Takeaways from Citi's Distressed Desk Analysts (Average Returns, Cash Balances, MF Global)

Yesterday, Citi kicked off its 2011 North America Credit Conference. As usual, Citi provided a strong offering of management presentations across the credit spectrum as well as many fascinating panel discussions (just to name a few: Global CDS Central Clearing Update, 2012 Implications of Dodd-Frank and Changes to the Banking Regulatory Scheme, a high yield panel, etc). Most relevant to us, Citi's distressed desk analysts presented a variety of actionable ideas to a large audience of distressed debt investors.

Before the analysts discussed their investment ideas, Rohit Bansal, the head distressed trader at Citigroup, kicked off the discussion with a few interesting observations. First, he noted that after to speaking to a number of clients, the average distressed fund was ranging from -5% to 2% in terms of return for 2011. Second, he noted that there was a significant amount of cash waiting on the sidelines, to the range of 25-40%. The "pain trade" as it were is making accounts want to wait until there is more clarity on the macro scene before risking capital. He did note that funds with locked up, long-term capital will be more willing to bid on blocks whereas funds beholden to redemption risks are significantly more cautious.

Next, Marc Heimowitz, Head of Credit Special Situations, touched on an issue that is plaguing the entire investment community: Markets are being driven by macro exogenous risks. In theory, the issues in Greece should not affect the fundamentals of numerous businesses in the United States, but those same issues are dramatically affecting the pricing of underlying securities.

He then moved on to the level of dealer inventory. Here is a chart from Bloomberg:

You can see the precipitous drop since the 1H of this year. What makes this chart even more frightening is when you compare the above to the amount of total corporate debt outstanding which rises year after year after year. This effectively means that the amount of dealer inventory over the amount of corporate debt outstanding is near decade lows.

Personally, this is making execution all the more difficult and dealers (rightly so) are having to make wider markets less they be picked off by aggressive accounts. He closed by nothing they think Lehman's recovery falls into the 31-32 range with a 1 year average life (versus a market near 25.5).

Next, the distressed desk analysts each presented an actionable long / short idea from the variety of their coverages. While, I will not list each of these ideas (contact your Citi sales coverage for the list of ideas), I did want to to touch on one idea in particular, especially given the price action today: MF Global.

We first introduced MF Global's bankruptcy a few weeks ago. Since then, the broker-dealer has been placed into liquidation, a creditor committee for the holding company has been named, and many, many buy side analysts still are doing the hard work to value the recovery to creditors. This price action since the bankruptcy has been anything but stable:

Bonds were up 6 points today, driven by three reasons (in my opinion and listed in reverse chronological order)

• Creditor Committee counsel, Martin Bienenstock (Dewey & LeBoeuf), said in court: "We think there is potentially quite an estate to be amassed here for the benefit of creditors."
• Rumors that Appaloosa had been buying bonds in the mid 30s according to unnamed sources
• Rina Joshi, Citi's distressed desk analyst covering MF, laying out a case that the bonds could be worth between 50 cents to par at Citi's credit conference yesterday.

Rina presented a compelling case and I had the feeling, given the size of the crowd in attendance, the bonds would be up with the pitch. They started the day up 2-3 points and then really rallied into the close as the case proceedings heated up.

Rina first noted, and I think everyone covering the MF situation understands deeply, that there is significant missing info and much of the info analysts are working with is dated (for instance, the last broker-dealer financials we are working with are from 3/31). In essence, the bond (and bank debt) will receive value two ways: 1) inter company receivables and loans 2) equity from subsidiaries, both domestic and abroad.

Most people I speak to have been deconstructing the balance sheet by matching assets and liabilities, and then applying a "friction cost" or haircuts (to both sides in some instances) to come up with equity value that, in theory, should flow up to the intermediate finco and the ultimate holding company. A basis for this is that according to the most recent data we have, MF Global had VERY few Level 3 assets and thus, again in theory, friction costs should not be onerous to the recovery of the estate(s).

Rina demonstrated this with a variety of assumptions of the level of haircuts which restulted in a par recovery for a small levels of haircuts and lower recoveries for larger haircuts for a range of 50-100 cents on the dollar. These levels have to then be discounted depending on your hurdle rate and how long until you expect to receive distributions. Ultimately, and I think this was my biggest takeaway, she noted that the trading level of the bonds imply $2.6B of equity was lost at the organization which she seemed to be aggressive. She did note that if the $500M+ of missing funds were not recovered, this would ultimately affect recoveries on the order of 20-30 cents, but she believes that money is somewhere in the system.

For full disclosure, I have yet to establish a position in the name, despite a nagging feeling that recoveries will be north of 50 cents here. ~$600M doesn't simply just go missing, assets were seemingly liquid, and some people I've spoken to say that a number of the overseas operations are amazing assets that will flow equity to boost holding company recoveries. The needle moves VERY quickly on this one given the leverage (i.e. an assumption of 1% friction costs to 2% friction costs greatly reduces recoveries). I continue to work through the issues and hopefully when the first MOR hits, I'll be able to update my model and share with readers. If you are working on this one, would love to hear your thoughts.