It is likely that one metric in John Paulson’s analysis of the financial sector in 2008, and his decision to bet against it, had much to do with his recent $1.4 billion Q-3 investment in Citigroup (C). In his 2008 end of the year letter to investors Paulson said that “the problem with many banks is that they don’t have enough tangible common equity to absorb anticipated losses.”
Tangible common equity is a subset of shareholder equity that does not include preferred shares or intangible managed assets. It is a measure of what common shareholders would receive if the company were liquidated. A similar metric is tier one common equity. It is a more arbitrary figure and is calculated using risk weighted assets.
There is a difficulty in interpreting bank evaluations of shareholder equity. The Federal Reserve used tier one common equity in their stress test analysis and many of the money center banks now highlight a tier one common ratio in their reporting. That metric, as we have said, is open to interpretation and does allow banks wiggle room to write down asset value. The basic tangible common equity ratio is the best indicator of shareholder value but banks have their own way of computing that ratio. (TCE, as defined by Citigroup, represents Common equity less goodwill and intangible assets, excluding mortgage servicing revenue, net of related deferred tax liabilities.)
In February of this year Citigroup C.E.O. Vikram Pandit said that his goal was to increase the company’s tangible common equity by an exchange of preferred shares for common stock. He hoped to increase TCE in the 4th quarter from $29.7 billion to $81 billion with the exchange of 27.5 billion preferred shares. He has achieved his goal and then some with TCE in the 3rd quarter reported at $100 billion and the TCE ratio at 10.3%. The third quarter ratio number is a substantial gain over a previously reported 2nd quarter TCE ratio of 2.2%.
The Paulson team has to have looked carefully at this metric and arrived at their independent estimation of Citigroup tangible common equity. They are, no doubt, in some agreement with the company’s impressive 3rd quarter figure.
An equally important issue for Citigroup is their “off balance sheet” assets and this is another area that Paulson and Company must have given very close attention.
In May of 2008 C.E.O. Pandit said that trimming the company’s $2.2 trillion in assets was a priority. At the time it was speculated that Citigroup had another trillion dollars in “Qualifying Special Purpose Entities” (QSPE’s). These are the trusts and financing vehicles that are home to the “shadow assets” and are not subject to capital reserve requirements. This releases funds and allows the banks to put more money to work. It is a way of leveraging their capital. The Federal Accounting Standards Board (FASB) wants these “shadow assets” to be properly accounted for and has set and, subsequently, extended several deadlines for the banks to meet new and more transparent standards. The next deadline is January of 2010 but the banks may, as they have in the past, protest and FASB may give them a Christmas present in the form of another extension.
Citigroup has been the most vocal protester regarding the implementation of the new FASB requirements. It holds securitized credit card debt estimated at $92 billion and that debt is the most likely to suffer delinquencies. The addition of any assets to the balance sheet, however, whether toxic or not, would require increased loan loss provisions.
It follows that Citigroup will be faced with loan losses and increased loan reserve requirements in the future and, considering the amount of repatriated assets, may require an infusion of additional capital. This would dilute shareholder value. Potential dilution of share value is an important issue when considering the purchase of 300 million shares only one quarter before the new FASB rules are to go into effect. The fact that the shares were purchased implies that the Paulson team believes that Citigroup has had some success in liquidating, selling or transferring those “off balance sheet” assets.
The two issues we highlighted are important ones but it is speculation as to their priority in the Paulson and Company due diligence process. The money center bank balance sheets and earnings reports, no doubt, hold many interesting secrets revealed to only the most heroic in the “grail quest” that is, understanding the workings of the financial sector.
(Citigroup has lagged the performance of its peers since the March 2009 low in the stock market).
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