10/12/2009 07:12 pm ET Updated May 25, 2011

The Real Story with Citigroup and the Other Banks

What happened at Citigroup last week was very interesting. They sold their Phibro commodities unit to Occidental Petroleum for $250m. That is a pittance. Phibro had average earnings of $371m in the past five years. The sale price is actually below Phibro's net asset value. So why would Citi give its assets away at such bargain basement level?

They had to do this deal so they could mollify the public's anger with the $100m contractual bonus Phibro had to pay star trader Andrew Hall. This is the result of government involvement in business, because it is too embarrassing to pay someone a bonus he will be paid anyway (similarly, pay restrictions at AIG led to massive departure of senior staff, and that couldn't have been beneficial to the value of tax payers investment in AIG).

This is indicative of the feeble management at so many of the nation's banks and financial companies. There are other examples, chief of which is the perplexing manner in which they construct their balance sheets.

Gerald Ford is an authority on banks, given that he made over $1 billion investing in banks and financial companies during several market cycles (he bought his first bank in 1975). The well respected Ford recently told Forbes magazine (for its Forbes 400 issue) that even now too many banks haven't put enough money in reserves to cushion losses. If they took the appropriate marks on their loan books they would be insolvent, says Ford.

So instead banks are stalling, in the hope that an economic recovery, coupled with a steep yield curve, would boost their margins and save them. This is not new, as banks have pulled similar tricks in almost every previous credit cycle. But now, regulators are also complicit in that they are dragging their feet on seizing weak banks. So far, 416 banks were put on the Federal Deposit Insurance Corp.'s troubled list. But many more should be added.

At the end of June, Citigroup was levered 12:1. Other banks have similar debt ratios. If it turns out that consumers are too extended and the recovery proves tepid, or the economy stalls again, many more struggling banks will fail. A new wave of losses from commercial real estate loans could also get more banks in trouble, not to mention all these mortgages where the borrower isn't required to pay down the principal, and often can't even keep up with the interest accruing. Recall that as of the end of the first quarter of 2009, about 14% of all mortgages had negative equity, and that number may double before the housing market stabilizes.

Poorly managed and over exposed, banks are not a very safe place for investors to be.

Alan Schram is the Managing Partner of Wellcap Partners, a Los Angeles based investment firm. Email at