The next chapter in Citigroup’s saga is unfolding as the Oscar winners are revealed

David R. Kotok co-founded Cumberland Advisors in 1973 and has been its Chief Investment Officer since inception. He holds a B.S. in Economics from The Wharton School of the University of Pennsylvania, an M.S. in Organizational Dynamics from The School of Arts and Sciences at the University of Pennsylvania, and a Masters in Philosophy from the University of Pennsylvania. Mr. Kotok’s articles and financial market commentary have appeared in The New York Times, The Wall Street Journal, Barron’s, and other publications. He is a frequent contributor to CNBC programs. Mr. Kotok is also a member of the National Business Economics Issues Council (NBEIC), the National Association for Business Economics (NABE), the Philadelphia Council for Business Economics (PCBE), and the Philadelphia Financial Economists Group (PFEG).


The next chapter in Citigroup’s saga is unfolding as the Oscar winners are revealed.

February 22, 2009

At a time when the price of an ounce of gold is now about equal to the value of 500 shares of Citigroup, we are about to witness the next chapter in the evolution of the federal governments role in shoring up the banking system. Under discussion now is the conversion of the preferred stock owned by the government into common equity (WSJ, Feb. 22, 2009, 8:25 PM). We expect this process to continue. It may end with the federal government owning large shareholding positions in numerous banks.

Will this be voluntary as the talks with Citigroup and various government regulators appear to indicate? Or will this become a mandated method of adding to the assistance to banks by forcing banks to accept these terms? Is this a dimension of Geithner’s stress test? It is too soon to tell.

The first round of Treasury Secretary Geithner’s new bank salvage plan was met with distain by the markets. Geithner created more uncertainty because his plan lacked details. Others have now exacerbated things with references to nationalization of banks by former Fed Chairman Alan Greenspan and by Banking Committee Chairman, Senator Christopher Dodd.

The insiders in the Obama Administration have avoided mentioning nationalization. They must stay silent. If anyone who holds a position within the administration mentions this possibility the markets will immediately respond with intense volatility as a reaction. President Obama, Secretary Geithner, and adviser Summers know that this time they must be clear and specific.

This leads us to believe that the story circulating about Citigroup is a way for the idea of nationalization to get vetted. Once markets realize that conversion means that the preferred shares become tangible common equity, the debt markets will see this as a positive force and may narrow credit spreads. Equity market prices in the shares of the banks that are the subject of these stories (like Citigroup) will not like it because of the possible dilution of the existing shares. But overall reaction in stock markets may be better than some expect.

The reason simply is that markets have been on edge due to uncertainty. Clarity in a plan and action which is measurable will calm markets. With clarity, agents in markets will be able to make their own estimates of value. Right now they have great difficulty doing so. And they feel the rules are constantly changing so they wait.

Like it or not nationalizing banks and our financial system is already at hand. It is here in substance due to the massive use of federal guarantees. It is the form which is not yet clearly resolved. That will soon change.

My colleague Bob Eisenbeis has used the metaphor from medicine to describe the process to date. Treasury Secretaries and others were like the doctors in the emergency room. The patient was having a heart attack and they were busy giving him a flu shot. That is about to change. Surgery is coming whether we like it or not.

We expect this move to common equity will come fast. With the price of a stock like Citi at $2 a share, the market is already valuing the expectation of large dilution. Two bucks represents a call option on the franchise. You get the rest of the bank for zero. Add the conversion of the preferred into common equity and the franchise value gets stronger because the likelihood of survival improves.

One final note. All these new forms of federal bailouts of banks are a direct result of the failure of Lehman Brothers. Federal authorities watched Lehman’s failure cause systemic risk to rise to unprecedented levels. They are terrified of another failure. That is why they are doing everything possible to avoid it.

Whether this is the correct policy is certainly a fair subject for debate. But that is not the issue. In the US we now have this policy whether we like it or not. The idea now is to figure out how markets will react to these details and then take measured positions subject to each investors risk tolerance. In today’s markets that means very small increments because risk tolerance has been worn thin.

David R. Kotok, Chairman and Chief Investment Officer, email:

Copyright 2009, Cumberland Advisors. All rights reserved.

The preceding was provided by Cumberland Advisors, 614 Landis Ave, Vineland, NJ 08360 856-692-6690. This report has been derived from information considered reliable but it cannot be guaranteed as to its accuracy or completeness.

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