Will Citigroup Survive?,Citigroup At The Edge

November 23, 2008

Citigroup may soon get all the sleep it needs. Investors are growing increasingly concerned that the global financial behemoth could go the way of Bear Stearns, Lehman Brothers and Merrill Lynch. Shares of the company, which was once the world’s largest bank, closed at $3.77 on Friday. The company’s board members reportedly met on Friday and will continue to talk over the weekend to discuss the firm’s options. There are a number of possible outcomes, not all of which conclude with the end of Citi. “Somehow they need to get the price of their stock up,” says James Ellman, a hedge fund manager at Seacliff Capital. “If they don’t they are in for a lot of big problems.”

Here are the most likely scenarios, in no particular order, that could unfold for Citigroup and its shareholders in the next few days.

1. citigroup

Most analysts believe Citigroup can survive its current market woes, though probably not without some changes. In a report out on Friday, Deutsche Bank analyst Mike Mayo, who has been a long-time bear on Citi, says the company has adequate capital to survive. When you factor in the $25 billion Citi got from the Treasury’s Troubled Asset Relief Program, Mayo estimates the bank has as much as $100 billion in cash cushion.

And Citi’s lending business has actually performed relatively well in this environment. In the third quarter, the company said it had $5 billion in loans on which customers were no longer making payments. In all, Citigroup has set aside $24 billion for loan loss reserves. For most firms, that’s a lot of IOUs to go bad. But for Citi it’s peanuts. In fact, $24 billion is just under 3.5% of Citi’s overall loan book of $718 billion. And that’s not a bad charge-off rate during a time when sub-prime mortgage loans are defaulting in double-digit rates.

“The issue with Citi is the degree to which the downtrend in its stock price affects fundamental factors, as seen with other financial firms over the past few months,” Mayo wrote in the report.

So to avoid the fate of Lehman or Bear, the firm’s board may feel like it needs to do something to boost it’s stock price. One option would be to boot chief executive Vikram Pandit. Some on Wall Street believe Pandit has not been quick enough to react to the problems of the firm and could still be in denial. On Friday, Pandit told top executives that he doesn’t believe Citi needs to sell off parts of its business to raise capital. Investors don’t seem to agree. The stock fell on the news.

Who could replace Pandit? Robert Rubin, the former Treasury Secretary and head of Goldman Sachs, could be one choice. He is currently a director and senior council at the firm. But Rubin has been at Citigroup for a number of years, and it’s not clear he has been helpful so far in stopping the losses. What’s more, with a Democrat headed back to the White House his eye may be on Pennsylvania Ave. and not Park Ave., where Citi’s executive offices are located.

Another choice could be Larry Fink, the head of money management firm BlackRock. He is regularly on the top of short lists anytime a big Wall Street job opens up. And so far, he has kept his firm clear of the worst parts of the financial meltdown.

2. File for Bankruptcy

For months, Citigroup has been dogged by concerns about the quality of the loans on its books. Citi was, after all, one of the nation’s largest sub-prime lenders, not just to homebuyers but through its credit card division as well. This week, the fears have centered on the quality of its corporate loans, and to a lesser extent its credit card business.

“If they had to mark all of their loans down to what they would be worth, there would be no equity left in the company,” says Ellman.

Here’s the math: Citigroup has, as Mayo said, about a $100 billion equity cushion, which could be wiped out if loans go bad. At the end of the third quarter, Citigroup had $17 billion in commercial mortgage bonds. According to Barclays Capital, the average CMB price has fallen 34% since the beginning of October. So erase $5.8 billion in equity right there. Citigroup was also a player in advising private equity companies on leveraged buyouts. As part of that business it lent money to the companies in such transactions. Now many of those deals look over-leveraged and ready to default. Those bonds are off 19% since the end of September. Citigroup holds $23 billion in leverage loans. So mark down that stake by $4.4 billion.

In addition, Citigroup holds $172 billion in loans to corporations. In general, corporate bonds have not fallen a lot because there have not been many defaults. The aggregate Barclays corporate bond index is down 3%. Still, because of the size of Citigroup’s loan book, wave goodbye to another $5 billion.

You may have read about Citigroup’s Special Investment Vehicles. Through SIVs and other structures Citigroup has kept some of its loan liabilities off its balance sheet. On Wednesday, Citigroup said it would repurchase the last of those SIV assets for $17 billion. But Citigroup still has a remarkable $130 billion in unfunded off-balance-sheet liabilities. Not all of that will go bad. But conditions don’t look good for the $2.5 billion in obligations to off-balance-sheet collateralized debt obligations, or to a lesser extent the $63 billion it has in asset-backed debt.

