Cary Crittendon, CFO of Citigroup, Speaks

Citigroup's CFO Gary Crittendon speaks:

Citigroup Business Update Call - Seeking Alpha: Gary Crittenden:

The way I would think about that is these were super senior securities, right? So they were in theory better than investment grade securities. If you track that index, at least the numbers that I have, just as an example, the AAA ABX, just to pick one, the O-62, had very, very little deterioration during the course of the first nine months of this year. I think in total it was off about 4%, so it dropped about 0.5% a month.

If you go into the month of October, after the first seven or eight days -- I don't know exactly when it was -- you see a very significant crack and it drops from 96 down to about 88 and losses 8% of its value in a very short period of time. The other indices had been down. I am talking about the As, the BBBs, had been down during the course of the year; the big movement there was a reduction by about half during the course of October so they have had movements but again you had significant movements in those. But it’s really at the high investment grade end where the values had held up very well during the course of the year but obviously you see that movement now.

Now, when we had thought about taking these marks, we have obviously if you look at what the ABX would imply in terms of real estate price reduction, it starts to imply very, very high numbers of price reduction in real estate. I guess our view is that it’s unlikely that those very high levels of price reduction in real estate will take place. So what’s actually happening is implicitly the market is saying that the cash flows associated with those securities have become more risky and so as we have thought about valuing those cash flows, we have put different discount rates on those cash flows and that’s reflecting the range that you see in the estimate here.

We’ll see, obviously, how that actually plays out over time. With that higher discount rate, looking at those cash flows in essentially or actually exactly the same way we did in the third quarter, you come up with a much larger reduction in revenue than we saw during the course of the third quarter.

The actual real realized cash flow will work out over time. I mean it depends on how the underlying mortgages actually get paid, how that cash actually flows. As you know, as a result of the rating agency downgrades the cash flow gets redirected from the subordinate tranches to the more senior tranches in the structure. We’ll see how that all get realized over time and the valuation I suspect of the super senior tranches will go up and down and we may liquidate some of these if market prices come back. We just simply don’t know.

We wanted to give you a sense of what we thought the impact would be during the course of the fourth quarter, but it really is very dependent on how the market evolves here now over the next eight weeks or so...

When Crittendon says that "if you look at what the ABX would imply in terms of real estate price reduction, it starts to imply very, very high numbers... it’s unlikely that those... will take place" the sentence should not come to an end. There should be a comma, and after the comma the sentence should continue "therefore Citigroup is sponsoring and investing in a new hedge fund to take advantage of the undervaluation of the ABX and similar market opportunities, and we are now raising capital." If you say:

• We're taking a markdown based on the ABX.
• But we believe the ABX is underpriced.

Shouldn't the very next sentence be:

• We are moving to profit from this mispricing?

Now it is true that Citigroup cannot be patient Graham-and-Dodd capital: it is leveraged 15 to 1, for Jeebus's sake. But it can sponsor and contribute talent to vehicles that are patient Graham-and-Dodd capital, can't it?

Comments

[jerry]

Hey Brad, Wednesday, 5:07am, the ISS will be directly over Berkeley and fairly bright to boot, -2.3 magnitude.

I'm going to watch it this morning -- where I am the ISS and the Space Shuttle will be flying in formation, if I can believe the timing, about 1 second, or a BOTEC 10 miles apart.

http://www.heavens-above.com

[Chris]

Where did it say 15 to 1 leverage? I can't find it ...

[christofay]

I think the guy, no matter the title, gives himself away in the first two sentences.

The CFO has a mind-set that closely parallels a typical text messaging college student, "these were super senior securities." So, better than triple A, they're SSS, super senior securities.

And "they were in theory better than investment grade securities." I thought trip A was investment grade.

When he says theory, he means "model." "Model" is going to have a meaning similar to Dick Cheney's Stove Pipe Dream Analysis, "you hear what you want to head and disregard the rest."

Our elites whether in the Federal Govt or in finance, home of American innovation, are basing their decisions on pipe dreams, of course, we're heading for a depression not a simple recession.

