Government Ups the Ante on Citigroup

Citigroup is in talks with federal officials that could result in the US government owning 40% of the bank, after shares in the distressed bank dropped to 17-year lows to $1.61 in trading Friday.   

Shares in both Citi (C) and Bank of America (BAC) plunged to lows not seen since 1991 and 1984, respectively, after Sen. Christopher Dodd (D-Conn) commented that the government may have to nationalize some banks.

Both stocks have lost more than 90% of their value in the last year, as the stock market now expects a high probability of the two being nationalized.

White House spokesman Robert Gibbs issued a statement after trading closed that the "administration continues to strongly believe that a privately held banking system is the correct way to go, ensuring they are regulated sufficiently by this government."

The moves at Citi come in advance of details set to be announced on Wednesday about a new "stress" test for up to 25 banks with assets exceeding $100 bn or more that are thought to be in trouble. The stress test is likely to focus on these banks' capital cushions, to see whether they can survive a deeper economic downturn.

The test could zero in on a conservative estimate of a banks' capital cushion, called "tangible common equity," (see below). Citi approached the government in advance of the new stress test due to its deteriorating balance sheet to see if it could convert either all or a portion of the government's existing $45 bn capital injection, which came in the form of preferred equity stakes.

The government's $45 bn in preferred equity would be converted into common shares in order to bolster Citi's capital cushion.

However, preferred equity does count toward regulatory Tier one capital cushions.

The issue now is converting the government's shares into common equity would give it voting rights and thus more of a say in the bank's operations.

A Serious Development

Giving the government more of a say in Citigroup's operations would be a serious development for the US economy.

As it stands now, the Administration's foreclosure plan would aim to keep borrowers in their homes longer by getting banks to cut down their loan amounts, instead of moving them out of their homes so other borrowers who can afford them can buy them.

Would a Citigroup with the US government as a majority owner be able to get a better deal on loan modifications for shareholders?

Or would Citi be run like Fannie Mae and Freddie Mac is now, as politically captive publicly traded companies who do Congress's bidding in the housing crisis, by taking on more assets and loans, moves that have pushed both nearly under water?

Already, Citi has acquiesced to Congress in agreeing to not oppose legislation that would allow for bankruptcy cramdowns. Bankruptcy cramdowns would be overseen by federal bankruptcy judges who are selected through political processes, who get appointed by politicians in this country.

Is Citi opening itself up to more political meddling in its operations? Will Citi be a viable, independent bank ever again?

Dwindling Market Caps

Citi and BofA now have a combined market value of less than $30 bn (Citi at $10 bn, BofA, $19 bn). Their combined market cap is now less than the market caps of Home Depot (HD), United Parcel Service (UPS), and Pepsico (PEP). Citi's market cap is now worth less than trust administrator Northern Trust Corp.  

The US government's $45 bn ownership of Citi, or 40%, could effectively make it the owner of Citi since Citi's market cap now is around $10 bn. Citi insiders, however, say they want the government to only own up to a 25% stake.

What's at Issue

A conversion of the government's $45 bn in preferred stock into common shares is advantageous to Citi on the one hand, but would effectively give the government plurality voting power if the government decides to keep the voting power of the common shares.

The move would effectively see the US taxpayer owning less than 50% of Citi, despite the fact that the $45 bn in taxpayer funds already spent by the government is more than four and a half times the market cap of Citi, (now at $10 bn), a troubled bank that has already received two bailouts, including a government backstop on $306 bn dollars worth of bad assets--with Citi taking the first $56.7 bn in profit hits, and the government taking the remaining $249.3 bn.  

As the Federal Reserve has lent funds on many of the dicey assets of these banks, many wonder whether the central bank, too, should go through a stress test of its own.  

The Government Speaks

A joint statement by the US Treasury, the FDIC, the Office of the Comptroller of the Currency, the Office of Thrift Supervision, and the Federal Reserve issued this morning says:

"Any government capital will be in the form of mandatory convertible preferred shares, which would be converted into common equity shares only as needed over time to keep banks in a well-capitalized position and can be retired under improved financial conditions before the conversion becomes mandatory."

The statement adds: "Currently, the major U.S. banking institutions have capital in excess of the amounts required to be considered well capitalized. This program is designed to ensure that these major banking institutions have sufficient capital to perform their critical role in our financial system."

The statement stops short of indicating whether the government will either in part or completely take over banks via a nationalization, similar to the government's takeover of American International Group, Fannie Mae and Freddie Mac. More conversion of preferred shares into common shares is on the way.

