Citi’s Leverage

More from Citi’s investor presentation…

There are plenty of slides talking about “Tier 1 Capital” and such.  I never understood those ratios and don’t think they’ll be worth much in a panic situation as banks lose access to hard funding sources like consumer deposits.  Using Citi’s Tier 1 Capital ratio of 10.4% would imply a leverage ratio of 100/10.4 = 9.6x.

But we know from the cases of Fannie and Freddie that regulatory capital ratios are very squishy.  Back out worthless assets from the bank’s equity calculation and the denominator may be halved.

In Fannie’s case, you had $2.5 trillion of assets versus ~$45 billion of “capital,” which implied a leverage ratio over 50x.  And yet that “capital” figure included at least $21 billion of deferred tax assets that Fannie wrote down to $0 in the most recent quarter.  (see this previous post on Fannie to understand why DTAs are worthless).

The reality is, intangible assets like deferred tax assets should NOT be included when calculating leverage ratios. Excluding those meant Fannie had a leverage ratio of 100:1!  When assets are 100x larger than equity, it takes only a tiny reduction in assets to reduce equity to zero.  And with house prices likely to fall more than 30% nationally, asset values are falling more than just a little.  This is why Fannie has already said they’ll need more than the $100 billion promised by Treasury.

Leverage ratios are important because they tell you how much money is in reserve to cover losses. That’s why you shouldn’t include faux assets like intangibles, deferred tax assets and goodwill.  These things are worthless in a bankruptcy court.  They can’t be used to pay off a company’s debts.  Wouldn’t it be great if you could use your tax loss carryforwards to pay off a credit card bill? (see that Fannie post to understand what I mean)

A leverage ratio is basically assets/equity.  If assets decline in value, and not because of a reduction in liabilities, then there has to be a one-to-one decrease in equity.  This is so because for a balance sheet to “balance,” assets must equal liabilities + equity.  In Fannie and Freddie’s case, you knew a long time ago that assets were going to fall at least 5% and that that would be enough to wipe out the company’s equity.  At its most fundamental level, a company’s stock price is its equity divided by the number of shares outstanding.  If equity = $0, then the stock price equals $0.  Fannie’s and Freddie’s stocks both trade pretty close to $0.

Now consider Citigroup. It has $2.05 trillion of assets listed on its balance sheet.  That includes $63 billion of “goodwill and intangibles,” worthless assets like Fannie’s DTAs.  Contrast this with the company’s equity of $151 billion, which would include $25 billion from TARP.  That implies a leverage ratio of 14x, not 10x as the bank would have you believe when it publishes its “Tier 1″ capital ratio.  Remove goodwill and intangibles from assets and equity and you have a true leverage ratio of 23x. = ($2.05 trillion - $63 billion) / ($151 billion - $63 billion).  That’s roughly the same calculation we did to get to Fannie’s true leverage ratio of 100x.

By the way, I’m giving Citi credit for the $164 billion of “other assets” on the balance sheet as well as $19 billion of assets of “discontinued operations” held for sale.  These sound pretty squishy too…

And now for the scary part.  Citi’s $2.05 trillion of assets are just “on-book” assets.  They have $1.6 trillion of credit commitments and $1.3 trillion of “off-balance” sheet commitments to boot.

You only need a small paper loss on the company’s assets (on or off balance sheet) in order to wipe out the company’s equity.

Now what if I told you the same is true for all the major banks in the U.S. and Europe?

You might think it prudent to keep some money under your mattress.

[Thanks to Cynthia Y. ($25), Bill T. ($5) and George P. ($45) for their donations.]

Posted in Wall Street, accounting, banking, bankruptcy, stocks |