All of these potential losses are based on the value that Citi is putting on its loans. And Citi has no obligation to write down all of the loans on its books. In fact, it recently said that it was going to stop taking so-called mark-to-market losses on an additional $80 billion in assets of its loan portfolio. So even if the value of its loans continues to fall, it may not have to take a hit to its equity. And as long as most of Citi’s borrowers keep paying, as most are, Citi will be just fine. That’s why most analysts see the possibility of the bank going bankrupt as out of the question.

But if Citi has not been marking its loans down to market value aggressively enough, the losses on its balance sheet could be even greater, which could be the case. “Though difficult to draw hard conclusions from comparisons between banks, Citi’s marks appear less aggressive than J.P. Morgan’s,” wrote analyst John McDonald of Sanford C. Bernstein in a research report last week.

All told, McDonald thinks that Citigroup has $88 billion in risky assets. That’s not quite $100 billio,n but it is close. And that’s what has the Citi-doomsday-folk yapping.

3. Citi Gets Sold

A sale of Citigroup used to be unthinkable. But at $20 billion in market capitalization, Citigroup has become a more digestible acquisition. Still, a number of the financial firms that would be interested are either hurting on their own and could not afford to add Citi’s troubled loans to its books, or have just completed another acquisition. So cross Morgan Stanley, J.P. Morgan and Wells Fargo off the list.

Goldman Sachs is one possible suitor. Its market capitalization of $21 billion is now slightly larger than Citigroup’s. And at $53 a share, investors don’t seem to be too worried about Goldman going under, yet. So Goldman could use its shares to finance an acquisition. What’s more, Goldman might like to get its hands on Citi’s $780 billion in bank deposits and 200 million customers. Goldman recently converted to a bank holding company and plans to start attracting bank deposits on its own. But opening up branches is costly. Buying Citi, even with its troubled assets, could be cheaper way for Goldman to expand.

Another possible suitor could be US Bancorp. The Minneapolis bank is one of the nation’s largest, but it has little presence on the East Coast, where Citi is big player. U.S. Bancorp has a market cap of $40 billion, about double the size of Citigroup. What’s more, U.S. Bancorp chief financial officer Andrew Cecere recently told the Wall Street Journal said that the firm was interested in making a large acquisition.

4. Uncle Sam to the Rescue, Again

After the mess that followed Lehman Brothers, regulators have no interest in seeing another big financial player go belly up. And now the government has a vested interested in not letting that happen. In October the government, as part of the TARP program, invested $25 billion in Citigroup. Treasury Secretary Henry Paulson has said he will do everything to protect that and other taxpayer investments. Paulson agreed to invest more money in AIG to keep that insurance company alive. So there is reason to believe he would do it again with Citi.

There are a number of things the government can do to help Citigroup stay afloat. Perhaps the lowest cost solution would be for the government to guarantee some or all of Citi’s debts. That would entail no initial outlay of funds. And with many analysts saying that Citi’s books are fundamentally sound, this could be the way to go. With a guarantee Citi would not be forced to sell its assets at a discount, if any of the bank’s creditors or trading partners want their money back. That would save Citi from having to write down its assets, which is what would wipe out its equity and send it into bankruptcy. Of course, if the bank does fail, the government could be on the hook for hundreds of billions of dollars of debt.

Another option could put more money into the firm from the TARP program. The problem with that plan is Citigroup may need more money than the Treasury could inject into the firm. Paulson only has $60 billion left of the initial $350 in TARP funds that he can spent without having to face a review from Congress. More importantly, the government does not want to end up owning Citigroup. Then taxpayers would be on the hook for all of the bank’s debt. So the most the government could invest in Citigroup would be $20 billion, which is the amount equal to what is held by current shareholders. If Citigroup were to issue shares to the government greater than its current value, taxpayers would be left with a more than 50% stake in the company.

Lastly, the government could make some regulatory changes and hope for the best. First of all, get rid of mark-to-market accounting. Some observers say it doesn’t make sense for loans that are performing, and the banks have no intention of selling anyway.

Next, the government could suspend trading in the credit default swaps on Citigroup’s debt. The price of those contracts, which pay out if Citi goes bankrupt, have been rising recently, and that is spooking the stock investors. Without that constant reminder of the increasing chance of Citi going out of business, some observers say the stock would rise.

“You break the negative feedback loop,” says Seacliff’s James Ellman.

Citi has already asked the government to restrict short-selling (where investors borrow stock in hopes that the price will fall) in its shares. Executives hope that getting rid of the people rooting for the firm’s demise could relieve some pressure on the company’s shares. What’s more, to close their positions, short sellers would have to buy the shares they borrowed.

Again, the stock would probably rally. But the question is, for how long? And none of these moves address the problem that is really holding down Citi’s shares. The bank has bad loans, and no one, probably not even the executives at Citi, know just how bad they are.

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