Shareholder Dilution

Letting the US government convert its preferred shares into common shares doesn't add any new capital to Citi. Again, instead, it's a bookkeeping maneuver that lets Citi bolster its capital cushion and reduce its leverage picture (see below).

However, the conversion would dramatically dilute existing common shares.

Sovereign Wealth Funds Balk?

Also another big concern for Citi: now under discussion is a move to convert $35 bn in preferreds held by sovereign wealth funds and others into common shares. However, until the US government's intentions are made clearer, it's not certain whether the SWFs will want to pursue this option.

As part of the plan, Citigroup officials hope to persuade private investors that have bought preferred shares--such as the Government of Singapore Investment Corp., Abu Dhabi Investment Authority and Kuwait Investment Authority--to follow the government's lead in converting some of those stakes into common stock, the Wall Street Journal reports.

Talks over a bigger U.S. government stake in Citigroup could put Singapore's sovereign wealth fund in the difficult position of having to decide whether to convert its beaten-down Citi stake into common stock and wind up owning more of the troubled bank than it might want, the Wall Street Journal says.

If the US government converts its preferred stock into common stock in Citigroup, all investors, including the sovereign wealth funds, would be diluted.

Citi's Race to Deleverage

Citi's chief executive Vikram Pandit is now desperately racing to deleverage Citi. He's moving to lay off 72,000 workers, trying to sell anything not nailed down to dump $500 bn off its $2 tn balance sheet, even selling a huge stake in the coveted brokerage Smith Barney to Morgan Stanley. 

The problem with the government's preferred stake in Citi is both dilution, the preferreds' dividends owed and now their conversion into common shares, which again means the US government could have voting rights in Citigroup, directing the bank to do its bidding.   

To date, the US Treasury has put up about $235 bn for banks largely by purchasing only preferred shares to avoid diluting common shareholders. Treasury Secretary Timothy Geithner's new plan would redo existing as well as the remaining TARP capital injections as convertible preferreds, meaning they could be  converted to common equity if necessary.

The Problem with Citi

Citi's leverage--its assets divided by tangible common equity--is more than double that of Goldmans Sachs. Citi's tangible leverage was 48 times its tangible common equity, versus 21 for Goldman, reports indicate. JPMorgan Chase's ratio is 26, reports indicate.

So, Citi needs $35 bn to get down to JPMorgan's level. Hence the talk of the $40 bn conversion of preferreds into common now. 

The government's preferred stakes do boost Citi's capital cushion, what's called in banking parlance its tier one capital. Preferred shares are included in regulatory tier one capital. Also included in tier one capital are goodwill sums (typically sums acquiring companies pay above a target's book value); intangible assets (the value of, say, the brains in a bank's M&A division); the money that will come in the door down the road for servicing mortgages; and retained earnings, the earnings a company has before it pays dividends, what it will plow back into the operations or use to pay down debt.

But the government's preferred equity investment does not help a very important measurement, a conservative one, that's used to value banks. It's called tangible common equity.

You may hear alot more about TCE in coming days.

TCE is what shareholders own once assets and liabilities are netted against each other and goodwill and other intangible amounts are knocked out. TCE does not include preferred equity.

On this basis, Citi looks pretty weak.

Say for example, that Citi must be forced to restructure through a bankruptcy restructuring. That is mentioning the unmentionable for what was once the biggest bank in the world. But watch this.

Here's the math. Citi has a net worth of $121.9 bn. It's got $1.9 tn in liabilities and $2 tn in assets.

It's got $28.5 bn in deferred tax assets, $34.2 bn in goodwill, $10.5 bn in intangibles, and $8.8 bn it expects to get in the door via servicing mortgages. Total all of those up and you get $82 bn.

Citi has sizable goodwill from its acquisition sprees which is why its leverage versus TCE looks dreadful now.

Now turn to just Citi's net worth on a hard asset basis. That means you'd knock out all of those sums, the $82 bn, because they could be argued that they are ephemera. Subtract $82 bn from $121.9 bn, its net worth, and you get a tangible common equity of $39.9 bn.

Divide $39.9 bn into Citi's $1.9 tn in liabilities and you get a leverage ratio of 47.6 times. That means teetering atop Citi's $39.9 bn in net worth are $1.9 tn in liabilities.

And Citi's overall assets are fifty times its tangible net worth.

Until recently, TCE--essentially a gauge of what common shareholders would get if an institution were dissolved--has been one of the less prominent ways to measure a bank's vigor. Now it's in vogue because TCE is also among the most conservative measures of financial health.

Watch TCE talked about more when the Treasury introduces its stress test.