And as for your question, you want to see Citigrope sell for a lost and invest for a long term profit simultaneously? Does that include selling a lost for the stockholders' account and buying for an investment fund for the top officers to invest, isn't this too Enron-like?

[christofay]

"We are moving to profit from this mispricing?" Maybe there's an obvious investing tool, but when you're responsible for the mispricing, that is, the crap is yours, how do you profit? First you have to book the lost, and that's $10 bil for starters. Then there will be fire after the smoke

[George J. Georganas]

Of course it must sponsor and contribute talent to patient capital. Unless, of course, talent just walks across to more patient capital without waiting for Citi to recover its senses.

[George J. Georganas]

Of course it must sponsor and contribute talent to patient capital. Unless, of course, talent just walks across to more patient capital without waiting for Citi to recover its senses.

[kharris]

Citi has contributed talent and capital to vehicles aimed at takeing advantage of mispricings. In the most recent instance, they are known as SIVs.

[Cranky Observer]

> it starts to imply very, very high numbers
> of price reduction in real estate. I guess
> our view is that it’s unlikely that those
> very high levels of price reduction in real
> estate will take place.

I realize The Prof already said this in more technical terms, but to a dumb observer in flyover country the first question that springs to mind is "why not"? Selling prices of house have gone insane in the last 3 years - during the dotcom boom I could understand the runup, but since the dotcom crash and 9/11 they have continued to go up with no new boom in sight? Why?

Cranky

[Alex Tolley]

Why on earth would one assume that the ABX should correlate with house prices? That model seems ridiculous to me given what we know of securities pricing and real estate pricing.

[save_the_rustbelt]

I think this conversation occurred sometime in 2005 or 2006 at Citigroup:

Controller: I'm getting nervous about these mortgage packages. I think we should set up a bigger allowance against these assets, because some of them will go bad.

Senior Management: No, we don't want a hit on earnings. Besides, we would also get a hit on our compensation, and we can get the auditors to sign off. What's the problem?

Controller: All bubbles burst eventually.

Senior Management: This is not a bubble, look at realty prices, look how hot the market is, the economy is great, wages are going up, Larry Kudlow said so (snark).

Senior Management versus Controller

Senior Management wins!!!

Shareholders lose!!!

[robertdfeinman]

This is a variation on all financial advise from those with a conflict of interest.

Anyone from Citi making a statement is trying to improve the outlook of the company, first, second and third. Therefore their analysis is objectively worthless.

As for recommendations as what to buy (or sell) the question I always ask touts is "if it's such a good deal why are you telling me about it instead of buying it up yourself?"

I've never gotten a good answer to that one. Personally I think a patient investor (not common on Wall Street these days) could do well by buying some of the financial firm's stocks that have been dragged down by the general panic. I'm thinking more of regional banks and the like not the big name gamblers like Citi and Merril.

[Kelly]

You don’t have to wonder whether housing prices are gonna go down in “very, very high numbers of price reduction”. The data is freely available here in flyover country. The city of Fort Worth where I live has a website that lists what houses are worth ( it’s actually Tarrant County’s site).
Not what someone would like to sell them for but what the TAD or “appraisal district” has priced them at. This is based on a fairly scientific analysis of size, type and what something like it, and near, has sold for.
You can clearly see a considerable price decline in the past two years. It’s not over either. Houses here are listed and after several months will go “off the market” for a couple and then come back $25K less. And they still don’t sell.
If anyone needs actual data you can start here;

http://taxoffice.tarrantcounty.com/AccountSearch.asp

[Paul J. Reber]

This is an interesting communication problem. The CFO is trying to soothe the fears of Citi investors and while I certainly don't know, I think the case he's pitching is somewhat plausible. Market valuations of illiquid securities can be wrong because by their very nature, there isn't enough liquidity for the markets to do their thing of good, rapid price setting.

I don't think it's implausible either that there's some panic in the market that has driven prices below true value or that the CFO is blowing smoke trying to save his company's valuation.

