Guest Post at Clusterstock

Hey, I wanted to let you, my loyal readers, know that I guest posted over at Clusterstock. The post, entitled “Investment Bank Scorecard” is my take on this past quarter as a whole. I think it’s worth clicking over and taking a look. I’d sum it up here, but, in all honesty, the value is in the nuances and small insights more than the general thesis.

Also, here is the chart attached to that post, in its orginal form.

Contrarian View: HR 1586 (T.A.R.P. Surtax Bill) will Create Millionaires

This is  just a  few quick thoughts, but I believe, in a few years, we’ll be able to take this bill and place it’s effects high on the list of unintended consequences. Let’s wonder what a reasonable firm would do in order to protect it’s people as much as possible from this legislation… I would put forth the proposal that a firm would give it’s employees the most “bang for the buck.” This seems to clearly be by paying in options. Now, I don’t know all the technical details behind how finance companies have to account for and value options given as compensation, but, using the CBOE option pricer and volatility from Morningstar, I get around $0.50 as the option price for a strike of $2.50 at the time Citi was giving bonuses out, around the time it was at $1.00. Or, if we use $2.50 for the equity price and the strike price, we get $1.62 option price.

Since those prices are per share for lots of 100 option, we get anywhere between 500,000 and 155,000 options, depending on when Citi’s rules would require it to re-cast it’s payments to employees. That’s obviously a huge range. However, for some context, when Citi was trading at $50 / share, having 500,000 shares would have meant you had $25 million in the bank. And 155,000 shares would have meant you had $7.75 million in the bank. However, let’s look at some more likely scenarios. Citi is currently trading at $3.00. As these options are longer dated (I believe the prices quoted above were for 3 year options), could one see a world where Citi is at $10, $15, or even $20 3 years in the future? I think so. So, 155,000 options would be worth between $1.55 million and $3.1 million.The other option is some combination of cash and restricted stock. As we see above, the total shares one would get, if merely receiving restricted stock (at the current trading level) is approximately half to two-thirds.

Now, obviously there are risks. Citi might not be around in three or more years–that is anyone’s guess! This assumes share price increases quite a bit (although the numbers look good even for more modest scenarios). However, all of these would be issues with restricted shares as well–which Wall St. heavily relies upon for compensation. Also, this is just for Citi, which is clearly in a more precarious position than some of it’s peers. For a firm like Goldman, Morgan Stanley, or even Merrill/BofA, the probability of defaulting is way lower. And, for those firms, volatility is lower, making options less valuable, and increasing the ratio of options to restricted shares. the purposes of comparison, Goldman is currently trading at approximately $100 and it’s two year volatility is around 60%. This yields an option price of around $39, or 3x as many options as restricted shares. So, for every $20 Goldman’s shares go up, one would make 3x as much if they had options.

You see where I’m going with this? Now, I don’t know the specific rules surrounding a firm’s ability to re-cast their payments once they’ve been made, or how they compute strike prices, restricted share award prices, or other details. But, I would bet that these firms go back to their employees and let them re-think some of their options (no pun intended).

Fun Super Irony Fact: HR 1586, in the 110th congress was the “The Death Tax Repeal Act of 2007”!!!

Citi: Breaking Up is Long Overdue (And Hard to Do Right)

Well, the Citi is burning… or breaking apart at least. Honestly, this has all been rehashed so much, I’ll not even bother citing where I have learned these basic facts and figures. First, though, I will say that Deal Journal‘s coverage has been great as has Alphaville‘s coverage. And, as usual, Felix is translating for us. Read all the coverage there (in between catching up on your reading).

The Facts

So, as is my usual M.O., let’s start with what we know.

• Smith Barney is going into some odd and very complicated joint venture. In an epic win for branding, it will be called “Morgan Stanley Smith Barney.”
• Citi’s private bank (focused on people with net worth of $10 million and up) and brokers who are housed within Citibank branches will not be part of the joint venture. Morgan Stanley’s franchise focusing on high net worth individuals, analogous to the Citi Private Bank, will indeed be part of the joint venture.
• Citi is looking to slim down it’s operations, seemingly across all product lines. Businesses rumored to be “on the block” include risky consumer finance businesses (Primerica and CitiFinancial), private label credit card business (credit cards issued by Citi, but branded by another company, like a retailer), and proprietary trading.
• Many structures are contemplated. Seemingly what will happen is another entity will have all those businesses transferred into it until each can be sold.

The Situation

Okay, seems clear. Now, what can we deduce from this?

First, the Morgan Stanley Smith Barney transaction will be an absolute and total nightmare. I predict the level of success will be somewhere between Merrill’s acquisition of Advest (disaster) and Bank of America’s acquisition of U.S. Trust (moderate success). Why do I believe this? Well, let’s look at what the joint venture creates: a massive, co-branded entity with business lines focused on high net worth individuals and, separately, more traditional clients of full-service brokerages. Also, this behemoth is responsible for selling both Citi and Morgan Stanley products! Morgan Stanley controls the entity and is left with no business lines that overlap with the venture. Citi retains brokers housed in their retail branches and it’s private bank, both direct competitors to the joint venture. Well, that hardly seems logical… To sell a business but still keep enough fragments of it to have to maintain the same infrastructure, support staff, and organizational complexity as if it wasn’t sold–things like stock trading, account processing, compliance, client account management, and relationship management software are all required no matter how many brokers you have.

