Citigroup Inc (C)

[BullNBear52]

Capital Is King Once Again
By FLOYD NORRIS

November 30, 2007
High & Low Finance

When you take big risks, you expect big rewards if all goes well. Right?

Well, not in early 2007.

As the credit markets continue to unravel, the public is getting a look at more and more of the strange financial concoctions that were cooked up by the financial engineers.

The latest one blew up last week. The investors who put up the money stand to lose about 90 percent of their investment. Clearly, they were taking big risks.

What were those risks? Essentially, they were guaranteeing, for 10 years, the credit of a group of financial companies, including credit guarantee insurance companies like Ambac and MBIA. A lot of defaults would be devastating to the investors, but so, too, would be rising market doubts about the quality of the companies’ credit. It was those doubts, measured in the market price of credit default securities, that brought on the losses.

Got that? They were guaranteeing the credit of the companies that guarantee the credit of large parts of the financial system. And they were guaranteeing that people would trust the credit of those companies.

When this deal was put together by UBS in March, Moody’s figured it was a sure thing and gave it a AAA rating. It seemed so safe that the upside — what the investors would get if all went well — was a truly teeny interest rate: the Libor rate plus one percentage point. (Libor is the London interbank offered rate, basically what banks pay on loans to each other.)

The demise of this deal — known as a constant proportion debt obligation is emblematic of what is happening to the financial system in the credit collapse of 2007. The financial engineers persuaded people that big risks could be financed mostly through safe investments. So AAA-paper financed subprime mortgages and leveraged loans. And in this case, it financed guarantees of credit for credit guarantors.

The ready availability of that financing encouraged more risks to be taken by lenders. Easy credit meant borrowers could pay off old loans with new loans, and thus seemed to make the risks lower.

In retrospect, it was inevitable this would blow up. It was not inevitable that the first problems would be in subprime mortgages. But a system that encouraged more and more risky lending, with less and less concern about credit quality, could not endure forever.

The most important question for the markets now is this: With the theory of riskless risky lending thoroughly discredited, where will new financing come from? The buyers of AAA paper have learned their lesson, and the flow of money has dried up.

One possibility is government guarantees. Guarantees by government-sponsored enterprises back the securities financing most new mortgages now, and Ben Bernanke, the Fed chairman, has suggested providing a direct government guarantee for some large mortgages.

The other possibility is to go back to the banking system, which would make loans it intended to hold, rather than to package and sell. That would mean “going back to the 1980s model, rather than the 21st-century model,” as one financial engineer put it privately to me this week.

But that would require banks to have enough capital to make and keep more loans, and the losses now being taken are cutting into that capital.

Wall Street preaches that there is such a thing as “optimal leverage.” In that worldview, too much capital depresses a bank’s return on capital and is, therefore, as bad as too little.

Fearing they would have too much capital, banks bought their own stock at high prices, benefiting shareholders who were fleeing. Now they must sell shares at low prices. Kathleen Shanley, a bond analyst at Gimme Credit, points out that in 2005 and 2006 Citigroup spent almost $20 billion buying back stock at an average price of about $47 a share. Now it is raising $7.5 billion from Abu Dhabi on terms that pay the Mideast nation 11 percent a year for three years. Abu Dhabi will end up with stock purchased at prices of $31.83 to $37.24. Buy high, sell low.

At least that deal assures that Citigroup will have adequate capital if it must report further losses from bad loans. Wells Fargo, a well-capitalized competitor, announced this week that it would unload $11.9 billion in home equity loans that it probably should not have purchased to begin with. It is taking a $1.4 billion reserve against losses. That is more than 11 percent of their face value.

Some banks would run out of capital long before they could take comparable write-offs, a fact that places more pressure on those banks to raise capital at a time when investors are already worried. Banks with capital concerns are not eager to make many new loans.

Much of the discredited “21st-century model” was aimed at finding ways to make loans without tying up capital. Now capital is crucial again. Unfortunately, there may not be enough of it to finance all the loans needed to keep the economy growing.

Read Floyd Norris’s blog at norris.blogs.nytimes.com.