The fact that he's not then taking his argument to the logical extreme of arguing for buying up the undervalued securities may reflect mendacity on his part. Or it could reflect a lack of confidence that investors will believe his account fully. It is a different thing to say "things are not as bad as they look, we'll ride it out" and "we're going to load up even more on these securities of difficult-to-estimate value because we think they are undervalued." The risk to the company of losing their long investors by scaring them further with the latter claim is probably larger than the risk to losing the investment opportunity that may be available.

A simple corollary to this is that the companies who will be able to take advantage of the underpriced RMBS (if there are any) have to have both capital stock and "investor trust" stock. Perhaps this excludes any of the big players who are being forced to take writedowns now.

I think StR is onto something here too, that the sudden drop looks like the kind of thing that happens when manager's incentives were misaligned with the company's. I wonder if we are going to start hearing stories about managers whose compensation was along the lines of the asymmetric 2-and-20 system where they score big on gains, but lose relatively little if the company takes a pounding.

[James]

Who put those tranches together? Who ought to have known better than any rating agency what their true value was?

Financial risk management is the responsibility of the CFO, first and foremost. That is the difference (so far) between Goldman Sachs and Citi.

That CFO should be fired.

[ken]

Don't lose sight of what really matters.

The only important question is: Is Citicorp's 54 cent quarterly dividend safe?

At current stock prices that is a 6% annual yield.

As long as they have the cash flow to pay the dividend then nothing else can matter. Blips in stockholder intangibles like book value and quarterly earnings are just so much noise.

The only tangible to a shareholder is the dividend and if that is safe, then over the long term, the company should have plenty of investor interest.

[Ginger Yellow]

"The CFO has a mind-set that closely parallels a typical text messaging college student, "these were super senior securities." So, better than triple A, they're SSS, super senior securities.

And "they were in theory better than investment grade securities." I thought trip A was investment grade."

I don't really see the problem here. In a traditional securitisation structure, the AAA securities have just enough credit enhancement to secure the rating (give or take a few basis points). Super senior tranches, by contrast, have enough credit enhancement that there can be an entire AAA rated tranche beneath them in the payment waterfall. In other words, in order for a super senior tranche to default, a AAA tranche would have to default first. Clearly, this is "better than AAA". The ABX, so far as I know, does not reference super senior tranches, so it's reasonable to argue that it's not a very good mark for them. What is a good mark is another question entirely.

[christofay]

Obviously Ginger Yellow knows more about this subject than me, but I am not sure that "traditional" fits in this explanation. In my general understanding securitisation has only been practiced for the last two or three decades. what is new is the deluge of securitisation of sub-prime mortgages that has been practiced since 2000, hundreds of billions per year. Adding the credit rating agency stamp of good approval to get sub-prime to trip A is a new wrinkle. If "traditional" means what has been practiced the last couple of years, then, okay, "traditional," my time frame would be since the last great war, 1945, still the modern era.

The text messaging era "Super senior security" seems to be flooded away within moments of digging the foundation of a sub-prime now junk bond structure.

And if the ABX doesn't reference Trip S in this instance, what is this self-referential structure of mark to modeling (sniff the glue) relating to?

There's a rule of thumb when bad news hits a stock there's going to be a cycle of bad news. The first deca-billion of write-offs at Citigrope, Merril Lynch, Bare Stems, are going to waterfall with more billions across the Street and through several quarters till we hit the several hundred billion marks.

[christofay]

This is from the Big Picture, "S&P500 ex-Risk?", not a respected blog at this site, but this question seems a more contemporary approach:

"Here's the odd factor: It turns out that many of the arguments made in favor of U.S. domestic growth have been based on an assumption that turned out to be false. To wit: The Financials, the largest sector in the S&P500, had legitimate, sustainable, normalized risk-based earnings.

"That basic premise turned out to be wrong.

"Picture a race car driver, going way too fast in the first half of a track. He puts up record breaking lap times, only to crash and burn in the last turn. His driving coach would say his risk-adjusted speeds were irresponsible.

"That's how I perceive what has been going on with the Financial sector. It wasn't Fraud, but rather a reckless disregard for Risk that led to outsized returns on many big cap stocks in the group.

