Analysing a bank’s financial statements is a bit like suing your family lawyer for malpractice; the jury may be on your side but the evidence is invariably circumstantial.  However, in times such as these  when even charities are screwed by their bankers – it is best not to trust anyone. Worry not, we at Kafila are not just concerned with playing theory-theory and pseudo-secular Hindu-bashing, we are also deeply concerned about the financial crisis – it has a direct impact on the bonuses taken home by our CEO and board-members. Accordingly, I offer you a simple step by step way to figure out when your bank will go under.Written in an easy conversational style, this post is an invaluable tool pedagogic for Kafila readers both young and old. Stay with me guys, this is going to be fun.

First a bit of background: In May 2008, Vikram Pandit finally stamped his authority on the behemoth company that he had been chosen to lead. Signalling a bold break from the past, he replaced Citigroup’s 2007 slogan “Let’s get it done” by reviving Citigroup’s 1970s slogan “The Citi Never Sleeps”.   While the new/old ad campaign is sure to bring back memories of more profitable times, the firm’s precarious financial situation suggests that The Citi apart, Pandit won’t be getting much rest either. Mystery Question: What will it take to wipe Citi out?

First up, we get a hold of Citigroup’syear-end financial disclosures for 2008. Fortunately for us, Citi is registered with the SEC in the US, and so is required to file a yearly 10-k disclosure statement, and a quarterly 10-Q. Almost all banks post their statements on their websites. Citi’s can be found here.

While Citi’s enormous size and complexity makes it a rarity even among financial services firms, the 10-K for 2008 offers enough for a quick diagnosis of the ailing company’s malaise.

Now as we all know (and if you dont, I’m telling you) the balance sheet of any firm can be understood by the simple equation: Assets = Liabilities + Owner’s Equity.  Assets are the stuff that have productive capabilities – cash, machines, monies due to the firm etc. Liabilities are things the firm owes to others – debts, goods and services due etc. Owner’s Equity is the stuff that the firms owners get to keep (and share with their share holders). With me so far?

The other thing we all know, or if we don’t any banker will tell you, 2008 has been an annus horriblis for the banks. It has been a year where certain assets that banks thought were safe and valuable, were found to be worthless.  This forced banks to take writedowns.

So, using the balance sheet (pasted at the end), lets administer the following test:

As of the end of the fourth quarter of 2008, the Company had nearly $2 trillion worth of assets (under total assets on the Balance Sheet) and total stockholder’s equity of about $ 71 billion(again from the balancesheet).

Now we are going to measure “tangible equity” -essentially equity stripped away of  non-cash assets like goodwill, deferred tax assets etc. So we are going to take shareholder’s equity, add back reserves like loan loss reserves (because these are liquid assets) and now assume that all the assets that the bank holds are “at risk” except for cash, federal funds and federal securities. Assuming the Federal Securities are risk-free is luxury that only applies when the “federation” is the Federal Government of the United States of America. As the 1997 Russian Bond crisis illustrated, sovereign nations can, and sometimes do, default on their own debt.  However, the global financial order is premised on the collective illusion that the US  treasury is the safest place to park your money – otherwise the Chinese wouldnt hold a majority of their $ 2 trillion forex reserves in US treasuries.

However, recent comments by Chinese Premier Wen Jiabao suggest that the Chinese are not entirely comfortable with their follar-exposure. A recent article in the Wall Street Journal, qouted Wen Jiabao as saying:

“We have lent a huge amount of money to the U.S., so of course we are concerned about the safety of our assets. Frankly speaking, I do have some worries,” Mr. Wen said in response to a question. He did not offer specific suggestions on economic policy to the U.S. government, but called on it to “maintain its credibility, honor its commitments and guarantee the security of Chinese assets.”

But, to return to our Citi example:

On adjusting for intangible assets like goodwill and mortgage servicing rights, adding back liquidity pools like allowances for loan-loss reserves, and assuming that the only “risk-free” assets immune to write-downs are cash, deposits and Federal funds and securities we realise that Citi has tangible equity ( a non GAAP term) of about $53.5 billion as against relatively risky assets of about $ 1.2 trillion.

Thus, a simple calculation suggests that tangible equity represents about 4.5 % of total risky assets; implying that a 5% write-down on the risky assets would effectively obliterate tangible equity.  This is admittedly a rather stringent test, as Citi already allows for loan defaults in the form of loan loss reserves, but even if loans are removed from the calculation, tangible equity still represents only 8.3% of Trading account and investment assets.  Of course, Citi can take succour from the fact that a large percentage of these derivatives and securities are fairly thinly traded in the best of times and have not been traded since Lehman’s collapse. This allows them to mark them at “fair value” rather than to market.  The $300 billion treasury backstop is an implicit acknowledgement of the fact that if and when trading was to resume, Citi’s assets might be subject to another round of write-downs.

In fact, recent off-record comments with persons well placed at Citi suggest that the company could write down upto $80 billion over the next three years.

A look at the balance sheets of times now past suggests that Citi’s current plight isn’t as surprising as one might expect.  Perhaps one could consider an annual report from happier times – say 2005, when Citi reported a fourth quarter net income of $6.93 billion and a full year income $24.5 billion. In 2005, tangible equity represented 7.1% of “risky” assets including loans, or 15.6 % of Trading account assets and investments (excluding loans).  However, it is worth remembering that 2005 was the peak of the sub-prime lending period, where Citi built large amounts of assets that were subsequently learnt to be toxic.
Vikram Pandit has been excoriated in the press and industry insiders for his seeming inability to drag the company out of this current mess; however, he has proven to be unusually astute at tapping the US government and treasury for support.  As long as the Government agrees to back stop its losses, the Citi is safe but sleepless.