Tags: Citigroup, Jason Simpkins, Subprime

Citigroup and Others Still Reeling from Subprime Aftershocks

By , Money Morning •

By Jason Simpkins
Associate Editor

After an unyielding series of write-downs, losses, and layoffs, financial firms are still struggling to cope with the widespread fallout from the subprime mortgage meltdown. Now, with Goldman Sachs Group Inc. (GS) forecasting another heavy hit to Citigroup Inc. (C) and others in the fourth quarter, it appears the sector's turnabout remains in the future.

Citigroup may be forced to write off $18.7 billion in the fourth quarter, according to recent Goldman Sachs forecasts. Additionally, Citigroup might be forced slash its dividend by as much as 40% to preserve liquidity. The company announced on Nov. 4 that it was likely to write down its portfolio by another $8 billion to $11 billion.

"It will be a couple of quarters before the current credit crisis is fully digested by the markets," Goldman Sachs analyst William Tanona wrote in a report released last Thursday. "Fourth-quarter trading results are likely to be among the weakest we have seen in some time."

Tanona expects Merrill Lynch & Co. (MER) and JPMorgan Chase & Co. (JPM) to write down $11.5 billion, and $3.4 billion, respectively.

The Goldman Sachs analyst also said there was a possibility Citigroup would cut its quarterly dividend of 54 cents per share to help preserve $5 billion to $10 billion in capital. He rates Citigroup as a "Sell" and both JPMorgan and Merrill Lynch as "Neutral."

Tanona is not the only one predicting more trouble ahead for the battered firms.  Brad Hintz, an analyst at Sanford C. Bernstein & Co. LLC., predicted a $10 billion fourth quarter write-down at Merrill Lynch, resulting in a quarterly loss of $5.10 per share, according to Reuters. Tanona thinks Merrill will suffer a loss that's closer to $7 a share.

LBOs Another Obstacle For Leading Lenders

And the troubles for the world's leading lenders don't end with the subprime-mortgage crisis. Citigroup, Goldman Sachs, Morgan Stanley (MS), JPMorgan, and others, all still are struggling to unload a massive amount of debt accrued from the record number of leveraged buyouts (LBOs) in 2007. 

Some of the companies are offering discounts on the debt of as much as 10% in an effort to clear a $231 billion backlog of high-yield bonds and loans, according to a recent report from Bloomberg News. The news agency reported a record $438 billion in leveraged buyouts for 2007.

Buyout groups use their own funds and debt to pay for takeovers and then expand profit margins by boosting sales and selling off assets. Once profits climb, the new owners recoup their investment - and a hefty profit, besides - by putting the company up for sale, either via an initial public stock offering (IPO), or by selling it outright to a larger corporation.

But that entire transformation process takes time and in the interim the lenders who financed the acquisitions now find themselves in a compromising position. The reason: The collapse of the mortgage-backed securities sector has left investors without a taste for the higher-yielding - and therefore riskier - types of assets. Unable to sell the bonds and loans at face value, and desperate to unload the debt, banks are now selling off the assets at deep discounts.

Lenders first started lightening their debt loads in September when Kohlberg Kravis Roberts & Co.'s lenders sold $9.4 billion of the loans that had been used to finance the LBO of First Data Corp in April. The loans were offered at a 4% discount, which cost Deutsche Bank AG (DB) and four others approximately $360 million.  The banks also issued $2.2 billion of bonds at a loss of $114 million, leaving them with another $10.4 billion in debt that still needs to be sold.

According to JPMorgan, banks still have $161.9 billion of loans - and $69.6 billion of bonds - left to distribute, all of it related to LBOs. Bankers led by Goldman and Citigroup hold $17 billion of unsold debt left over from the acquisition of Alltel Corp.

Bank of America Corp. (BAC), Deutsche Bank, JPMorgan, and others, still are on the hook for $22.3 billion promised for next year's scheduled buyout of Harrah's Entertainment Inc. (HET), according to filings with the Securities and Exchange Commission.

"A python that swallowed an elephant is being absorbed through the system," Mario Gabelli chief executive officer of the Rye, New York-based Gamco Investors Inc. (GBL), told Bloomberg. 

And it's a record-sized elephant at that: The just-concluded 2007 established an all-time record for LBO activity.  As the subprime crisis began to unfold, the total value of LBO deals dropped to $101.9 billion in the back half of 2007, a significant decline from the $336.4 billion in the first six months.

But for the lenders, the damage had already been done. There was just too much deal-related debt washing through the financial markets.

"The market can absorb all of these deals,'' John Eydenberg, head of leveraged finance for the Americas at Deutsche Bank in New York, told Bloomberg News. "It is [just] a question of time and price."

Cashing In On Potential Turnaround Profit

Despite the financial sector's obviously severe problems, many of the large banking institutions still represent potential turnaround plays for aggressive investors. Take Citigroup: Its share price was down nearly 50% in 2007, but some bold Contrarians see that as an opportunity. Citigroup remains globally diversified and many portions of its business still reflect double-digit growth rates.

It's also trading at a mere seven times earnings. Large globally diversified companies with a P/E of 12 or less are often considered a bargain. And while its stock price is currently hovering around $30, Citigroup's shares could easily climb back above $60, several contrarians have said.

Outside investors are already scrambling to move back into to Citigroup to fully exploit its profit potential. Most recently, Abu Dhabi Investment Authority sovereign-wealth fund got its foot in the door, investing $7.5 billion for a 4.9% stake in Citi. That's not to say that the worst is already over for Citigroup. And its shares are certain to remain volatile. But those who are willing to weather the storm now may be very glad they did so in as little as a year or two from now. [For a Money Morning investment research report detailing the investment opportunities in Citigroup, please click here. The report is free of charge].

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