Battle Stations

Pandit 'Near Death' Hoard Signals Lower Bank Profits (Update1)

By Bradley Keoun

Nov. 2 (Bloomberg) – Citigroup Inc. and JP Morgan Chase & Co. are hoarding cash as if another crisis were on the way.

Citigroup has almost doubled its cash to $244.2 billion in the year since Lehman Brothers Holdings Inc. filed for bankruptcy, the biggest such stockpile of any U.S. bank. The lender, which last year came so close to a funding shortfall it had to get a $45 billion government infusion, is under pressure from the Treasury Department and regulators to keep more money on hand for emergencies, even as markets improve.

The caution, which may help restore confidence in the financial system, offers little comfort to shareholders, who can expect to see shrinking returns as banks put money into liquid investments that yield one-twelfth the interest rates of loans.

"It's a smart longer-term move, but it will take down the rates of returns these companies can generate," said Eric Hovde, chief executive officer of Washington-based Hovde Capital Advisors LLC, a hedge fund with $1 billion of financial-industry and real estate investments. "If you start to see more economic stabilization, then liquidity levels would start dropping, but they'll never go back to the insane level they were pre- crisis."

Regulators say banks got too aggressive in the years leading up to last year's credit-market seizure, operating with too little equity capital and putting too much money into illiquid investments such as loans and complex, hard-to-trade securities and derivatives.

'Core Principles'

A lack of funds "can contribute as much or more to the firm's failure as insufficient capital," the Treasury Department said in a Sept. 3 statement of "core principles" on financial regulation. Lehman, the New York-based securities firm that declared bankruptcy on Sept. 15, 2008, after losing access to its funding, had said in a statement five days earlier that it had a "strong capital base."

Banks should "hold a pool of unencumbered, liquid assets sufficient to cover likely funding shortfalls in the event of an acute liquidity stress scenario," the Treasury said. Such a scenario might occur when depositors rush to pull their money, companies suddenly draw down credit lines or trading partners unexpectedly demand additional collateral, the department said.

Worldwide, financial companies have raised $1.4 trillion of capital since the start of the credit crisis in mid-2007, diluting shareholders' stakes while shoring up the buffer that insulates depositors in the event of a failure.

Increasing Liquidity

The four largest U.S. banks by assets -- Bank of America Corp., JPMorgan, Citigroup and Wells Fargo & Co. -- have increased their combined liquidity by 67 percent to $1.53 trillion as of Sept. 30 from $914.2 billion in June 2008, before Lehman's collapse, according to the companies' third-quarter reports. The amount equals 21 percent of the banks' total assets, up from 15 percent.

Liquidity includes cash, deposits at other banks and debt securities that can be pledged as collateral in exchange for overnight borrowings from the Federal Reserve or other banks.

Citigroup's total liquidity as of Sept. 30 was $450.3 billion, or 24 percent of assets, up from 16 percent in June 2008. The shift was reflected in the bank's third-quarter results, when interest income fell by $1.4 billion from a year earlier and pushed New York-based Citigroup, headed by CEO Vikram S. Pandit, to an operating loss of $750 million.

'No Choice'

The $244.4 billion Citigroup holds in cash and deposits is $131.4 billion more than it had as of June 30, 2008. That's five times as much as the $47.1 billion cash hoard Warren Buffett's Berkshire Hathaway Inc. had at its peak in the third quarter of 2007. Financial firms typically keep more liquid assets than other companies to comply with regulatory requirements.

"In my 44 years in the business, I have never seen a company with remotely as much cash as this," said Richard X. Bove, an analyst at Rochdale Securities in Lutz, Florida.

If Citigroup's cash and deposits, which earn 0.63 percent, had been put into loans, which fetch 7.2 percent, the bank would be getting at least $8.65 billion more in annual interest revenue. The risk is that some of those loans go bad, and the bank ends up losing more than the incremental revenue.

In the third quarter, the four biggest U.S. banks posted a combined 2.1 percent decline from the previous quarter in net interest revenue -- what they earn on loans and investments minus what they pay out on deposits and borrowings.

"Even though it makes no sense for a bank to have $245 billion in cash, Pandit has no choice," said Bove, who rates Citigroup "buy." "I don't think it's something to either praise him for or criticize him for. That's simply the fact. You either keep that cash or you're dead."



Citigroup and JP Morgan are taking steps that show they now understand our current unacknowledged crisis.

Yes, housing prices have collapsed and banks are taking steady write offs on their balance sheets. What is not generally acknowledged is the depth of the Commercial Real Estate bubble. Prices are still collapsing and write offs are only beginning to be taken by the banks. Citigroup in particular has a large amount of CRE loans that are highly leveraged that will result in enormous write offs.

Once we see a surge back into the US dollar, as I anticipate over the next few months, we will see real estate values plunge further, triggering even more write-offs.

As Andy Xie notes in a very good article in Cajing magazine:

Every party ends sooner or later, and I see two scenarios for the next bust. First, every trader is borrowing dollars to buy something else. Most traders on Wall Street are Americans, British or Australians. They know the United States well. The Fed is keeping interest rates at zero, and the U.S. government is supporting a weak dollar to boost U.S. exports. You don't need to be a genius to know that the U.S. government is helping you borrow dollars for speculating in something else.

But these traders don't know much about other countries, particularly emerging economies. They go there once or twice a year, chaperoned by U.S. investment banks eager to sell something. They want to think everything other than the U.S. dollar will appreciate; Wall Street banks tell them so. Since there are so many of these traders, their predictions are self-fulfilling in the short-term. For example, since the Australian dollar has appreciated by 35 percent from the bottom, they now feel very smart while sitting on massive paper profits. When a trade like this one becomes too crowded, a small shock is enough to trigger a hurricane. There must be massive leverage in many positions, but one just never knows where. When something happens, all these traders will run like mad for the exit, and that could lead to another crisis.

Surging oil prices could be another party crasher. This could trigger a surge in inflation expectation and crash the bond market. The resulting high bond yields might force central banks to raise interest rates to cool inflation fear. Another major downturn in asset prices would reignite fear over the balance sheets of major global financial institutions, resulting in more chaos.

The first item Xie discusses is the short squeeze to which Roubini refers. The devastation in stocks and even bonds could be significant.

In summary, it is a dangerous time to be heavily invested in stocks and even bonds. Deflationary forces are playing out that could clobber virtually every asset class. Yes, the US dollar collapse will come eventually, but not before a "flight to safety" causes the dollar to rise substantially with the negative effects outline above.

For these reasons, I continue to like cash and precious metals.





  1. Once we see a surge back into the US dollar, as I anticipate over the next few months, we will see real estate values plunge further, triggering even more write-offs.

    PW, I do not understand how a surge in the dollar will cause real estate to plunger further. I do not understand the connection.

  2. I am anticipating another credit freeze, or at least, the credit market becomes "slushy". As credit is further restricted, housing prices and commercial real estate fall more. It happens to coincide with a "flight to safety" to the US dollar from riskier assets.

  3. PW, Ambrose Evans Prichard wrote an article about Japan's coming currency collapse. Do you think that this will exacerbate the credit freeze that will arrive in the next six months? How will the collapse of the Yen affect the global markets?

  4. Japan is an interesting case that will be dealt with in a blog post over the next day or two. There are hugh implications to the global economy if the 2nd largest economy hits the wall.


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