugh, NFL, etc., licensed all genres of Music, launched five satellites covering North America, sells radios at Best Buy or thru pre-installation on cars, and bill subscribers for $10 a month.

It should be a sales / customer relationship driven business, and it well accumulated 19 million subscribers (6% of U.S. population), which became the CEO’s bragging rights. well deserved.

The problem was with that many fans and $1.6 billion revenue last year, it barely broke even. It has lost over $11 billion over years and $3 billion in debt – the 3-page list of debt on its 10Q reads like a textbook. With $1.3 billion due this year, it doesn’t stand a chance without taking another mortgage – a $2 billion some one.

Great timing.

What’s its worth 

Last Friday's close price labeled it at $368 million, short of $20 per subscriber. My gut feeling is it should be worth a lot more than that.

Risks

• It could file for bankruptcy in a few days.
• The churn rate is too high at 25% last year. If it’s about the car radio installation, it’s bad news these days.
• It has almost $1 billion deferred revenue on its book. I don’t know what it is.
• Its subsidiaries of equity interest is losing money.
• A lot of convertibles. You may have problem counting shares.
• People may find out that they don’t need a radio to listen to radios, and Sirius XM becomes an icon.

http://icecurtain.blogspot.com/

Foreclosure

So “housing is the problem,” as many pundits proclaims on saving the economy. I very much suspect that when they say housing, they actually mean the ever-deteriorating and at certain zip code massive foreclosures.

Admittedly plunging housing price can hurt in certain ways, but it is now also proved that there has been an asset bubble in the housing market, and its bust would reserve the inflated housing price back to somewhat normal state (although the fair price of the real estates, or any asset classes, is vague at best and nobody know for sure what it should be). At least, lower house prices may do some social good.

Why Foreclosure is the Sin

Closely linked to but different from the housing price, foreclosure is a case at the heart of the problem. This is how it feeds into the financial/economic crisis.

· Foreclosure and the resulting housing price deflation/excess supplies hits directly the construction companies, mortgage agents that have cropped up during the housing boom. The golden days are now over.

· Foreclosure generated a shockwave into the mortgage market, which has morphed over years into a long chain of regional banks, GSEs (Fannie and Freddie), securitizationers of CDOs/CLOs, SIVs, monoline insurers, and at the end of the chain a variety of institutional investors including major banks, mutual funds, hedge funds, sovereign funds, and pension funds – foreign and domestic. You may have heard the story that some Scandinavian workers lost their pension because some Californians got foreclosed upon. It’s a small, small world.

Fathom this: the U.S. mortgage market is sized $13 trillion, so that an additional 1% foreclosure generates $130 billion loss at par. In addition to the massive write-off we have already observed, financial institutions would have to fire-sell those troubled assets (deleverage) to meet capital adequacy requirement, if replenishment is not available. Those fire-sales drag down the market price and investor confidence. If the now controversial mark-to-market accounting rule (MTM) applies, it cascades into waves of book value losses. The result: drying-up of credit availability.

That said, holding back foreclosures would ease the balance sheets better than bolstering housing price could.

· Foreclosure, if not chosen, causes family grieves. As you can imagine, it is not pleasant to get foreclosed. I heard that some enforcement agents that come to help move out carry guns. Hired guns, literally. “Anna?”

The Many Faces of Foreclosure

Foreclosures are many-facet and various types deserve different attentions and treatments. So as to set the stage for a to-do list, I feel it is very much necessary to dissect the types of foreclosures.

The categorization starts with whether it is primary or secondary residence. There are well-grounded reasons to distinguish these two.

Foreclosure of Primary Housing

These are people who bought a first house as a home.

· Family A: the family faces foreclosure when they lose major source of income due to, for example, recent job loss – happening at a brutal rate of half a million net in each of the recent three months. They are unfortunate people, but not necessarily low-income ones – some belong to the proud jumbo type.

· Family B: the family has a stable income but fell victim to the fancy mortgage innovations (2/28, terser rate, ARM, HELOC, and whatnot), very possibly without a full knowledge of what they bought. When the rates reset, they suddenly found that they cannot afford it.

In short, they tripped over on predatory lending. Some online pieces exposed that mortgaging was so hot a profession that guys with criminal records got hired by imprudent mortgage peddlers. In certain areas where predatory lending became standard practices, why does that make a difference?

One more thing. I found it absurd when some talking heads blaming “people taking mortgages they couldn’t afford.” Few people would sign mortgage contracts when drunken.

Foreclosure of Secondary Housing

These are people who owned houses and borrowed to purchase a second house, a third house, and so on, many expecting to resell back into the trending-up for a capital gain.

· Family C: a well-off family that put down some extra cash for down payment and took mortgages and invested in extra houses. When housing market tumbled, they chose to foreclose it – “just take the house and forget the debt.” Credit score many get hurt, but according to some reports it is ironically a sensible choice against taking a $100,000 portfolio loss. Funny.

· Family D: this family is wild speculators. They took mortgages to buy a second house, possibly on a 2/28, and anticipated to take a short-term ride and cash in for a profit. Some guys allegedly loaded up to seven extra properties, fueling them with rent money. When the trend went south, the plan got smashed.

Types other than the above and combo types notwithstanding, I guess the four represent most of the home buyers. However, beware that I leave one crucial question unanswered: what is the portion of each, geographically? I doubt I would be able to obtain such info to make my parsing valuable.

Possible Solutions and Setbacks

Here’s what I think should do, with noticeable distinction between the primary- and the secondary-type: Do workout for the former, let go the latter. The reason is simple. The former has the incentive and will to keep their (only) homes, aka the quintessential part of the American dream, though some help is necessary.

The way to do it (the workout) is to reduce the installment payment level by extending the length of payment and reducing rate/refi. Both are getting done as of this moment today to a certain extent.

Besides the technical issues given the complicated value chain of mortgage slicing and dicing, there is a risk: the Type-A family may still not able to afford the worked-out arrangement or may re-default after a while. For them, the key is income/employment, and this is exactly the very challenging issue of the economic crisis.

The weird thing is: you take down the mortgage rate for those facing difficulties, a side benefit occurs for those don’t need help – their home purchase cost also fall, and it may not be what you aim to achieve.