Monday, December 10, 2012

Investors don't share Citi's view of the value of its assets

In his Wall Street Journal Heard on the Street column, David Reilly makes the case for requiring banks to provide ultra transparency by looking at the difference in valuation put on Citi's assets by its management and market participants.

He concludes that the important valuation is the market's.

This valuation is based on what has been disclosed to the market.  If there were ultra transparency and Citi was required to disclose on an ongoing basis its current global asset, liability and off-balance sheet exposure details, this valuation might be different given the enhanced disclosure.
Once again, Citigroup is showing why investors have lingering doubts over the value banks place on their assets. 
Citi is looking to shed about $171 billion in crisis-era assets it still holds, equal to about 9% of its balance sheet. Of these, about $95 billion are North American mortgages. The problem: Citi and markets have very different views of what these mortgages are worth.
Speaking at the Goldman Sachs Financial Services Conference last week, Citi finance chief John Gerspach encapsulated the dilemma. 
Because the mortgages are loans, not securities, they are held at face value with a loan-loss reserve created against them. In this case, it is about $8.5 billion. 
Mr. Gerspach said the bank remains "very comfortable with the level of reserves we have allocated to these mortgages." Yet, he added that if the bank were to try to sell a sizable portion of them, it would require "a substantial write-down" in their value. 
That is part of what is preventing large-scale sales. Yet the assets weigh on Citi's stock, which trades at just 60% of book value. 
Citi isn't alone in such value conundrums. In its most recent financial stability report, for example, the Bank of England questioned whether U.K. bank assets were overvalued because reserves for loan losses weren't adequate. Doubts about that, it added, were likely in part responsible for big U.K. banks trading at about three-quarters of book value.

This is why the Bank of England's Financial Policy Committee urged the banks to come clean about their on and off-balance sheet exposures and any losses still being hidden.

For Citi's investors, though, the issue is particularly vexing. Not only are they eager to see the bank shed the assets, which tie up capital and depress return. But the bank also doesn't have the greatest track record when it comes to valuing some assets. 
During the financial crisis, it insisted its problems were due to liquidity issues in the market, not looming losses in some of its holdings. Yet it was ultimately forced to take about $52 billion in bailout money....
Granted, the problem Citi faces with these assets, in what it calls Citi Holdings, also relates to their sheer size. 
Mr. Gerspach noted that the lower market prices the mortgages would likely fetch would be "driven by the cost of financing, a liquidity discount…, and a buyer's desired equity returns."
Regular readers know that the way to return liquidity to the secondary market for mortgages is to provide observable event based reporting on all activities like a payment or delinquency involving the mortgages before the beginning of the next business day.

With current information, buyers can independently assess the risk of what they are buying and, after purchasing the mortgages, know what they own.
And the bank can hold on to the mortgages, as it has been doing, and hope that the market eventually comes its way or that the loans pay down.
The last 5 years have shown that the market will not come back without observable event based reporting.  Investors have other assets that they can buy that do provide transparency, so they have little incentive to gamble on assets that are the equivalent of purchasing the contents of a brown paper bag.
There is a cost for waiting, though. In a recent report, Goldman analyst Richard Ramsden estimated that spinning off the mortgage assets could in theory boost Citi's returns by three percentage points.
Given that Citi's cost of funding these assets is zero thanks to Federal Reserve interest rate policies, these mortgages must be losing money still if selling them would boost Citi's returns.

This definitely calls into question the idea that $8.5 billion is adequate reserves on $95 billion of mortgages.
So these assets are an albatross around Citi's neck. And investors eyeing Citi likely are marking down their value below what the bank carries them at. That feeds into the bank's valuation discount. 
Granted, the market may be wrong about the assets' value and Citi, right. But as banks have learned the past few years, the market has the last word on such matters.
So ultimately, it is in the banks' best interest to provide ultra transparency if they ever believe that the real value of their assets is in fact greater than the market's value.

Right now, by continuing to hide what is going on with their exposures, the bankers are confirming that the valuation of their assets is far less than current book value.

The question is how much less.  Since all of these banks were insolvent, the book value of their liabilities exceeded the market value of their assets, at the beginning of the financial crisis, it is reasonable to assume that nothing has changed.

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