Citigroup in 2007 (BAV, Tuesday, Week 2)
business-analysis-and-valuationyear-twoHow banks work:
-- Very asset intensive (huge balance sheet)
-- "Interest spread" model flows through balance sheet and income statement
-- Manage income statement for investors; manage balance sheet for regulators (esp. in a crisis). Natural tension...
Implications of fair-value accounting --- three kinds of assets:
-- Held to maturity: held at historical cost, amortized, subject to impairment checks
-- Available for sale: held at fair value, any changes hit the balance sheet as "other comprehensive income" ==> Why? Because if your house doubles in value in a year ($200K to $400K), you didn't really earn $200K more income that year.
-- Trading Assets: held at fair value, any changes flow through income statement ==> Why? Because if your job is flipping real estate, you actually did earn $200K of income.
Three ways to assess fair value of assets (in order of increasing subjectivity):
Level 1: unadjusted market price (equity in GE)
Level 2: mark to model, disciplined by market input (some unique GE corporate bond; not exactly like traded securities but pretty close)
Level 3: mark to model, unobservable inputs (claim on GE's future earnings from one particular project; no clear analogues)
Some managerial discretion in deciding which method to apply. Be wary if lots of assets valued via Level 3.
Regulatory requirements --- several ratios, big-picture takeaway:
Numerator = most kinds of equity (net of intangible assets and goodwill)
Denominator = risk-adjusted assets
How do banks get through crises:
-- Sell assets (problem: prices are usually bad)
-- Raise capital (problem: usually especially costly)
-- Cosmetics (sell appreciated assets and immediately replace them; re-classify; etc.)