The end result is a rock-solid capital structure strong enough to endure Great Depression level stress tests.

TO BE NOTED: From Barron's:

HOT RESEARCH AM

Citigroup Ready to Right Itself

The bank is set to take advantage of new rules, regulations and reality.

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Citigroup (C: NYSE)
By Singular Research ($3.77, May 20, 2009)

AS ONE OF THE most troubled banks exiting 2008, Citigroup (ticker: C) is now one of the most optimally positioned to take advantage of new rules, regulations and reality.

We are initiating coverage with a Buy rating and a 12-month price target of $7.70.

[Treasury Secretary] Tim Geithner and the Obama administration are prepared to do whatever it takes to escape today's financial quagmire. Fortunately they have moved away from all-out nationalization, and instead are focusing on ensuring that banks are well capitalized, management teams have accounting flexibility, and that stock prices are free from manipulative downward pressures (upward pressures are fine, at least for now). Though reviews have been mixed, intentions questioned, and programs criticized, all levels and branches of government are slowly but surely constructing a new environment in which banks return to prudent banking and lending practices -- a goal shared by Citigroup.

Since the fourth quarter of 2007, Citigroup has reduced headcount by 20% and overall expenses by 25%. Since the third quarter of 2007, Citigroup has trimmed its balance sheet by 23%, including a 65% decrease in collateralized debt offerings (CDOs) and subprime exposure. Adding together public, private and government-related fund raising, over the last five quarters Citigroup has raised nearly $80 billion dollars in an effort to combat a once highly leveraged and risky balance sheet. Moreover, Citigroup is raising an additional $33 billion in common equity through an already announced preferred exchange in response to the findings of the U.S. Government's Supervisory Capital Assessment Program (SCAP). The end result is a rock-solid capital structure strong enough to endure Great Depression level stress tests.

Lending was strong in the first quarter, and we expect further signs of traditional banking and correlated revenue growth in the quarters and years to come now that Citigroup has a balance sheet that can withstand increased lending activity and overall asset growth. In addition, we have experienced firsthand, Peter Lynch-esque customer service and marketing across the bank's operations, all the way down to the teller window where new products are being offered.

We are forecasting fully diluted 2009 earnings of ($0.08) per share to account for the first-quarter operating profit, first-quarter one-time items, as well as further growth and profitability for the remainder of the year. For 2010, we are issuing an earnings forecast of 25 cents to account for increasing growth expectations upon economic recovery.

We are looking for a near-term price target of $5.50 based simply on Citigroup trading at 1.0 times its tangible common book value.

Longer term, as the company executes and regains investor confidence, we are projecting a 12-month price target of $8.25 based on both historical and peer group average price-to-tangible-book multiples of 1.5 times.

-- Jonathan Hegranes"

"So let’s count the other red flags and see if they were numerous enough and obvious enough."

The Trader's Narrative with a list you won't want to check twice:

"After writing that Madoff offers the biggest due diligence lesson for investors, some argued that the red flags are only obvious in hindsight and wouldn’t have been if so clear if one had to make the decision before Bernard’s admission of running a Ponzi scheme. ( BS )

To be generous, I’ve assumed that the whole nature of the trading strategy, the inability of others to reverse engineer it, and the eerie equity curve it created, were not red flags ( THAT'S WAY TOO GENEROUS ).

So let’s count the other red flags and see if they were numerous enough and obvious enough. (The thumbnails are from the SEC’s website and clicking on them will take you to the larger version.)

RED FLAG #1
Madoff Investment Securities was both the broker dealer and investment advisor:

RED FLAG #2
Madoff traded in the same securities that he recommended to advisory clients:

RED FLAG #3
Madoff not only was the broker dealer, creating a conflict of interest where his firm was trading in the same securities as he was trading for clients, but he actually had custody of the assets!

RED FLAG #4
They got into some hot water over some small compliance issues. Madoff’s firm was censured and fined a small amount $7,000. But this meant they did have a blot on their records:

RED FLAG #5
Jim Vos, head of Aksia - a hedge fund advisory firm, noticed that although Madoff’s firm was supposedly highly advanced and automated, they sent paper copies of their trading records to clients instead of providing electronic access to the firm’s trading platform.

