Is There Any Value at Citigroup? Nom de Plumber on Basel III Dysfunction

In this issue of The Institutional Risk Analyst, we feature a comment from our friend Nom de Plumber, a risk analyst at a major NY bank, about the train wreck we all know as Basel III. But first we want to start off with some additional comments about the presentation by IRA Vice Chairman Christopher Whalen this Tuesday in New York at the investment conference sponsored by BCA Research.

The title of the panel is "IS THE BANKING SECTOR IN SECULAR DECLINE?" The answer to that provocative question is yes and no. Yes the US banking sector is reverting to the mean in terms of equity and asset returns, and business models. But no, this is not so much a decline as a return to normal. Click the link below to read Whalen's presentation, including a summary of the top-level Q2 2012 bank ratings and analytics published by IRA.

http://www.rcwhalen.com/pdf/BCA_0912.pdf

There was time when bank stocks traded like bonds. Equity returns in good years barely broke out of single digits. Those few banks which had market traded equity saw betas at or below 1. The reason for this, very simply, was that bank stocks were illiquid and deliberately so. The revenue and earnings of banks were only a concern to a stable group of long-term shareholders. Nobody cared what % of the S&P 500 was attributable to bank stocks.

Over the past 20 years, however, banks have been turned into speculative vehicles as growing public sector debt, grotesque monetary policy by the Fed and ridiculous public policies in Washington regarding the housing sector have forced banks to become hedge funds. Today the largest banks do not serve the economy so much as feed upon it in a parasitic fashion, creating risk in ways and amounts that cannot even be measured accurately.

Notice in the charts for the BCA presentation that Citigroup ("C") is used as a comparison to the large bank peer group in terms of defaults, recoveries and exposure. Notice that C's default rate is well above the peer average, which includes C in the calculation. With a beta close to 2 and a loss rate a standard deviation above the peer group average (excluding Citi), only a complete idiot would be willing to hold C as a long term "investment" unless that bank compensated for the additional risk in terms of an increased dividend payout. But that is not the case.

C currently offers a dividend yield of 0.1% vs. 3.1% for JPMorgan Chase ("JPM"), 2.5% for Wells Fargo ("WFC") and 0.5% for Bank America ("BAC"). WFC has a beta of 1.3, JPM is at 1.6 as of the Friday close and BAC is 1.8, just below C. So if you are an "investor" and not a volatility chasing disciple of Jim "Mad Money" Cramer, you buy WFC and JPM. But all of the zombie money center banks are basically volatility plays, not true investments, since all four of these institutions arguably insolvent.

So if C has a higher beta and lower cash flow yield, why would anyone own the stock? The answer, very simply, is volatility. The reason you own C is not as an investment per se, but because the stock is big and moves around a lot. We occasionally hear analysts try to make a case that C represents "value" at current levels, but such arguments don't count for very much where we are concerned. C remains a subprime lender with an above-peer loss rate and a below peer investor payout.

This is not to say that we think people ought to run out and buy WFC. As Whalen noted on Bloomberg Radio today with Tom Keene and Jonathan Weil, WFC's has the most aggressive accounting among the top four money center banks and arguably the worst disclosure. Practices such as booking up front the full profit from residential loans and also taking the value of cross-sell opportunities into current income make us more than a little nauseous when looking at WFC. At 1.34 x book value, WFC is arguably the most overvalued of the top banks.

Of course, none of the above is recognized by the supposed regulators who are meant to supervise C, WFC and the other zombie banks. If the Basel III capital framework was even remotely sensitive to business models, then C would be required to hold substantially more capital per dollar of assets than either JPM or WFC. Instead the minions of mediocrity who populate the federal bank regulatory agencies spend time pondering the unknowable and irrelevant in pursuit of safety and soundness.

Part of the reason that government agencies have turned Basel III into such a complete mess is that the capital framework ignores the single biggest threat to banks and consumers, namely the governments themselves. Thus we saw last month the ECB arguing for less capital to address liquidity concerns generated by the gyrations in the market for government bonds, so called "risk free" assets.

http://www.bloomberg.com/news/2012-08-27/ecb-said-to-urge-weaker-basel-liquidity-rule-on-crisis-concerns.html

"The regulatory mistake is trying to define in advance what should be completely liquid assets under all market scenarios, and then mandating all banks to own them, for the hundred-year flood which happens every ten years (1987 equity crash, 1998 LTCM failure, 2008 global collapse, 2018…..)," notes Nom de Plumber.

"This policy-sponsored version of an ultra-crowded trade will simply spawn the next loss-correlation debacle. Once everybody subsequently needs to sell Basel LCR-compliant assets under stress, which buyers will provide such liquidity? If investors and regulators can know in advance all potential scenarios, we would not be in the fifth year of this global crisis."

A much better approach would be to foster general market liquidity, Nom de Plumber argues, without favoring or disfavoring specific assets, by restoring:

* legal contract sanctity

* loss privatization rather than socialization

* risk-capital sufficiency

* credit market pricing integrity (removal of zero interest-rate policies).

But of course none of these wise prescriptions are likely to be included in the Basel III framework anytime soon. The whole purpose of Basel III, we should recall, is to make the world safe for profligate, insolvent governments and their debt emissions. Going back to the Great Depression and WWII, the entire framework of international finance has been predicated on government debt being the top of the economic food chain. But the financial crisis of 2007 now shows that this assumption is badly flawed.

Rather than giving government debt the lowest risk weighting, Basel III should assign the highest capital charge to government debt and the lowest to top-quality corporate obligations. Instead Basel III seeks to give advantage to government agencies with debt loads that can only be repaid via inflated currencies. These same government and their captive central banks pursue policies that undermine the value of money and of bank assets. Thus Basel III and the governments which sponsor it are doomed to fail, in terms both of keeping banks and currencies safe and sound.