Michael Klein: Some facts and figures

The Global Credit Crisis: How Bad Will it Get? April 14, 2008

Michael Klein - Chairman and Co-Chief Executive Officer, Citi Markets and Banking

I am a banker from a U.S. bank with offices in over one hundred countries, so I sit, arguably, at the epicenter of what is this unbelievable storm that continues to sit over the developed markets' financial world, and I think, increasingly, a storm that's focused on the Anglo-Saxon financial world as we sit today.

Now, coming out of the IMF meetings this weekend and frankly, over the past several weeks, the questions has been consistently been raised, "Where are we in this?" Are we near the end? Have we found the bottom? In a truly American term, what "inning" are we in? Let me say very clearly that you'll hear a lot about that today. I'm just going to give you facts to make your own sense of perspective. First and foremost, we're in the tenth month of financial market turbulence. Ten full months. We're in probably the twenty-eighth month of real estate market declines. The impact of those two forces in the U.S. are accelerating, not decelerating. As of this morning, with announcements from one of the major U.S. banks, we clock a total of $241 billion lost, pretax, from banks and/or from investment banks, based upon simply actions from the beginning of 2007 onwards. Virtually all of those losses are tied to the mortgage market. When one considers the leverage ratio of banks and/or investment banks, which are typically 15 to 30 times leveraged off their equity, that means we have seen, as of this morning's announcements, $4 trillion of capital taken out of the system. We have to add to that the definition of terms that probably many of you have now hear of; I certainly wish I had never heard of- asset-backed commercial paper SIVS, CLOs, CDOs-a roughly $5 trillion class of alphabet soup which has seen another more than $1 trillion loss. Five trillion taken out of the financial system. Add to that what has occurred in the mortgage market in general which is a roughly an $11 trillion market. That's 1x GDP. The underlying house value that underlines these mortgages have dropped, meaningfully. Is it 10%, is it 15%, is it 20%? Others will give you estimates. These are the staggering numbers that are weighing on the economy as we see it today.

Now, these are very, very, very large numbers. They're almost unfathomable when one considers roughly 50% of GDP taken out of the markets that finances consumers and finances corporate activity. Growth, growth capital, day-to-day sustainable capital. Now, certainly some of that money has been replaced. Part of it's come from new investors, sovereign wealth funds--$75 billion of new equity. The central banks have clearly stepped in, in a very large, meaningful way. And perhaps half of this capital withdrawal has been replaced. But we still live in a world with very constrained capital. A world that is decidedly different that ten months ago. It is more volatile. More volatile in the sense that current risk factors are viewed as three times more than they were during most of this decade, as measured by many different markets. We live in a world that the inputs into these particular data points whether it's the cost of oil or the value of the dollar, have changed meaningfully.

And the biggest input is really the continuum of that which funds the day-to-day activity of companies and consumers. And that continuum has always been the same. It starts with central banks, it goes through universal banks, makes it ways into brokerage firms and capital markets participants, and it ends with investors. And in very buoyant times, as we lived with over the past decade, it was those net marginable investors-the hedge funds, the private equity funds-they drove the equation. But in a period where the markets get tough, the cycle goes back to the beginning, which is central banks and universal banks. That's where the problem today gets tricky. Universal banks have felt the brunt of these losses. Universal banks have seen a 60% decline in the value of their companies. And universal banks have seen an increase in the cost of their doing business that is extraordinary and needs to be understood. Traditionally, money center banks can receive funding at virtually no premium over government funding costs.

During the period of the crisis in mid-March with Bear Stearns, the cost of bank financing themselves was more expensive than the cost of high-yield bonds. You must understand, in the world of investment-grade living, if the central counterparties are funding like non-investment-grade entities, that's not sustainable, and of course that is recovered since the tumultuous period of the middle-March period.

