MEDIA: Television
STATION: BLTV
MARKET: Cable
DATE: 07/18/2008
TIME: 02:02 PM ET
PROGRAM: On the Economy

Kathleen Hays, Anchor:
Hello, there. Welcome to Bloomberg’s “On the Economy.” I’m Kathleen Hays. So we now take a closer look at Citigroup’s earnings and the relationship between financial firms and Fannie Mae and Freddie Mac. Joining us is Mark Sunshine, president of First Capital, a commercial lender. Mark, welcome.

Mark Sunshine, President of First Capital:
Thank you. Thank you very much for having me.

Hays:
And I might add to our viewers that before you helped start First Capital, Oppenheimer along, many years on Wall Street here in New York, so you’ve been watching these kinds of things for a long time. I want to ask you today, what is your response to what we saw with Citigroup? It struck me all week, earlier in the week, “Oh, JP Morgan, only down 53% -- less than we thought!” It’s damning with faint praise in a way.

Sunshine:
Well, I think that’s right. JP Morgan had the advantage of actually having earnings in their earnings release. I think we should be talking about Citigroup and talking about it’s the loss release and the amount of the losses weren’t quite as bad. You know, as we talk about Citigroup, the clip that you ran a little while ago about if you’re going into the cage, not being mulled by the lions but coming out alive; that’s pretty much what happened to Citigroup. Everybody’s glad that it’s not going to fail in the near future. The bank’s going to survive to make it another quarter or two. But they have got massive problems.

Hays:
What are those massive problems and what does it mean for their future because so many people have said, the naysayers, at least they won’t make it through in this form, they won’t make it through in the same shape and size?

Sunshine:
Well, I would tend to agree with the naysayers. Some of the massive problems are, as we start to look at Citigroup, look at the balance sheet. They went into the second quarter with about $2.2 trillion of assets. Supposedly they shrank by about $100 billion of assets. That leaves $2.1 trillion of assets on the balance sheet. Now as it turns out, they forgot to mention the other trillion or so, which is a very hard number to say when you’re talking about a bank. $1 trillion of off-balance sheet assets that are not mentioned really in their loss release that there’s no capital to support. Now the last institution that thought it wasn’t going to support those off-balance sheet vehicles on those off-balance sheet assets, was Bear Stearns. And we saw what happened to them – how much support they got from the rest of the investment community. Citibank has those off-balance sheet assets and they need to support them and they need the capital to support them. I think management’s doing a great job in what they’re doing, but at the end of the day, in very round numbers, their tangible equity ratio, if you reconsolidate those off-balance sheet assets is about 2%, which is catastrophically low.

Hays:
And what should it be for someone like Citigroup?

Sunshine:
Most banks should be in the 5, 7-10%, depending on the risk perspective of those assets. The other thing that was interesting in this Citigroup release was the securities and banking revenue was down 94%, I think it said. And somehow they managed to somehow bury in the release the fact that fee income and a bunch of different components of what was the old Solomon Smith Barney franchise, in particular the Solomon Bros. franchise has sort of fallen off the side of a cliff, and that’s very bad for Citi also.

Hays:
Well you know when you mention Bear Stearns, of course, one of the difficulties for Bear Stearns is it was so heavily into the mortgage business, and we know what’s happened to those assets, whether they were bundled or not bundled and they’ve really gone through the whole system. With Citigroup though, is that as much of an issue? Aren’t they a much more broadly – if they have all kinds of things off-balance sheet – isn’t it a much broader array of assets so that they’re not so dependent on a turnaround in the housing market, or are they?

Sunshine:
The Citigroup issues are different and I don’t think they are quite as dependent on the turnaround in the housing market. Citigroup has some spectacular businesses that they run on a global basis, but they have some very serious internal problems that result from fundamental management neglect over the last 4 or 5 years before Pandit and his crowd came in. And some of those things are things like not having integrated risk management systems, so that the executive management couldn’t look at the risk position of the institution and have an idea by looking at one report or a series of integrated reports and know what the risk position was; computer systems that didn’t talk to one another; tremendous amounts of inefficiency, things that frankly the last group of executive managers should have taken care of and have left to Pandit and his crowd to fix. And from what I hear, they’re actually taking those steps to fix them.

Hays:
But they’ve got to maybe run a little bit faster than some of these other things that are maybe catching up to them. We want to bring into the discussion as well, Alex Pollock. He’s resident fellow at the American Enterprise Institute. Alex, welcome.

Pollock:
Thanks, Kathleen. Great to be here.

