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How Berkowitz Got Comfortable with Citi

The Fairholme manager describes the thesis behind the fund's recent purchase of Citigroup stock.

Michael Breen: Speaking of mulligans, you just bought a firm that probably wish it had one for the past couple of years: Citigroup. Maybe you can let us know how you got comfortable with that, because a few years back, you were speaking about how you couldn't get transparency on the big banks and the financials.

So is it a case of the blind now being able to see, or have things been shored up to a point that anybody can get comfortable with it? Why don't you give us the thesis for Citigroup?

Bruce Berkowitz: I think it's a bit of both. In the U.S., this was not a bankruptcy, but it's gone through a scrubbing process, very similar to a bankruptcy, by the U.S. Treasury. Citigroup has spent a good amount of time with the U.S. government and many of its financial regulators, going through every liability and asset in the books.

After such a period of time, you normally are able to count the cockroaches. That is, the liabilities have been under a microscope for quite a period of time. There's been huge capital injections by the government. There's been a massive amount of dilution to old shareholders. And you're starting to see some stability, the beginnings.


It's very much what I call now the pig in the python. You have to look at their liabilities. So you have to look at their bad debt, and you have to continue to watch how the company is digesting its bad debt.

At the same time, you have to see the new debt that's coming in, the new loans that they're giving out. It's fascinating. It amazes me, with financial institutions, the extent, the amount of new loans that are being created in relation to the total loan portfolio.

So it's just now, in my opinion, a question of time, an ingestion period, where how many more quarters is it going to take before the new loans start to outweigh the old, existing loans?

Breen: Can you comment on the quality and the profitability of the new vintage versus the old and how that might be underestimated or ignored? Or is it even important?

Berkowitz: Well, what we learned from AmeriCredit, and Household International a decade ago, and Wells Fargo in the late 1980s, early 1990s, is that when times are tough, you're looking to shrink down the business. And the new loans that you do put on are your best loans.

So loans, for example, from AmeriCredit, from mid-2008 forward, are quite profitable loans, as you can see in their vintage curves. And that's going to be the case with many of the banks and financial institutions. And as time goes, their build will increase and increase as the bad stuff decreases.

And to some extent, bad may not be as bad as everyone thinks, because just like the last time and the time before, when you get into a financial crisis, the pendulum swings from one extreme to another, from greed to fear. You have bank examiners going in there, into every major bank and financial institution, and they're pushing hard, and they're pushing hard with reserves and markdowns and valuations.

So from a very liberal, sort of nonchalant valuation policy of a few years ago, you now have a very tough regime in place. And we'll see. Normally, in most cases, at this point in the cycle, the valuations are reasonably conservative.

Breen: And so for Citigroup, it's safe to say they are far enough out of the woods that you're comfortable with the equity, where, with the real-estate debt, with the bankruptcy, it's a different situation, and you're taking a different spot on the capital structure.

Berkowitz: Right. We're in there. Our major partner is the U.S. government. I mean, Citigroup is woven into the fabric of the United States. Citigroup will be around. I hope it will be around in a smaller form. It will be around in a better form, it most likely will be around with different management, and Citigroup will move on.

Michael Breen does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.