Tuesday, October 16, 2007

Citi Earnings As Expected

"This was a disappointing quarter, even in the context of the dislocations in the sub-prime mortgage and credit markets. A significant amount of our income decline was in our fixed income business, where we have a long track record of strong earnings, and this quarter's performance was well below our expectations" Citigroup (C) CEO Charles Prince.

The details: Net income was $2.38 billion ($0.47/share), vs. $5.51 billion ($1.10/share) a year ago. Revenue was up slightly to $22.66 billion from $21.42 billion. Analysts were expecting earnings of $0.43/share on $20.8 billion in revenue. Results included a $1.35 billion writedown for leveraged loans, $1.56 billion for subprime mortgages, and a $636 million charge for fixed income trading, as well as a $729 million gain from its stake sale in Brazilian credit card transaction processor Redecard. Credit costs included a $780 million increase in net credit losses and a $2.24 billion charge to increase reserves for bad loans. All were about as expected after the Oct. 1st warning.

Word is out that Citi, JP Morgan (JPM) and Bank of America (BAC) are working with the treasury to create a $100 billion "superconduit" fund. The fund will buy assets held by so-called structured investment vehicles (SIV's). These SIVs are kept off of banks' balance sheets, making it difficult for investors to gauge their related financial risks.

Some fear a rush to sell SIV's could spark a broader credit crunch that would dent the economy. Unloading the assets to the banks would enable sellers to meet pending redemptions and facilitate rollovers. Robert Steel, the Treasury's deputy undersecretary for domestic finance said there won't be any public money involved in the fund and "The goal here is to help the markets start to work." He continued, "This is a temporary solution in order to transition the market on to more sound footing."

Essentially, the three banks (maybe more) ad going to be buying these SIV's from other institutions for pennies on the dollar. Bank "A" has a SIV that it neds to roll over but because of the markets, it is either very expensive to do so, or getting the underwriting is very difficult. The Banks will by that from you for pennies on the dollar, taking it off your books and the cash will provide the holder needed liquidity. I don't know about you but anytime you can buy a dollar for 20 cents, the odds of being successful look very good. This bears a close watching.

Next quarter, $1.7 billion in mortgages "reset" to higher rates. This represents only 2% of Citi's mortgage portfolio. In 2008, that number hits $10 billion or 11%. No estimate of many of these mortgages are expected to be refinanced before they reset were given but each Fed rate cuts increases the odds these will not default.

On the conference call the amount of reserves was the main topic of conversation. As I read it through I kept getting the same feeling. Citi has taken reserves in excess of what it really needed to for Q3. The tone a management was Q4 of last year, Q1 & Q2 of this year illustrated out plan was working until the unforeseen events of Q3 this year. There seemed to be a underlying confidence about Crittenden and Prince about Q4 this year.

I said it before and I think it holds true that the banks are using this quarter to sweep as much dirt as possible away and take their lumps all at once. Crittenden said more than once that he is seeing market conditions improve and that additional loss reserves would be required "If there is significant deterioration in the credit environment that goes beyond where things are today". Simply put, things would have to turn again dramatically for the worse for Citi to be forced to write down more assets in Q4. What seems more likely is a release of reserves either in Q4 or probably in Q1 2008 (most likely) to add to earnings and valuation increases in assets. Citi can write off 2007 and get 2008 off to a goods start in this way.

Isn't this "managing earnings"? Yes, but not in a bad way. Let's be honest. Citi has their models but credit conditions could turn again for the worse and in that case, the additional reserves Citi has taken will buffer results against that.

All in all I am right back to where we started last week. Q4 will decide Prince's future. He has all the start aligned so to speak, excess reserves, low expectations, improving market conditions and a lower Fed rates. If he screws it up he deserves whatever he gets.

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