Now, Citi further complicates it’s own dismantling with respect to the Smith Barney transaction because, well, it’s not east to answer the question, “Which advisers are part of Smith Barney?” For years Smith Barney has been hiring away brokers who focus on high net worth individuals but didn’t want to be part of the private bank–these teams had a structure and style all their own. These teams also use the private bank’s platform and infrastructure. Where do these brokers go? With the joint venture or to the private bank? They need access to products and services which will not be part of the joint venture (but which might be duplicated by Morgan Stanley, although I doubt it). I don’t know where these teams go, and I’d be 97% sure Citi doesn’t know (and Morgan Stanley is, most likely, not aware of the issue).

Just to summarize, we see that Citi has created an entity it intends to compete with and which diminishes their distribution capabilities and other value of their remaining businesses, while not diminishing any of their infrastructure needs.

Next up, we have the dismantling of the mothership–everything that isn’t Smith Barney within Citi. Let’s first note that the infrastructure argument from above applies here, it seems like no business line is going to be cut, merely focused. Although, there are probably still some sort of cost savings here because these franchises rumored to be spun off have always been marred with issues due to the lack of integration. For example, it’s been reported that CitiFinancial lives on it’s own systems and isn’t integrated in any way with other consumer businesses.

Mundane details aside, though, who is going to buy these businesses? In this market, when you cherry pick the worst businesses and try to sell them who is buying these businesses for anything but rock-bottom prices? Further, if you don’t sell the businesses A.S.A.P., then you’re still at risk for the losses. I’ll say that I don’t see the value in identifying to the world the businesses you are about to neglect–totally demoralizing the employees and hitting productivity and profitability hard–before you’re ready to actually dispose of those businesses. Further, why would anyone buy the businesses Citi had that were under-performing all these years? It’ll be interesting to watch how they position these “assets” for sale. Will they admit the problems and put those in front of potential buyers as immediate ways to increase value?

Two last points to be made, both about the investment bank.

1. Citi is spinning off the assets guaranteed by the U.S. Government. What will that do to the financial status of the government’s investment?
2. Citi is said to be shutting down all proprietary trading businesses. Anyone who has been watching knows that those businesses are either the few remaining revenue generators or have dismantled themselves long ago. And some, like Metalmark or the hedge fund that hadn’t launched or began operating yet (but was founded by Morgan Stanley alums), were clearly acquired at top dollar.

Further, this means Citi is going to drastically scale down it’s trading operations. When one is merely an order taker, and cannot use the firm’s capital, there is a very limited upside. You have turned a white collar professional into the best paid grunt ever. While some Citi traders clearly deserve this, it’s not clear that a complete strategy change won’t kill Citi’s sales and trading operation totally.

The Elephants in the Room

After all this, Citi still has some big issues that will challenge it’s ability to operate effectively going forward. Some of these are holdovers from my earlier issues with Citi…

How is Citi going to deal with the politics, infighting, legacy technology issues, and fractured culture? These, I would argue, are the real sources of the tens of billions in writedowns. No effective risk management. No sense of responsibility. No trust in management. No ability to even see all the risks on the books.

Why won’t Citi need more capital or have to deal with further catastrophic losses? Especially with these assets being de-emphasized and starved of capital. I have yet to hear a god answer, really, about why the steps beyond the Smith Barney transaction are even newsworthy. Until something is sold or shuttered, it’s all financial engineering and corporate legal maneuvering.

I guess we’ll see…

Semblance of Rationality in Compensation Structure, Finally

It’s finally occurred. As I just read on Clusterstock, there is officially some sort rationality creeping into Wall St. payment structures. Claw-backs are here, as I suggested previously (I was hardly alone). Now, I wonder what the real impetus behind this sort of decision really is. Is it public officials railing against bonuses? Traders who were paid millions to put on the positions that are now sinking their (former) employers? Or, perhaps it’s the fact the C.E.O.’s and executives who are used to taking no risk whatsoever, as Felix also intuits, and are used to being compensated in the ponzi scheme that has the slogan, “in line with our peers.” This sort of groupthink, parading as transparency (that only pertains to rising compensation, obviously) has been championed by familiar names. But, other familiar names have been railing against exactly this sort of thing (yes, all of those links are to distinct posts on the Icahn Report …). I wonder if some of those executives are angry at having to give up theirs and not being able to inflict the same on their minions… Not totally unjustifiable, after all it wasn’t John Mack who persoanlly took the positions that have caused writedowns at his firm, just like it wasn’t Vikram at Citi. Still, when the kings get stung you know the subjects will feel it.

This relates to some other topics on anti-competitive behavior, but I’ll leave those for the time being.

The Return: An Interesting Sign of Confidence

In the beginning, there was Charles Schwab returning to the epononymous firm. Then there was the return of John Mack to Morgan Stanley. Then, there was Jeff Kornthal’s return to Merrill. And now, there is Mike Gelband returning to Lehman Brothers. High level executives coming back into the fray seems to be both a huge vote of confidence and a harbinger of the worst being behind or nearly over.

This, to me, sends a huge signal. If you left, when things were good, and then an unmeasurable storm sets in, why would you return? One would need to be very confident that things were over. A returning executive would need to have a high degree of comfort that the problems internally were well understood and able to be fixed. If these sorts of tests weren’t met then why would one re-marry their fate to a firm they specifically took a financial risk divorcing? One thing never lies, I’ve noticed–the people indicators. Now, Mr. Gelband might be wrong, or things might get worse, but still…

Disclosure: I recently bought some shares of LEH … and I’m feeling pretty good about that move right about now.