Citi's New Deal

EMac will be out of the office for the next week and a half or so.

Citigroup got a jump on the government's onerous stress test of the capital cushions for 19 banks, those with $100 bn or more in assets, by getting the government to convert a massive slug of its preferred stake into common shares, the third time the government has come to the aid of Citigroup.

The move gives the US taxpayer a significant voting stake in the bank. Citi also says it helps restore its capital ratios under the most conservative of measures.

But does it really?

The move to convert the taxpayers' stake into common shares comes at the same time that Citi has reported a deeper loss for its fiscal fourth quarter, due to a huge pre-tax $9.6 bn impairment writedown for consumer banking units it acquired in North America, Latin America, Europe and the Middle East.

The new share conversion does not mean the government will be pumping more taxpayer cash into the bank. Instead, it's a swap into a different class of shares that don't pay a dividend. Now the US taxpayer can only hope that Citi will heal and its shares will improve in order for the government to make a profit.

The US Treasury also says that Citigroup was replacing the majority of its board of directors as soon as possible. Chief executive Vikram Pandit is keeping his job.

The question now for Citi investors and taxpayers alike: Has the scramble to right size Citi set the troubled bank on a course to heal itself? Will the US taxpayer profit off of this investment? And will the government now be calling the shots behind the scenes at Citi?

Sources close to the matter say Citi has "significant amounts of liquidity," and that Citi has been running its "own conservative stress tests" versus what it expects to see from the government's stress test.

And after it goes through "that process Citi will still have a very strong" capital cushion under a strict measure that could be used, the conservative tangible common equity, [TCE], which is essentially a bank's assets netted against its liabilities, sources close to the matter say.

Bank Shares Getting Pounded

Shares in Citigroup (C), Bank of America (BAC), JPMorgan Chase (JPM), Wells Fargo (WFC), and the 15 other banks on the list of 19 have been getting slammed since the Citi deal on the conversion was announced.

In fact, bank stocks have been getting hurt as far back as TARP 1.0, launched last September, when the government started using $700 bn in taxpayer money to buy more equity stakes in banks in order to bolster their capital. The stock markets rightfully saw that as a tidal wave of dilution, which is why bank stocks started flying south faster than a goose in winter.

And the downward trajectory picked up speed Feb. 9th, when US Treasury Secretary Tim Geithner announced the government's latest bank rescue plan. In that plan, you'll see the government said it would stress test banks with $100 bn or more, and if those banks failed the stress test, then the government would convert the taxpayers' existing preferred shares into common shares.

Those conversions will act like blood thinner to existing shares, as banks have to issue more common shares to satisfy the government. It was then that bank stocks really started a faster spiral downward.

And now the Citi deal provides another harbinger to come, a possible increase in government control because those shares come with voting rights.

Sources close to the matter say the government's common stock in Citi will be stuck in a trust overseen by the US Treasury. That trust will have its own mini-board of supposedly independent officials to oversee them.

So envision mini boards staffed by supposedly independent officials overseeing 19 trusts at the US Treasury, accountable to the government, potentially putting pressure on the banks.

The New Citi Deal

The US taxpayer has owned $45 bn of Citigroup's preferred stock that the government bought when it made two separate capital injections into the bank late last year.

Preferred shares are much like bonds in that holders received a fixed dividend.

But by getting preferred shareholders to convert their holdings into common stock, Citi is able to cut its quarterly dividend payment to the US taxpayer, which was 5% on the initial $25 bn TARP investment, and 8% on the second $20 bn TARP investment. Citi also pays 7% pays to sovereign wealth funds for their preferreds.

No Details Yet on the Stress Test

As noted, if a bank fails its test, the government could force the bank to raise more capital or accept additional federal bailout funds.

But the government has yet to release details on what measures it will use to gauge a bank's capital cushions--uncertainty which has helped pummel shares in the banking sector.

So what's difficult now for both the banking sector and the markets "are the factors unknown," whether this mass scramble to bolster capital cushion will "pass what is the government's minimum level" of what suffices as a bank's capital cushion, say sources close to the matter at Citi.

"Everyone would fail that" conservative stress test, the tangible common equity test, though details are not out yet, sources close to the matter at Citi say.

Bank officials also note that the government's stress test could be "differently applied depending on the bank," though government officials "haven't provided any guidance" yet as to what they will do.

In pre-market trading, Citi's stock fell 30%, a plunge that might be expected given the government's conversion. The conversion rate for swapping the preferred stock to common shares is $3.25, a 32% premium to Thursday's closing price.

Will the Government Now Run Citigroup?

Given the new trusts set up to hold the government's common stock ownership, the issue now is -- will Citi be essentially run by the US government?

According to sources close to the matter, the answer for now seems to be no, although the government is putting pressure on Citi to more rapidly break itself up and restructure, as well as make more efforts to install an independent board. Citi now plans to replace three board members on its 15-member board.

The plan for now is to put the government's new common stock into a voting trust that would be overseen by trustees appointed by the government, sources close to the matter say. Those trustees haven't been named yet.

They could be non-government, "independent" officials, as in the case of AIG's voting trust, and the government will "appoint trustees to exercise its vote" on the common, sources close to the matter say.

Details of the Deal

The transaction is meant to shore up Citi's TCE to a level that reduces uncertainty and brings back shareholder confidence in the bank, whose market value is now well below that of companies such as Home Depot, UPS and Pepsico.

Citi will offer to exchange common stock for up to $27.5 bn of the US's existing preferred shares and trust preferred securities. The conversion price is $3.25 a share. The U.S. government will then match this swap up to a maximum of $25 bn face value of its preferred stock at the same conversion price.

