The Banking Miasma

Citigroup (C) and Bank of America (BAC) are both trading at less than 90% of their peak value, and for several good reasons, not least of which is the possibility that on any given Monday, shareholders may find themselves holding worthless shares.

An article this weekend in Barron’s (”Banking’s Evil Twins? Not Exactly“) claims that BAC is the stronger of the two, and that it may thrive where C doesn’t.  However, it’s not at all clear from the article why anyone should prefer the former over the latter:

• As the article explains, once the conversion of preferred shares is completed, Citigroup will have a tangible equity ratio of nearly 4%, versus Bank of America’s 2.68%.  The article lists some ways that BAC could boost its ratio to nearly 3%.  3 is smaller than 4.  So why doesn’t Citi come out ahead on the question of tangible equity?  (Here’s a helpful video explaining the concept of a tangible equity ratio.)

• Paying more attention to risk-adjusted assets, BAC’s 10.6% Tier 1 capital ratio is above average but again, still lower than C’s (11.9%).

• The one highlight, BAC’s “earnings power,” is also uncertain in our view, especially since the $4/share Barron’s projects assumes a normally functioning economy and 2003-level earnings from BAC’s recent acquisitions, Countrywide and Merrill.

Of course, any discussion of future earnings is pointless until the nationalization question is resolved.  The Obama administration has consistently rejected the idea of nationalization even as they pursue exactly that policy with Citigroup – albeit slowly and equivocally. It seems that nationalizing the most troubled banks – whether or not the term is ever officially endorsed – is inevitable, and that much financial pain could have been avoided had bolder steps along these lines been taken months ago.  Paulson-Geithner gradualism is an attempt to do two mutually exclusive things: to retain the potency of privately held shares while drenching them in a soup of federal participation.  In other words, the policy of the Bush and Obama administrations is a failed experiment in financial homeopathy.  Pseudofinance is evidently no more helpful than pseudoscience.

Until equity holders have reason to believe that they’ll still be equity holders six months from now, i.e. that they won’t be wiped out by the government, the stocks of both C and BAC are functionally just call options with a little positive theta.  The prevailing view seems to be that the longer equity holders survive, the less likely it is they’ll be nationalized, meaning that shares should increase in value just by virtue of the passage of time.

And on this nationalization question, C is more vulnerable.  The U.S. Federal Government already has a 36% stake in the company, and may not be able to act further without diluting shareholders into nonexistence.  While we aren’t sanguine about the post-crisis prospects for either bank, BAC’s odds of surviving are higher right now, relatively speaking.  One common objection – that nationalizing one bank requires nationalizing all or most of them – seems misplaced when these stocks are already under $4 and when the most likely takeover scenario would be a “surprise” weekend affair that everyone already expects.  As we remarked some weeks ago, the risk of nationalization has probably already been priced in; we don’t know any sane investor who is buying the financial sector as a value proposition.

Buying shares as lottery tickets is one approach, but not an ideal one. Normally, we’d use risk-defined option spreads to express our view with more precision.  But there’s no sense in paying time and volatility premium for stocks under $4.  Alternatively, we suggest buying BAC and shorting C on a dollar-neutral basis.  At current prices (as of March 6, BAC is $3.14; C is $1.03), that’s nearly a perfect 1:3 ratio, although Citigroup shares might be more difficult to borrow.

If equity in Citigroup gets wiped out and Bank of America shares don’t, the trade will win on both fronts.  The trade should be a wash if both banks meet the same fate, whether nationalization or survival as going concerns (the attached chart illustrates their high correlation over the last twelve months).  If by some miracle Citigroup soldiers on while BAC falters, the trade will lose, and spectacularly so: any overnight short squeeze would make stops irrelevant, and we don’t care to guess how high Citi shares might jump if freed from both the possibility of and the need for nationalization.  We expect the companies to share each other’s fate, one way or another, with a relative BAC win as the third most likely outcome.