Too Big to Fail but Still a Mess

12/11/2008 11:07 am EST

Focus: STOCKS

Michael Shulman

Editor, Short-Side Trader

Michael Shulman, editor of ChangeWave Shorts, says the government won’t let Citigroup collapse, but its shares are still vulnerable.

A growing consensus on Wall Street has the economy hitting bottom in mid-2009, after an undramatic but steady slide through the first half of the year.

The [recent] ChangeWave Alliance Corporate Sales Survey calls this view into question. The bottom line from the survey is that fundamentals are deteriorating, and will continue to deteriorate in the first quarter of 2009, at a rate that's higher than current Wall Street expectations.

And once Wall Street wakes to the reality, individual stocks (and the market) will head our way.

In three words, the short-term outlook is bumpy, unpredictable, and volatile. This situation is making the timing of new recommendations—and the management of existing ones—a bit more difficult than usual.

However—and with a big nod toward fundamentals—I recommend puts on Citigroup (NYSE: C). It's a company whose fundamentals are clearly continuing to deteriorate.

I cannot say in strong enough terms how willfully Wall Street is ignoring the train wreck that is the large banks, led by Citigroup.

Congress may hope to change laws to make things better, but it cannot change the laws of mathematics, the balance sheets, and the off-balance-sheet assets of big banks. They are in terrible shape and getting worse, despite the government's efforts. Citi's balance- and off-balance-sheet assets are built upon very little tangible book value.

The stock has moved up strongly in recent days, based on technical factors and people who are simply unwilling to read Citi's financial reports.

What do I know that others don't? Absolutely nothing that is not readily available in public documents.

For example, Citigroup lists $165 billion in "Other Assets" on its balance sheet, but provides no details. Intrepid reporters and bloggers have discovered that a good chunk of these assets are Deferred Tax Assets—the same accounting gimmick used by Fannie Mae and Freddie Mac—and these are equal to an approximately astounding 30% of current shareholder equity and 80% of tangible equity.

Deferred tax assets are essentially tax losses to be used against profits in the future. So, the company really has $7 billion tangible equity to support $2 trillion plus in assets and $1.2 trillion in off-balance-sheet assets. (Before the government announced its rescue package, Citigroup said it “has a very strong capital and liquidity position—Editor.)

These are more accounting gimmicks and an impossible leverage ratio over time as more write downs come.

But it's good for us, as management is a mess and even if the company wants to sell parts of its operations to raise cash, what price do you think it could get? And, if Citigroup needs more money form Uncle Sam, which I believe it will, this time shareholders are going to get creamed.

So, let's buy the Citigroup March 2009 $4.00 Puts (COW) under 80 cents. (They traded above 40 cents Wednesday, while the stock closed above $8.00—Editor.)

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