Citi: That Sinking Feeling

The banking giant's shares flounder after analysts downgrade the company, citing a lack of capital and exposure to shaky credit pools and subprime mortgages

For all its financial might, Citigroup (C) is undercapitalized according to some Wall Street analysts sounding fresh alarms about the banking behemoth's balance sheet. Citigroup shares tumbled nearly 7% on Nov. 1 after three analysts downgraded the company's stock.

Citigroup's tangible capital is 2.8% of assets, just over half the industry average of 5%, according to Meredith Whitney, a bank analyst with CIBC (CM) World Markets. "They don't have enough capital, pure and simple," Whitney says. "They will have to address that, ASAP." She downgraded the stock on Oct. 31 to sector under performer from sector performer. A Citi spokesman declined to comment on the report or on the issues it raised.

Domino Effect

Citi shares closed on Nov. 1 at 38.51, down 6.9% for the day and setting a new 52-week low. The company's shares are down 28% so far this year, and back to a level they last traded at in early 2003. Admittedly, it was a bad day for the market, and particularly for the financial sector. The Standard & Poor's 500-stock index fell 38.13, or 2.46%, to 1,511.25, and the Dow Jones index plunged 362 points.

The fear spread to others in the field: Morgan Stanley (MS) dropped 7.2%, Barclays (BCS) fell 7.1%, Merrill Lynch (MER) was off 5.8%, Bear Stearns (BSC) fell 5%, and Lehman Brothers Holdings (LEH) fell 5%. Deutsche Bank (DB) and Credit Suisse Group (CS) both finished 5% lower.

Cutting Losses

The crux of Whitney's argument is that Citi is undercapitalized because it has spent $26 billion on acquisitions since 2006, while taking $6 billion in write-offs and raising its dividend—all without any significant increase in net income. She predicts the company will be forced to address the problem by cutting its dividend, selling assets, or raising capital. Similar concerns have been expressed about Merrill Lynch (, 10/30/07).

On Oct. 31, Citi and Nikko Cordial (NIKOF) signed a share exchange agreement stemming from Citi's $12 billion acquisition of the Japanese bank, announced earlier this year. During the last year, Citi also raised its dividend 10%—to 54¢ a share—boosting its payout by $1 billion, according to Whitney. Last month, Citi announced it would take $6 billion in writedowns to cover losses in the credit markets. Meanwhile, earnings fell 9% in 2006 and are expected to decline 14% this year before rising 14% in 2008 and 8% in 2009, according to Whitney's forecast.

Downgrading and Restructuring

CIBC isn't the only bank with concerns about Citi. Credit Suisse analyst Susan Roth Katzke downgraded Citi on Nov. 1 to neutral from outperform. Katzke wrote in her report: "We're concerned vis-à-vis the need for incremental inventory writedowns in the investment bank." Morgan Stanley analysts also downgraded Citi on Nov. 1 to underweight from overweight, based on concerns about its exposure to shaky credit pools and subprime mortgages, along with its "thin" capital levels.

Investors are pushing for management changes and, ultimately, the breakup of the giant company, which has a market cap of $192 billion. Katzke said the only hope for the shares, down 25% so far in 2007, is a major restructuring. "The opportunity in this stock rests in the prospects for organizational change, i.e.

, the breakup of Citi into several separate, more manageable or saleable businesses," she wrote. That could be accomplished along any number of lines, possibly by splitting off the retail bank, the insurance unit, the global assets, and the corporate finance and investment bank. Some investors have openly called for the ouster of Citi CEO Charles Prince III.

If Citi decides to raise capital by selling assets, it probably will have to part with higher quality businesses such as real estate and credit cards. That's because the market for riskier assets has all but dried up, according to Whitney. Moreover, the need to sell assets to raise capital could limit Citi's ability to grow over the longer term, she notes.

Decline and Growth

Analysts and investors will anxiously await the results of the fourth quarter, which will be released in January. Some expect that the company could be forced to take an additional writedown in the range of $1 billion (, 11/1/07), to fully reflect the decline in the value of its fixed-income investments. Investors already are worried the problems in the credit market could become systemic and bring down a major financial institution (, 10/26/07).

Of course, it's possible that Citi could try to rebuild its capital levels by relying on organic growth. But that would take a long time. Whitney estimates that it would take seven quarters, or nearly two years, to rebuild its tangible equity and asset ratios to 4.5%, a level "close" to the industry average.

If the company is forced to make loans to support its troubled investment pools, known as structured investment vehicles (, 9/10/07), the process could take even longer, she warns. Either way, it's a good bet most investors aren't willing to sit around waiting for that to happen.

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