Now what we have today is significant constraints. I would say, we have seen two acts already be completed. The first act was early August of last year, the beginning of the liquidity constraint. Many of you will understand fully what transpired; I won't go back into a tremendous amount of detail. I'll simply say the following: The sub prime issue was but a pin pricking a wide and perhaps very overblown bubble. Where that played through was largely unregulated, leveraged, financing pools that were opaque and that implicitly or explicitly exploded in August. As the value of underlying real estate was understood to fall, these big huge vehicles that were buying virtually all of the risky paper, imploded. And in a space of two or three days, tremendous amounts of assets were thrown into the financial system hoping to be rescued, and the system clogged. And that system clogging has rolled from asset class to asset class to asset class. From subprime to municipal bonds to leverage loans to so-called auction rate securities, all the way to the actual end, which is banks and central banks.

That gets us to act two, which is credit constraint, which is what we've been living through right now. We are only now unfortunately, at the beginning of the third act, which is the recession and the period with which we see actual corporate activity declines. Now I point that out in the following sense: We've had four major dichotomies during this ten months. The financial economy versus the real economy. The U.S. versus international markets. The emerging markets on the whole versus everyone else and debt versus equity. The U.S. equity markets are still fairly close to record levels. Much of the world that we live in are growing at record levels. We have over 100 countries growing at over 4%. These dichotomies have continued. But now, we see the beginning of what is a convergence of these dichotomies. We see the beginning as General Electric reports a concerning earnings announcement on Friday. As we see the beginning of challenging unemployment numbers. We see the convergence begin and that brings us into act three. Now will this be a three-act play, a four-act play, a five-act play? We don't know. We don't know. But all of the discussions we're now having, today, sit from a prism of seeing this particular swirl that we are in the midst of.

Now, what's the good news? The good news is-I'm going to read you some comments from the newspaper, because sometimes the newspapers tell us more. The New York Times said "the collapse of a major investment house, symbol of Wall Street-era dismantling"-you will all recognize Bear Stearns; "facing unfortunate facts it's time to declare it's a recession." That's The Washington Post. "Middle East investor buys a major stake in a U.S. bank," The Associated Press. Of course, Citi. "Leveraged buyouts, high-fliers, no more." Of course, The Wall Street Journal. And "the market for bank debt is incomplete disarray," from a Merrill Lynch research report. If I read all of these to you, you all say, "Yeah, I saw something like that." However, every one of those was a quote from a newspaper in 1990. Every single one. Now, 1990, the world was declared dead and between the 1990 death and 2000, equity markets grew 240%; complex financings grew 1400%; and growth and value activity-corporate investments and M&A-grew 700%. You go through the 2002 difficult cycle and all of those numbers tripled into 2007.

So the good news. We're living in the middle of the tumult. We don't yet see the end. But we are seeing very good beginning highlights. And what are they? I'll just point to a couple and then I'll move over to the miked panelists who will have more concrete data. First, Citibank was able to raise $35 billion of capital in two months. Why does that matter? Thirty-five billion dollars of capital is more capital in all but six banks in the world have in total. And Citi was able to raise that from the world's investors in two months. Housing supply versus demand. Housing starts have already been cut by 50% to adjust the imbalance in the housing market. Very rapid adjustment factors. JPMorgan went out and bought, regardless of the price, $300 billion of risky assets, a very, very aggressive move to consider in this part of the cycle. Logjams are clearing as complex pieces of investment paper are selling that were not saleable two or three months ago. All of the markets for investment-grade debt, initial public offerings, are in fact open, surprisingly in the middle of one of the greatest calamites for financial service companies, the largest ever U.S. financial IPO took place with the IPO of VISA. These are just small pieces. And Microsoft makes a hostile bid for a competitor, Yahoo.

What does this mean? It means sophisticated players are seeing that there is value today in the opportunities in front of them, which is a very positive indicator. I would postulate to you the following. We are in the middle; we can't see the end. Those people that see value are beginning to take risks. That's a positive. Central banks are taking aggressive action. That's a positive. Banks, investment banks, and investors are taking constructive views on regulation, constructive views on their assets. That's a positive. We will wake up from this and when we do wake up, we'll face the bigger issues facing U.S. and Germany, which is the long-term trends of jobs moving to low-cost locations and wealth following the cost of commodities to commodities producers to commodities users. And that's principally the transference of wealth to the Middle East, Russia and others. And the big, big challenge, I would say for all of us, is as this current credit crisis continues, we will fall further behind on those transferences if we don't more dramatically and more aggressively address the current concerns today. Thank you.