Citibank's $12 billion dollar loans

It's easy to see this headline and think subprime loans. Don't. These are not subprime loans. They are not based on subprime loans. In fact they have nothing to do with mortgages. They are corporate loans.

And what is a corporate loan? it's a loan to a corporation. It's a short to medium term loan that is secured by the corporation's assets and comes with a set of stipulations that the corporation has to follow. Recently it has been a key part of the LBO (leveraged buy out) market that took companies of all types and sizes private. It differs from high yield bonds (junk bonds) that fueled the Drexel junk bond LBO craze of yesteryear because they are senior secured instruments.

So why was Citibank stuck with so many? Citibank, and every other investment bank, was involved in the loan market because it was instrumental to the buyout market. To participate in a large multi-billion dollar buyout, a bank or a syndicate of banks bids for the right to loan the acquiring company the money to buy it. So for example, private equity fund PEF is buying company XYZ for $30 billion dollars. They go to their bankers and say "give me your best deal!". The banks figure that out, and loan them the money and the transaction goes through.

What do the investment banks do now? well they don't want to hold the loans, they want to sell them. And usually they do, to hedge funds, bond funds and CLOs. And there was a healthy demand for the paper, so the banks could be aggressive on what they charged the private equity firms. They were waving in deals and printing paper. But there's a lag between when a bank commits it's resources and when a deal closes and in that time the credit markets ground to a halt.

So the banks were suddenly left with billions of dollars of loans clogging up their balance sheets. This is not what investment banks are supposed to do. They are supposed to buy and sell, or loan and sell. The sell part of the equation had disappeared. the buyers had disappeared. And to get buyers, the banks had to lower the price.

So now $12 billion dollars of loans on the books was work 80 to 90 cents on the dollar, or a $1.2 to $2.4 billion loss.

So the banks are losing money on good assets. Not to be confused with the subprime crisis, where the banks are losing money on bad assets. How can you lose money on good assets? buy at the wrong time.

Plenty of people bought tech stock before the bubble burst. Some bought brain freeze stocks like pets.com, but lots of people bought good solid companies for more than what they should have. They were supposed to keep going up, they went down and money was lost. The companies were still good and are still in business now (look at Oracle for example).

So Citibank is just cleaning house. This frees up some capital, allows them to take a loss and move on.

And the brilliant part of it is that the private equity firms, the very people that borrowed the money, are buying the debt. Not all of the debt, but a good deal of it. They're doing this because of three main reasons. The first, is that it's a good deal. They like the company, believe it's going to get bigger and better and will make money in the long run. They already own the equity (an LBO buys the equity of a company), so why not the debt too. And at a discount. And as the company improves, and the credit market improves, the debt will become more desirable and will be traded.

The second reason is more pragmatic. Private equity firms need the investment banks to raise money. It might not be working now, but it will in the future. People have long memories.

The third reason is a pure CFO play. The loans were made in a very aggressive market and are very low. If they were refinanced, it would be at a much higher rate. By buying the loans, they are helping out the acquired company's balance sheet.