"Merrill Lynch (MER) just wrote down $8 billion dollars, erasing 5 years of profits. Citigroup (C) dinged $11 billion. Washington Mutual, (WAMU) Countrywide Financial (CFC), Bear Stearns, GMAC -- there seems to be an ongoing parade of mea culpas that are erasing not just quarters of profits, but years of earnings. And there are likely to be many more of these, as tier 3 assets get priced appropriately.

"What's truly astounding is that we may only be seeing the tip of the iceberg. Its possible that the big brokers and banks have $1 trillion in toxic debt on their books to be written down. That would equal decades -- not years -- of profits to be wiped out.

"To paraphrase the WSJ, "the financial crisis is becoming Shakespearean comedy."

"So here's the odd question that I have been wrestling with: Given what we now know about how the true nature of the S&P500 earnings in this group, what did the past few years of data actually look like? Now that the big Banks have erased nearly all of their earnings of the past few years, what should that data have looked like from 2003-2007 with most of the Fins as a goose egg?

"I would like to see historical data adjusted for the S&P500 for the Financial sector's losses...."

[christofay]

Our currency has become the Xera. It should come in sheets like the traditional S & H Green Stamps with a picture of "What, me worry?" Alan Greenspan on the soon to be much more commonly handed around one hundred Xera denomination. And for the Wall Streeters there is the 1,000 xera blotter but with "Gotta replenish the coffers" mug of our President.

My other oil market question is who or what is going to give President Bush his present. The King of Kuwait gave his dad a million xeras, Bush the Stabilizer Bunny deserves 10 million, at least. It's probably gonna have to be Saudi Arabia.

Kuwait is already bailing on accumulating more xeras.

[Tom Spencer]

It is worth while getting to the root cause. Clearly some loans have been made that should not have been. Why were they made? Prof. DeLong has said in other fora that lenders assumed that property values would continue to grow, so that even if collateral was insufficient initially, property values would quickly grow into making it sufficient. Mr. Crittendon appears to be agreeing with Prof. DeLong. By contrast, I had long figured that mortgage brokers were willing to lend to poor credit risks on the theory that the result was a loan that they could sell at a profit and if (when) the loan got into trouble it was not their problem. The source of the bad loans matters. If it is falling (or just not rising) property values, then by keeping track of property values, traders in mortgage backed securities (MBS) can get a fair idea of what securities are worth by looking at property values ind ices. If, however, the problem is loans made to people who cannot afford them, then owners or potential buyers of MBS cannot tell what they are worth until they know whether the MBS are composed of sound or unsound loans. Does anyone to what extent the bad loans come from mortgage brokers who worried about what loans they could to a not very careful buyer and whether the loan made economic sense?

[christofay]

I think the entire structure is at fault from the mortgage to the MDS to the CDO from the securitisator to the rating agency to the insurer to the low interest rate fixer. So if the adults are in town, start at the top, Greenspan. If the securitisator wasn't taken the junk mortgage off the originators hands, the cycle wouldn't have ballooned to the trillion zera level.

[christofay]

Excuse me, the trillion xera level

[Ginger Yellow]

"Obviously Ginger Yellow knows more about this subject than me, but I am not sure that "traditional" fits in this explanation. In my general understanding securitisation has only been practiced for the last two or three decades. what is new is the deluge of securitisation of sub-prime mortgages that has been practiced since 2000, hundreds of billions per year. Adding the credit rating agency stamp of good approval to get sub-prime to trip A is a new wrinkle. If "traditional" means what has been practiced the last couple of years, then, okay, "traditional," my time frame would be since the last great war, 1945, still the modern era."

Well the Eurobond market is only 40 years old, but we can still talk about traditional Eurobonds. If the term makes you uncomfortable, use something else. It's just a label. The point is that super senior tranches a) have a meaning which justifies believing them to be 'better than triple-A' (ceteris paribus), and that there's nothing particularly special about them. They just have more subordination than a non-super senior triple-A tranche.

They're not specific to subprime or CDOs of ABS either. You see them in lots of other asset classes where investors want exposure but very little risk. The really interesting thing in Citi's case is that it wasn't buying them as an investor. It turns out $25bn of their subprime exposure, the bulk of the super senior positions, came from liquidity puts given to investors in CDOs over the summer. I'm very curious as to how widespread this practice was and how it was authorised.

