To The Moon

The collapse of Silicon Valley Bank, part of SVB Financial Group (SIVB), has dented market confidence in the global banking system. In my last article, I explained that they were two key reasons forthis utterly avoidable debacle: 1) Colossal risk management failures by SIVB management 2) Failures of regulatory design and oversight. The culprit in this crisis has not been (so far) credit risk (but this may come later). Rather, it is due to the rapidly rising interest rates in 2022, where the banks have accumulated large unrealized losses on their securities portfolio (comprising predominantly of "safe" U.S. Treasuries and Agency MBS). The problem is that these unrealized losses due to accounting treatment (or manipulation by management at times) were not reflected in the capital ratios of the banks. In some cases, the size of the unrealized losses grew bigger than their capital base, essentially meaning that they were trading whilstinsolvent. The penny finally dropped when SIVB attempted to raise capital and the market suddenly realized that this risk transformed into both liquidity risk and then evolved into solvency risk as the banks were forced to realize these losses. The Fed had no option but to backstop the system. Make no mistake, this was completely avoidable with effective regulatory oversight. This was all plainly evident for everyone to see in the 10-k fillings of the banks. The implications are widespread and the emergency response by regulators could be tantamount to the Japanification of the U.S. banking system. The regional banks are in trouble and some our kept on life support by cheap liquidity provided by the Fed. As with every banking crisis, winners will also emerge, and in this case, the winners are likely to be the large U.S. G-SIB banks such as JPMorgan Chase & Co. (JPM), Bank of America Corporation (BAC), Wells Fargo & Company (WFC), and Citigroup Inc. (NYSE:C$Citigroup(C)$ ). These banks are benefiting from deposit inflows due to flight to quality. The massive regulatory agenda since the GFC has transformed these banks into fortresses of capital and liquidity which protects shareholders as well as the system. Given recent developments, the regulatory reform agenda is now firmly focused on the regional and mid-size banks as opposed to the too-big-to-fail banks. Finally, the large banks' business model is also much more diversified, with capital markets, transaction services, investment banking, wealth management, and security services businesses. They are no longer reliant on higher-risk loans like commercial real estate. Understanding Citigroup's Unrealized Loss Position Firstly, investors should understand the difference between securities held-to-maturity ("HTM") versus held-for-sale ("HFS") and how much of this is already included in the capital ratios. In short (and glossing over some of the accounting technical aspects), HTM is not revalued on the balance sheet and is carried at par and, therefore, also excluded from the capital ratios. So, where unrealized losses are outsized compared to its capital base, that is a huge red flag. Banks typically do not hedge HTM to a great extent, as the hedging gains/(losses) would introduce "unwanted" volatility to the bottom line. This is exactly what transpired with SIVB, and the regulatory supervisors completely took their eyes off the ball. HFS unrealized losses, on the other hand, do not flow through the profit and loss statement but are recognized in the equity line (Accumulated Other Comprehensive Income, or "AOCI"). For large banks (greater than $700 billion in assets), this is included in their capital ratios and consequently most of the large banks hedge that exposure to reduce the volatility in their capital ratios. Smaller banks, though, rely on the "AOCI filter" exemption, and thus AFS unrealized losses are excluded from their capital ratios. The above two paragraphs explain what has gone horribly wrong with some of the regional banks and are a manifestation of the two-tier regulatory framework that was substantially more intrusive on the large U.S. banks compared with their smaller cousins. Now let's considerCitigroup's numbersand assess the risks (spoiler: Citigroup liquidity is exceptionally strong). Citi's High-Quality Liquidity Portfolio ("HQLA") comprises the following: As can be seen above, Citi is highly liquid with $242 billion of cash on hand as well as securities in its HQLA portfolio. In addition, as disclosed in the 10-K, it has additional access to liquidity sources above and beyond the HQLA: As of December 31, 2022, Citigroup had approximately $1,045 billion of available liquidity resources to support client and business needs, including end-of-period HQLA assets; additional unencumbered securities, including excess liquidity held at bank entities that is non-transferable to other entities within Citigroup; available assets not already accounted for within Citi’s HQLA to support the Federal Home Loan Bank; and Federal Reserve Bank discount window borrowing capacity. Consider the unrealized losses in Citi's securities portfolio starting with HFS assets: As you can see, the unrealized losses on the HFS are a modest $6.6 billion. As highlighted above, Citi hedges most of its portfolio to avoid capital ratio volatility. Investors should note that the unrealized loss is already included in AOCI and thus already included as a reduction in its capital ratios. The HTM portfolio, however, has approximately $25 billion of unrealized losses mostly generated in 2022: Still, this is relatively modest in the context of Citigroup's ~150 billion capital base and liquidity buffers of ~$240 billion of cash and ~$255 billion of AFS securities (as well as other liquidity options as outlined above). In short, there are no concerns with Citigroup's liquidity and/or unrealized losses. The Crown Jewel - Treasury and Trade Solutions ("TTS") TTS is Citi's crown jewel and currently delivers quarterly revenues of ~3.5 billion and ~30% ROE. The TTS business is effectively all of the liquidity, payments backbone, and the entire working capital financing side of the business across 95 geographies. It is plugged into almost 270 direct clearing platforms and thus enabling a closed-loop payments system for Citi's clients. Citi is looking to grow this in the middle market (commercial banking) space as highlighted in a recent presentation by the Head of the business: But I'm particularly excited also about the mid-market segment. In the Investor Day, we talked a lot about commercial bank and how we're building out that opportunity. Our relative market share is dwarfed by what some of our competitors have. And if you think about the future and if you think about what clients are looking to do, particularly the mid-market clients, everybody is looking to go global. So we've helped some of the large Fortune 500 companies go global over the last 10, 20, 30 years, and particularly in this new digital environment that we're operating in, we think that there's considerable potential to take all that we've done and built for the large Fortune 500 companies and use that for the benefit of the mid-market clients as well. So we think there's opportunity despite a stressed macro environment, it helps us project our agenda on a go-forward basis as well. Currently, the commercial banking revenue is only 10% of TTS revenue. The dislocations in deposit flight to safety due to the SIVB collapse are very positive for this business. Any corporate treasurer that does not contemplate onboarding with a G-SIB bank, would be putting his/her career at risk. Once a TTS relationship is established, it is awfully sticky. Citi has the best product suite and dwarfs all other banks in terms of market share and capabilities with FinTechs and digital players. I have little doubt that Citi will be picking market share at very attractive returns going forward. Final Thoughts I would avoid the regional banks for now. There are a number of material headwinds including deposits outflows, regulatory scrutiny, and likely reform and a weak economy that is likely to hit commercial real estate and private equity. Citigroup, and some of the other large U.S. banks, are massively benefiting from a flight to safety trade. Citi's TTS is especially well-positioned to take material market share in the commercial banking space. I am buying the panic. Source: seeking alpha