RED FLAG #6
Madoff Investment Securities’ auditors were Friehling & Horowitz, a 3 person team which consisted of one lone CPA with a small 13′ by 18′ office in New York. Hardly adequate to monitor a firm that traded a good chunk of NYSE and NASDAQ volume.

RED FLAG #7
Shockingly enough, Madoff didn’t take the usual 2/20 fees most hedge funds do. Instead he only profited from the trades that his firm was doing for the “investment fund”, claiming that this was enough. Given this form of compensation, it is very possible most “sophisticated investors” assumed that Madoff was involved in some sort of shenanigans but turned a blind eye for those stable returns ( WISHFUL THINKING AND GOVERNMENT GUARANTEES ).

Here’s an excerpt from a 2001 Barron’s article on Madoff Investment Securities secrecy:

Curiously ( IMPOSSIBLY ), he charges no fees for his money-management
services. Nor does he take a cut of the 1.5% fees marketers like
Fairfield Greenwich charge investors each year. Why not? “We’re
perfectly happy to just earn commissions on the trades,” he says.

Perhaps so. But consider the sheer scope of the money Madoff would
appear to be leaving on the table. A typical hedge fund charges 1% of
assets annually, plus 20% of profits. On a $6 billion fund generating
15% annual returns, that adds up to $240 million a year.

The lessons of Long-Term Capital Management’s collapse are that
investors need, or should want, transparency in their money manager’s
investment strategy ( YOU THINK ? ). But Madoff’s investors rave about his performance
– even though they don’t understand how he does it ( WISHFUL THINKING AND GOVERNMENT GUARANTEES ).

RED FLAG #8
Madoff Investment Securities was a family business, with Madoff’s brother, sons and daughter as well as his niece (married to a previous SEC compliance officer) all worked at the firm.

“All of his family members grew up with this being our lives. When it is a family operated business you don’t go home at night and shut everything off, so you take things home with you, which is how all of us grew up”

Mark Madoff (pictured on the right with his father, Bernard L. Madoff, left)

Peter Madoff, pictured below, was a senior managing director and head of trading and compliance at Madoff Investment Securities. He began at the firm in 1965. With so much family involvement, one can’t help but ask how much they knew and if it was even possible for one lone patriarch to organize, control and maintain such a huge fraud all by himself.

Click to see large version:

Aksia LLC, broker dealer, due diligence, fraud, hedge fund, Jim Vos, Madoff, Madoff Investment Securities, ponzi scheme, public disclosure, SEC

The reasons that investors took these risks were Wishful Thinking and the Government Guarantees.

"To take it at face value is a bit naïve."

As I thought, there's endless reporting on Madoff, so I'm just going to pick out tidbits that interest me. Here's Paul Kedrosky:

"More Madoff Near-Misses: Barron's, MAR/Hedge, etc.

A Barron's story from 2001 is being forwarded everywhere today. In it, the publication came close to nailing the Madoff story almost eight years ago. Here is a key paragraph:

Still, some on Wall Street remain skeptical about how Madoff achieves such stunning double-digit returns using options alone. The recent MAR Hedge report, for example, cited more than a dozen hedge fund professionals, including current and former Madoff traders, who questioned why no one had been able to duplicate Madoff's returns using this strategy. Likewise, three option strategists at major investment banks told Barron's they couldn't understand how Madoff churns out such numbers. Adds a former Madoff investor: "Anybody who's a seasoned hedge- fund investor knows the split-strike conversion is not the whole story. To take it at face value is a bit naïve."

More here, and the original MAR/Hedge story that seemingly sparked the Barron's piece is here.

And while I'm on the subject of Bernie Madoff near misses, an insider view from someone who did due diligence and walked years ago."

This is an example of Wishful Thinking. You see what's going, but choose to ignore it, on the hope that you'll be wrong. It's very common, which is why people who commit fraud can use it so effectively. It's a bit like the magician using expectations to fool people.