The Citigroup "Rally"

The performance of the stock market today, March 10, 2009, I believe, provides us with a clear indication of what is predominantly on the minds of investors. The major concern of investors is the value of the assets that are carried by companies on their books, and especially on the asset values on the balance sheets of financial institutions.

I say this because Citigroup has been the “poster child” of what most investors feel is wrong with the financial markets and the economy. The perception is that Citigroup is so weighed down by assets that are not performing and that must be written down that there is little or no hope for its survival outside of a full takeover by the United States government.

Focus has been so strongly focused on the “asset problem” that other institutions, like Bank of America and JP Morgan Chase & Co., have also been affected with concerns about the value of their assets. As a consequence, the stock price of these and other financial institutions have declined drastically due to the uncertainty as to whether or not they are solvent.

The stock market took off right from the opening bell this morning. The cause—a memo written by Vikram Pandit, the chief executive officer of Citigroup, to employees of his organization indicating that Citigroup had been profitable for the first two months of 2009 and was likely to turn a profit for the first quarter of the year. If this happens it will be a sharp turnaround in performance for the company, a move to the black after five consecutive quarterly losses.

There was no indication about any special write-offs or credit losses, but the memo gave hope to the idea that Citigroup, even after such write-downs, would post a profit for the first quarter.

The hope that was forthcoming, I believe, is the hope that Citigroup will now be operationally in the black going forward and that this kind of performance would give them the time and cushion to continue to work off bad assets and take more modest charge-offs against profits in the future.

The hope is certainly not that Citigroup is “out-of-the-woods.” That would be too much to hope for. To me, what is captured in the market response is that Citi may still have time and not be forced into some precipitous governmental takeover action.

Now, let me say that this was just one day and just one piece of action released by someone that needs, in the worst way, to give some sort of encouragement to his troops. Tomorrow is another day and there will be more information and more market maneuvering in the future. But, it was a day in which there was a possibility for hope—no matter have small that hope might be.

The problem had been that investors had perceived asset values declining with no bottom to be seen. And, there was no one or no event in sight that might put a stop to this decline.

This is why I believe that the financial markets have not been giving President Obama and his team “good grades” on their efforts to craft an economic policy and a bank rescue bill. The economic recovery plan was proposed and passed by Congress, yet there was no “bounce” in the market due to this program. So far, any bank rescue bill talked about or outlined has been deemed a dud.

It is this latter failure that the financial markets have been reacting to. To the financial markets the concern over asset values has dominated everything else. The recovery plan does not address this issue and so does not provide any confidence to investors over possible bankruptcies and takeovers related to institutions that are insolvent due to the bad assets on their books. Expenditures on infrastructure and education and health care and so on are one thing, but a stimulus package like the one that passed Congress cannot prevent a collapse of the financial system as the value of assets plummet and are recognized.

And, so the memo relating to the two-month performance of Citigroup hit the market and gave investors some encouragement that there might be some possibility that the problem related to asset values maybe…just maybe…could be worked out. And this attitude spread to other companies and other areas in the stock market.

We see that the stock of Bank of America Corp. rose 28 percent, the stock of JPMorgan Chase & Co. rose 23 percent, and the stocks of PNC Financial Services and Morgan Stanley increased by double digit numbers. Of especial interest is that the stock of GE rose by 20 percent reflecting the spillover of the positive attitude given to the banks was also given to GE and the concern over the fate of GE Capital.

Again, all of these companies have seen the price of their stocks decline in the past six months or so because of the concern over the value of their assets.

As mentioned, stocks rose from the opening bell, seemingly responding to the contents of the Pandit memo. But, the market responded to other news that they interpreted in a positive manner.

Fed Chairman Ben Bernanke gave a speech that reinforced the “good news” coming out of Citigroup. In this speech, Bernanke discussed the need for moving onto a new regulatory system. The part of his statement that market participants focused upon was Bernanke’s claim that the accounting rules that govern how companies value their assets needed to be changed. The Fed Chairman was careful to say that he did not believe that the mark-to-market accounting rules should be changed. Still he did talk about how asset values should be treated and investors reacted to this in a positive way. Again, the focus of the market was on asset values and little else.

There was one other bit of news that the financial markets reacted to in a positive way and that was the comment of Barney Frank about the “up-tick” rule. This statement, although important in itself, was only a side-show in the movement of the stock market today. Its just that when the good news is poring in, look out!

The important take away about the performance of the stock market today is that the major focus of the investment community is on the value of the assets on the balance sheets of banks and other organizations in this country. This message should be read loud and clear by the Obama administration. Spending plans are fine, but the recovery of the country depends very heavily on what is done about the value of the assets on the books of banks and other organizations and how losses in value are going to be worked off.