[Cranky Observer]

> Clearly some loans have been made that
> should not have been. Why were they made?
> Prof. DeLong has said in other fora that
> lenders assumed that property values would
> continue to grow, so that even if
> collateral was insufficient initially,
> property values would quickly grow into
> making it sufficient.

Seems to me there are two different questions there: (1) were investment vehicles sold that were not correctly labeled for their level of risk (colloquial sense of "risk") (2) did those investment vehicles include fraudulent mortgage loans.

Maybe investors would have been perfectly happy to buy packages of very risky loans (yeah, and their derivatives) if those packages had been correctly labeled as such. Of course, the investors would have demanded a bigger cut and the investment houses' financial statements would have been different...

The fraudulent mortgage loan thing is entirely separate IMHO. The overvaluing of houses has been going on for a long time now and local taxing jurisdictions play a role, as does the hunger for putting little Johnny in the perfect school district. The acceptance of bad or just no documents has been described as a feature of the new mortgage market for a long time, and compared to the old way where the mortgage officer called up your pastor and work supervisor to assess your "morals" before writing the loan I have to say it is better despite the downsides.

Cranky

[Ginger Yellow]

Most securitisations have representations and warranties requiring the originator to buy back (legally) fraudulent loans at par. If you count self certified loans as fraudulent per se, that's another matter. Also, in some cases, the originator is now not around to buy back those loans.

[christofay]

"The really interesting thing in Citi's case is that it wasn't buying them as an investor. It turns out $25bn of their subprime exposure, the bulk of the super senior positions, came from liquidity puts given to investors in CDOs over the summer."

Now you have got me stumped.

Citi was selling liquidity puts assuming that liquidity will stay liquid, they were going long that there will always be more money to borrow to buy junk bonds?

No, let me back up, what's a liquidity put? A put that the volume of buying n selling will go down?

And somehow this put gets a better than trip A rather than a at least 50% call for margin?

Is there anything traditional, and that's the word that I say doesn't fit our present discussion, about this "structure" (better to call it gaming if we can't simply say gambling)?

We are far out on the oceans in our titanic ship of state where the monster waves are more frequent by a couple of orders of magnitude than we assume.

I mean we even have a fan-boy of Greenspan on this blog saying that the Chinese are going to have to provide a solution as it is just too damn hard for we conservatives.

[Ginger Yellow]

As I understand it, and I'm still digging around for more details, the liquidity puts were arrangements with investors in short term debt forming the super senior tranches of some CDOs, designed to reduce the overall funding cost. They (Citi and other liquidity put providers) would repurchase the debt if it could not be remarketed cost effectively. They became popular in around 2004 (Citi says that they were entered into with regard to CDOs issued before December 2005).

Presumably, starting in early summer this year it became impossible to remarket the CP issued and so the puts were exercised, bringing the exposure back on balance sheet.

From JP Morgan research:

"Money market tranches are favored by bank (e.g. Citibank) liquidity providers that
have ready access to liquidity at short notice. Medium term notes are favored by
non-bank liquidity providers that don’t have commercial paper programs and have
relatively less access to immediate liquidity.

In a typical structure, at the time of writing, money market tranches are sold in
the L minus 2 to plus 10bp area. The liquidity put costs an additional 20bp and a
remarketing fees cost an additional 4-6bp, leading to an all-in cost in the L+22-36
area, well below spreads on a typical SF CDO senior tranche (L+60). If remarketing
is unsuccessful, the tranche can be put to the liquidity provider in the L+40-70bp area
(i.e. liquidity provider is a backstop buyer at an agreed upon price). We note that
money market tranche price is also a function of size of issuance, with tighter pricing often achieved on larger tranches because, for example, many institutions are limited as to the percentage of a tranche that they are allowed to purchase.

In contrast, spreads on medium term note issuance are slightly wider (L+12), but the
liquidity put is slightly less expensive (15bp) because the notes mature less often. As such, the total cost for medium terms notes is a few bps higher than for money
market tranches."