Sunday, November 23, 2008

I'll Sell You All the CDS on Citi, Suckers

CDS spread has gotten an undeserved attention as some sort of prophetic leading indicator during this crisis. Is there something special about CDS buyers and sellers that make CDS spreads more insightful than anything else? NO, of course not.

If you think the 40 bps CDS premium on US is ridiculous (for up to 5 years anyway), then I have a surprise for you. Citi CDS was going for 470 bps last Friday. This is close to imminent default range. It's much worse than the usual junk credit.

All the bad news and gloomy speculations about Citi notwithstanding, the simple fact is that

1. Citi deposits will not be endangered. This is hugely political. Governments around the world cannot afford to let it happen, or else they'd be stoned to death by the revolution.

2. Citi bonds will not default. Although Paulson maintains that he didn't think the decision to let Lehman go down was a mistake, everybody knows (Paulson included) it was a critical mistake in transforming a financial crisis into a full-blown global, economic crisis. I think we've learned the lesson by now. The world cannot deal with another CDS settlement of a big company. Not Citi, not GM.

Beyond the above two points, everything else is in play, including wiping out equity.

But, before you get too excited about the parallel between Citi and Bear/Lehamn/AIG, think about the following:

1. Unlike the situation weeks before Bear/Lehman, even for weeks for Morgan Stanley, no bank is stopping trading with Citi. Remember, some banks stopped trading with each of them WEEKS before the trouble became public. It's a very easy decision for them to make, with negligible downside compared to the risk IF they seriously think there's a real risk. But no, nobody stopped trading with Citi, as of the past Friday.

2. Unlike Bear/Lehman/MS, Citi is a real bank with real deposit base. I don't know about the off-balance sheet toxic asset in Citi that everybody suddenly seems to know. But the crucial difference is that Citi is not an investment bank. As long as you believe humanity is not quite stupid enough to march off the cliff, Citi will survive - with pain, maybe, but they will survive.

I think it's quite clear by now that the emerging market crisis of last month is mostly aritificial and technical. They are vulnerable for sure. But there's no structural deficiency in BRIC world in the same order of magnitude as in the developed world. China will be hurt by decrease in demand in goods. India will be hurt by decreasing demand in offshoring. Russia will be hurt by slumping oil price. Brazil will be hurt by slumping oil price (ethenol) and FDI. But none of them is nearly as severe as the chronical, structural deficiencies of future-mortgaging and over-consumption in the developed world. As demonstrated by the 4 trillion Yuan plan announced by Beijing, they are at a point where they CAN create enough demand domestically to get through a temporary glut.

What does this have to do with Citi? My point is the world, not just the US government, will not allow Citi to go down. The US government may not have enough credibility, with Paulson changing his mind every week. But the world ganged up together is a credible threat to the shorts.

And, dare I say, with its truly global franchise, Citi is in a better position to benifit from emerging markets while most other banks, much more concentrated in US and Europe, are exposed to the long struggle ahead of us in the develped world.

If you want to say Citi is too big to manage, that's fine. But it still does not negate the fact that Citi is truly too big to fail -- not just to US, but to the world.

I don't know what will happen to Citi stock. But if you want to buy Citi CDS, I can sell you as much as you want.

Wednesday, November 19, 2008

Public Ownership Is A Fraud

Michale Lewis' epic piece "The End" makes a great read, even if you don't agree with all of his points or accounts. To me, the central theme is that the beginning of the end of Wall Street was Salomon going public. By going public, the wealth of investment banks is transferred from the public to the previous private partners, while the risk goes the opposite way. This is indeed the single most critical, systemic discourse between risk and reward in our financial system.

I'll take that one step further and say the very notion of "public ownership" has become a farce in modern economy.

1. First of all, few shareholders nowadays intend to "own" it for a long time to begin with -- holding a stock for over a few years is considered an indication of old age, I guess.

2. Secondly, for the few old-fashioned shareholders with the real ownership mentality, they have very limited visibility to what's going on in "their" company. Quarterly report is a mockery of transparency for all modern companies large enough to cross the IPO threshold. This is especially true for financial companies, considering the notion of "off balance sheet", the myriad of derivatives, and the increasingly nonsensical accounting rules (I'm surprised few have criticized FASB in this mess yet).

3. Thirdly, even if transparency becomes real and meaningful via some drastic change in law and regulation, shareholders have little use of it. You can vote once a year in shareholders' meeting and hope the board would exercise oversight for you, just like what you do with politicians. Well, you know how well that's been working out. If you think I'm being cynical, just look at the trend in executive compensation over the last few decades.

4. Even if shareholders care, can get visibility, and have an effective board, the obscenely high executive compensation, and especially the most insane, illogical, anti-owner notion of golden parachute, still provide enough cushion for irresponsible and incompetent behavior for at least some executives. Heads you win, tails you don't lose. Risk-reward breakage. Disaster is guaranteed.

We've seen this farcical notion of public ownership blowing up on our collective face in steel, air carrier, banking, telecom, insurance, auto, technology, air carrier, banking, insurance, auto... Now even GE is in trouble. Every time we find a few culprits, scapegoats to satisfy our frustration, then carry on the same fraud, only to see it blowing up somewhere else a few years down the road.

Time to take a step back and survey the history, folks. Do we want to continue this fraudulous public ownership or go straight to state ownership? Most of our mortgages and banks, some insurance, and autos it looks like, are already state-owned. Or worse yet, tax payers just pay and don't own anything.

Public ownership was once a great idea. And it worked when life was simple and scale was manageable. But today's world is different. We need to either drastically rethink corporate governance model in public ownership or revert back to private ownership. The other alternatives are state ownership or even worse, like what we're heading into now, fantom public ownership with tax payers taking on the ultimate risk without any reward.

I don't think Wall Street is dead. There'll be smart and hardworking people setting up private-ownership investment banks soon, because the future state-owned banks cannot possibly compete and be financially viable without constant stimulus, bailout, and suffocating regulation.

Out of the ash, an Old Wall Street will re-emerge.