Hays:
Yes, well in terms of the banks – I was just talking with Mark Sunshine about how some of the losses came in smaller than expected this week, obviously some are more exposed to mortgages, some less – but broadly speaking, what is your sense of where the financial industry stands now and how much it depends on this bailout for Fannie and Freddie being passed and being passed quickly.

Pollock:
Let’s start with the real estate exposure you mentioned before of Bear Stearns having a heavy real estate exposure. So does the entire banking system on average. If you take all depository institutions together, that’s 58 percent of their total loans are real estate loans of one kind or another. So there is a terrific real estate concentration in the banking system…

Hays:
Alex, just one moment. I hate interrupting people like this, but we have got breaking news. Motorola, according to the headline on the Bloomberg terminal, is accusing Apple iPhone executive of taking secrets. We just have a headline but we know what a hot item the iPhone is. We know how Motorola has been struggling with its own issues around the Razr. So you can see that Motorola shares currently are up just a couple of cents at $7.39. We’re going to get more on that as we have it. Alex, I’m sorry to interrupt, continue with that thought.

Pollock:
No problem. Just a thought that the banking system taken as a whole is very heavily exposed to real estate, obviously some more than others, but on average it’s a lot of exposure. Among the banks, the bigger banks are less exposed on average and among smaller banks, two thirds of their loans are tied to real estate. So if you have a sustained fall in real estate prices as we’ve got, it’s a very serious matter.

Hays:
Alex Pollack, you sit tight. Mark Sunshine, you sit tight as well. We’re going to continue to look at the banking system, Fannie Mae, Freddie Mac, and see if we get more on Motorola “On the Economy.”

We’re continuing now with Mark Sunshine of First Capital, Alex Pollack at the American Enterprise Institute. Alex, you were just outlining how there are many financial institutions with large real estate exposures. So let’s go from that to the Fannie Freddie backstop plan. Is it going to pass next week and what form should it pass in to be the most effective for helping the housing market and the least damaging to taxpayers?

Pollock:
Of course we know we were talking about concentration in real estate. Fannie and Freddie are completely focused on the housing market but the housing finance market is completely focused in Fannie Mae and Freddie Mac. And that’s why it’s pretty clear that something will pass. The requirement is to keep the debt markets of the world, the fixed income markets confident in Fannie Mae and Freddie Mac credit. That’s of course different from the equity markets and the thing about a GSE is you have this division between the debt markets implicitly and perhaps soon explicitly supported by the government versus the equity markets, which aren’t. I think it’s highly likely we’ll get some legislation rather soon. The form that I’m suggesting is that the government ought to go right ahead and inject subordinated debt capital in the form of a senior subordinated debt into Fannie Mae and Freddie Mac so the bond buyers around the world can say “We see they’re committed. No problem. We keep buying the bonds.” But the government has the senior and sixth position in the capital structure.

Hays:
I want to ask you both about Freddie Mac and it’s going to try to sell some shares. It’s had this registration now with the FCC. Mark, how about if there’s uncertainty over the pulse and backstop plan, does that create risk then for investors if they actually want to buy shares of Freddie. If you’re a new investor, you might say they are pretty cheap, the government’s there, maybe I can make some money.

Sunshine:
Yes, I think it does create uncertainty for new equity investors because at the end of the day, the problem with Freddie Mac and Fannie Mae taken as a whole or taken individually is the fact that they’re overleveraged. I mean, they have got great businesses and a great market position and frankly a pretty darn good portfolio. The delinquency rate combined for the two entities in the middle of a mortgage recession and a mortgage crisis is only about 1%. The problem is their tangible equity ratio is only about a half a percent, give or take a little bit. They can’t operate as private entities with a half a percent tangible equity ratio and 1% delinquencies. They’re upside down. An entity like that, if it’s truly going to be a private entity, needs to operate with a 5 to 7 to 10% capital ratio. The same as what we said for Citigroup. So $10 billion is a spit in the bucket and it isn’t going to do very much. The other choice, other than raising a whole bunch of additional equity, is to nationalize the companies, which is really what they are right now, is nationalized companies to begin with.

Hays:
Alex, I have got the same question for you on certainty over the Paulson plan. Doesn’t that create risk for investors in a Freddie stock sale?

Pollock:
Yes, absolutely. We have seen from various bailouts like in the latest case, Bear Stearns that you can go in and take care of the creditors while severely punishing the equity holders. What Mark said is right. Fannie Mae and Freddie Mac never have been private companies in any real sense. They’re government supported companies and the government support is about to move from implicit, as we always said, to explicit and then that makes the tie that much stronger.

Hays:
Okay, gentlemen. We have to go. Thank you so much for joining us. Mark Sunshine of First Capital. Alex Pollack of the American Enterprise Institute. We’ll have you back soon. We’ll take some more time on this important topic.