E*Trade Marked To Reality - What Happens If Citigroup Is?

In a mark to reality event long overdue, Wall Street portfolios are hurt by E*Trade Firesale.

E*Trade Financial Corp's firesale of mortgage-backed securities has conjured up a new worst-case scenario for Wall Street's portfolio of subprime assets by knocking their value even lower.

Financial analysts on Friday said E*Trade got anywhere from 11 cents to 27 cents on the dollar for its $3.1 billion portfolio of asset-backed securities. The portfolio sale was part of a $2.5 billion capital infusion from a group led by hedge fund Citadel investment Group.

"The portfolio sale, one of the few observable trades of such assets, has very clear, generally negative, implications for the valuation of like assets on brokers' balance sheets," Credit Suisse analyst Susan Roth Katzke said.

Citigroup investment bank analyst Prashant Bhatia said E*Trade actually received 11 cents on the dollar for its portfolio, if you factor in that the brokerage received $800 million in cash minus 85 million shares it issued. He said that implies Citadel's received stock compensation worth about $450 million, leaving E*Trade with only $350 million for its $3.1 billion portfolio.

Goldman Sachs analysts said they were surprised by the size of the discount on the E*Trade portfolio because 73 percent of the assets were backed by prime mortgages, or loans to people with solid credit.

Marked To Reality

This is what happens when assets that were marked to model finally get marked to reality. The implication are ominous. While admitting using simplistic analysis Credit Suisse analyst Susan Katzke estimates the following writedowns based on what happened at E*Trade, assuming pricing at 26 cents on the dollar.

• Merrill Lynch (MER) could take a $9 billion after-tax hit to the valuation of assets underpinned by subprime mortgages.
• Citigroup's (C) after-tax write-down could be $26 billion.

Note that in reference to Merrill Lynch, Susa Katzke said $9 billion was related to subprime. Note that 73% of E*Trades portfolio was prime. That is quite a haircut on so called prime paper.

In Citigroup Fighting For Its Financial Life I noted Citigroup had $134.8 Billion in level 3 assets and a whopping $939 billion in level 2 assets. Here is the chart again for convenience:

Citigroup Assets By Class



Would it be so hard to believe that those $355 billion in Level 2 derivatives if "marked to matrix" would be worth 10% less if marked to reality?

Citigroup SIVs

Citigroup's latest 10-Q had this to say:

Citigroup has no contractual obligation to provide liquidity facilities or guarantees to any of the Citi-advised SIVs and does not own any equity positions in the SIVs. The SIVs have no direct exposure to U.S. sub-prime assets and have approximately $70 million of indirect exposure to sub-prime assets through CDOs which are AAA rated and carry credit enhancements. Approximately 98% of the SIVs' assets are fully funded through the end of 2007. Beginning in July 2007, the SIVs which Citigroup advises sold more than $19 billion of SIV assets, bringing the combined assets of the Citigroup-advised SIVs to approximately $83 billion at September 30, 2007. See additional discussion on page 46.

The current lack of liquidity in the Asset-Backed Commercial Paper (ABCP) market and the resulting slowdown of the CP market for SIV-issued CP have put significant pressure on the ability of all SIVs, including the Citi-advised SIVs, to refinance maturing CP.

While Citigroup does not consolidate the assets of the SIVs, the Company has provided liquidity to the SIVs at arm's-length commercial terms totaling $10 billion of committed liquidity, $7.6 billion of which has been drawn as of October 31, 2007. Citigroup will not take actions that will require the Company to consolidate the SIVs.

Those paragraphs appear to be an attempt to whitewash Citigroup's exposure. SIVs are off balance sheet assets partially owned by Citigroup. While Citigroup it may not have to provide funding, if those SIVs lose money Citigroup will lose money.

However, because those assets are off balance sheet, Citigroup does not have to mark those losses to market. Citigroup desperately does not want those SIVs on their balance sheet. Nor does Paulson, nor does anyone else who is involved in SIVs. Quite simply Citigroup cannot afford to have those assets on its balance sheet. That is how I interpret Citigroup's statement "Citigroup will not take actions that will require the Company to consolidate the SIVs."

The implications are obvious: the Super-SIV bailout is nothing more than A Fraudulent Attempt at Concealment. More details are out since then, with Paulson Announcing Super-SIV Failure Already. While the Super-SIV bailout has already failed, Citigroup is so over-leveraged it can't bring those assets onto its balance sheet. If it did, it would have to mark them to market.

Citigroup's Leverage Problem

Citigroup's funding strategy is based on liquidity and leverage concerns.

Citigroup Inc. said late Friday that it has reduced the assets of so-called structured investment vehicles (SIVs) the bank sponsors. Assets in the SIVs the company advises have declined to $66 billion as of Nov. 30 from $83 billion at the end of September, a Citigroup spokesman said in an e-mailed statement.

"The funding strategy for Citi-advised SIVs remains unchanged from the disclosures in our third quarter 10Q filing," he added. "We continue to focus on liquidity and reducing leverage."

Moody's Investors Service said earlier on Friday that it may downgrade the ratings of some SIVs sponsored by Citi, including Sedna Finance and Zela Finance.

This past week Citigroup gave up close to 5% of its equity in a panic move to shore up capital in return for a $7.5 billion in cash. I talked about this in Petrodollars Return Home.

But what happens when they need another $26 billion as Credit Suisse analyst Susan Katzke is suggesting? What happens if those level 2 assets were marked to market? What happens if Citigroup has to bring those SIVs back on to its balance sheet? What happens when Moody's, Fitch, and the S&P continue downgrading CDOs? What happens now that credit card losses are rising and commercial real estate is tanking?

To reduce further leverage by selling assets, Citigroup will have to mark any assets its sells to reality at a time when nearly all asset classes are under attack. Good luck reducing leverage.

Citigroup had $127 billion in equity "on paper" as of September 30th 2007 . The closer one looks at this the more suspect that equity is.

Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com
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