Based on the maximum conversion, the U.S. taxpayer would own about 36% of Citi's outstanding common stock. Existing shareholders would own approximately 26% of the outstanding shares, with the balance of the shares owns by trust vehicles, among others. 

Sources close to the matter also say Citi doesn't plan to do any more capital raises as it has "ample liquidity."

So now the US taxpayer owns more of Citi -- up to 36% if the preferred stakes are fully converted.

TCE Bolstered

Citi says in a statement that the swap would increase the TCE of the company from the fourth quarter level of $29.7 bn to as much as $81 bn. That, though, assumes the full exchange of $27.5 bn of preferred securities, the maximum under the deal.

Citi's Tier 1 capital ratio is 11.9% as of December 31, 2008, ranking among the highest of big US banks.

And now Citigroup feels it is well positioned to go through the government's "stress test," which will test its ability to endure various negative economic conditions, including, some suggest, a further 20% drop in home prices, a high unemployment and slowdowns in GDP (the government just reported a revised 6.2% drop in GDP for the fourth quarter of 2008, deeper than the 3.8% downturn initially reported).

Uncertainty still abounds about the government's plan, which has kept private investor money on the sidelines.

Until the stress tests are done, investors won't know which banks might be taken over by the Federal Deposit Insurance Corporation, bondholders won't know whether they will suffer along with shareholders, and nobody knows which parts of the capital structure the government stands behind and which it is prepared to see wiped out.

Do the Math on Citi's Cushion

How strong is Citi's capital cushion under the most conservative of measures?

By the standard used by bank regulators, it's pretty strong. That standard is called Tier 1, and is a bank's cash reserves; its equity capital, including common and preferred; and retained earnings, which are a bank's earnings before it pays out dividends, or what it will use to reinvest in the business or pay down debt.

The problem is, bank regulators may have let banks get fast and loose here, and load into this Tier 1 cushion ephemera such as goodwill assets, which are typically the extra amounts companies pay to buy other companies above their book value, basically to seal the deal.

Also chucked in there are intangible assets, for things like the value of the brains in a bank's M&A division. Plus, Tier 1 has in it money that's not in the door yet for things like servicing mortgages down the road (called mortgage servicing rights).

That's murky stuff that's really not solid bank capital, some analysts would say.

So instead you may hear about another stricter, more conservative measure, called tangible common equity. TCE is what shareholders own once assets and liabilities are netted against each other and goodwill and other intangible amounts and all that other stuff is knocked out.

It's basically a bank's net worth based on its hard assets -- its tangible assets. It's a really tough measure that's used to value a company going through a restructuring or, say, liquidation.

So watch this analysis of Citigroup on a TCE basis.

Citi has a net worth of $150.8 bn. It's got $1.8 tn in liabilities and $1.9 tn in assets. 

Sitting in Citi's Tier 1 cushion, is $44 bn in deferred tax assets, $36.7 bn in goodwill, $14.5 bn in intangibles and $5.7 bn in what it expects to get from servicing mortgages.

Total all of those sums up and you get $100.9 bn.

Now, turn to just Citi's net worth on a hard asset basis, or TCE basis. That means you'd knock out of its $150.8 bn in net worth all of those sums -- the $100.9 bn -- because they could be argued that they are not very useful as capital right now.

Do that and you get a tangible common equity of -- yikety yikes --$49.9 bn. That means teetering atop Citi's $49.9 bn in hard, tangible net worth is $1.8 tn in liabilities.

Divide $49.9 bn into Citi's $1.8 tn in liabilities, and you get a leverage ratio of 36. That may not sound so hot -- in fact, it sounds as levered up as any hedge fund during the bubble. Which is why Citi is scrambling to unload assets and preserve capital.

That's before the conversion of $52.4 bn of preferreds into common.

Citi's Math

But watch Citi's math on its TCE, which is as follows.

Citi instead starts with its common equity of $79.9 bn (my figure was nicer to Citi, I used its $150.8 bn in net worth).

From that $79.9 bn, Citi subtracts out goodwill of $30 bn, $14.5 bn in intangibles and $5.7 bn in what it expects to get from servicing mortgages. That gets you to $29.7 bn.

Citi here is holding fast to its $44 bn in deferred tax assets, arguing it can use it down the road to bolster profits.

To get to $81 bn, you add to that $29.7 bn the $52.4 bn in conversions Citi just got from preferreds into common shares. 

That includes the $12.5 bn in the conversion to common from Kuwait and Singapore and other investors. That brings you to $42.2 bn.

Another $14.9 bn in publicly issued preferred stock will convert to common. So that gets you to $57.1 bn. Next the government will convert dollar for dollar up to $25 bn. That gets you to $82.1 bn (yes Citi knows that's off by $1 bn, but hey it's close. And yes $1 bn is still a lot of money).

Sovereign Wealth Funds to Go Along?

To date, Citi has sold preferred stakes to several sovereign wealth funds [SWFs]. They are the Government of Singapore Investment Corp., the Abu Dhabi Investment Authority and the Kuwait Investment Authority. It has also sold preferred stakes to a New Jersey state fund and former CEO Sandy Weill.

So far, Kuwait and the Singapore SWF says they will convert, with Singapore converting its $6.9 bn in Citi preferreds into common stock to help bolster the bank.

And Singapore is giving Citi quite the helping hand here, doing so at a conversion stock price for the common at $3.25. The haircut compares to an initial conversion price of $26.35 for the fund. It's also giving up its 7% dividend.

So now Singapore's already pummeled stake means it will own more of the trouble bank than it might have initially wanted. No word yet on whether New Jersey and Weill plan to convert. The Abu Dhabi preferred stake converts into common in 18 months.