This is important too because of what is on coming in the future. It seems as if the credit problem is going to accelerate as the defaults rise on credit card debt, as interest rates need to be reset on Alt-A and option payment mortgages over the next 18 months or so, and the looming bust in the commercial real estate market. The asset value issue is not going to go away soon.

So, we got a rise in the stock market. We may get several more in the next week or so. I don’t believe anyone can predict the movement in the stock market over the coming six months. There are still too many uncertainties. And, even if the stock market were to rise over the next six months, my bet is that the asset valuation problem is still going to be with us. And, in all likelihood it will still be with us next year at this time.

Banks and Asset Write Offs

Banks are using this time to take substantial write offs against their assets. The time is right for them to do this and the investment community expects them to. It would be imprudent for any institution to NOT take substantial write offs now. But, I am only arguing that the write offs should be realistic.

It should not be the case that managements try and ‘over shoot’ their losses so as to show favorable results in the future. The managements of financial institutions must work to regain the trust of their customers and investors and this can only be achieved if the managements show that they understand and can control their balance sheets. To me, it is just another sign of bad management to try and manipulate earnings now so that these institutions can re-coop these faux-values in the future. How dumb do they think we are?

Yesterday, Citigroup, Inc. reported its fourth RED quarter, writing down another $4.4 billion in assets. This brings their total writedowns to about $45 billion! Merrill Lynch & Co. wrote down $9.5 billion bringing its total writedowns to over $50 billion! The day before J. P. Morgan Chase & Co. reported write downs of $3.6 billion as well as a $640 million after-tax loss related to its acquisition of Washington Mutual. Wells Fargo set aside $2.5 billion for future loan losses and the Bank of New York Mellon Corp. increased its credit loss provisions by 20%.

This is the time in the financial cycle when organizations must come up with a firm estimate of the asset base they have to work with. They must reduce their reliance on financial leverage as much as they prudently can. They must reduce their interest rate risk by immunizing their balance sheets as much as possible. They must reduce their reliance on accounting ‘gimmicks’. They must improve their reporting and communicating processes so as to achieve as much openness and transparency with their customers and investors as they can.

To me, these are nothing more than good management practices (See my post of October 14, “Good Management Never Goes Out of Style.”). They tend to go out of use as an economy heats up and are forgotten the most right before a financial system starts to contract. Thus, management must take time and effort to get their act back in order once the contraction begins. Businesses NEVER just “tend to business” during these times because they must focus on getting back to basics and this can almost totally distract a management during this period.

Furthermore, in my estimation, financial institutions have another task at this time. To me their business model has to change somewhat to reflect the advance of Information Technology and the uses of information and data that have resulted from these advancements (See my post of October 16, “The Special Case of Financial Institution.”). It is going to be interesting to see how banks and other financial institutions adjust to these changes and create workable models of sustainable competitive advantage without just relying on financial engineering to generate earnings. Trading models and arbitrage models are unstable in the longer run and cannot help build institutions that are going to excel and last.

The financial industry is going to be a very interesting one to watch in the next few years and there are going to be some real opportunities in which to invest. It may be a little early to “pick a horse” right now…although we seem to be coming through the financial collapse we still have the economic contraction to go through and this will cause other strains and stresses on our banking and financial system. And, it seems as if most analysts are predicting that this adjustment will be relatively long and deep.

There will arise some financial organizations that will really be good buys. The question will be about how to pick them. I have expressed some ideas over this past week and I will just repeat what I think is going to be the most important factors to concentrate on. First, don’t just look at the person at the top. J. P. Morgan’s Jamie Dimon and Citi’s Vikram Pandit are getting a lot of the press right now. They, and a couple of other chief executives, are ‘showing well.’ The important thing to me, however, is the quality of the teams the chief executives are building around them. This may be difficult to discern, but a ‘good’ top executive is one who is proud of his or her team and allows them to be known and to shine. Stay away from the chief executive (and his or her company) which is the only one allowed to be in the spotlight.

Second, check out where the organization is going. The idea of focus is crucial here. Is the organization doing a good job of defining its business and the fundamentals that underlay this business? As mentioned, organizations get in trouble when they cannot define their businesses well and rely on financial engineering or ‘gimmicks’ to produce results. This is going to be somewhat tricky as financial institutions ‘re-tool’ their business model to fit modern information technology and the new regulations and regulatory institutions that will inhabit the environment. Look less to trading and arbitrage to carry the day and more to the development of products and services that build on the evolving technology and establish customer relationships.

Finally, observe how the management team brings innovation to the marketplace. Financial institutions are dealing more and more with Information Goods and consequently must learn how to adapt and innovate within a constantly changing world. In order to do this well, managements must learn from the Information Technology industry. The managements of financial institutions must realize, however, that information is inexpensive, tends to be ubiquitous, and cannot be controlled. How these managements handle this reality is ultimately going to determine who the winners are in the future.