Why Citi May Need a Merger

Because of the weakness in its capital structure, the financial-services giant may need to pair up with another bank

You think you've got a tough job.

As Citigroup (C) nears a decision on its new chief, it's becoming increasingly clear that the financial-services giant will present severe challenges for any executive. The latest development came on Dec. 10, when one research analyst said it will take years for Citigroup to recover from its billions of dollars in losses in the credit market and that it may even need to merge with a stronger partner to mend its balance sheet.

The company's writedowns (BusinessWeek.com, 11/13/07)—$6.5 billion in the third quarter and $8 billion to $11 billion in the fourth—prompted the resignation of Chief Executive Charles O. Prince III last month. David Hendler, a senior analyst at CreditSights, now says that such writedowns may put Citi in "a precarious position in terms of capital levels." The result, he wrote in a research report, is that "the company could have to consider options ranging from dividend cuts to major asset/business unit sales, and/or a full-scale breakup or even potentially M&A with a stronger bank."

The strategic choices are inevitably intertwined with the CEO search. "Which course Citi takes," wrote Hendler, "could also hinge on who takes the top job, which it seems Citi has been having a difficult time filling."

Issue of Independence

Hendler isn't the first analyst to point out the weaknesses in Citi's capital structure. Meredith Whitney, a bank analyst with CIBC World Markets (CM), downgraded the company's stock (BusinessWeek.com, 11/1/07) more than a month ago over the issue.

What's new is the question of whether Citi will remain independent. Hendler said JPMorgan Chase (JPM) would be an ideal merger partner. He noted that JPMorgan CEO Jamie Dimon and other top JPMorgan executives have worked at Citi, and that JPMorgan Chase has a demonstrated capacity for pulling off large deals, such as the combination of JPMorgan and Bank One.

Still, a deal with Citi would be on a completely different scale. Even after the recent dive in its stock price, Citi's market capitalization is $173 billion. Citi wasn't immediately available for comment. JPMorgan declined to comment.

Hendler said investment bankers have floated the idea of a combination of Citi and Bank of America (BAC), but that such a deal may not be able to win federal regulatory approval. Bank of America and Citi would have 14% of U.S. bank deposits, well above the regulatory limit of 10%.

High Exposure

Citi is expected to wrap up its CEO search (BusinessWeek.com, 11/15/07) this week. The leading candidate is Vikram Pandit, the head of investment banking and alternative investments at Citigroup and a former president of Morgan Stanley (MS).

One of the key problems a new Citi CEO will face is its exposure to SIVs (structured investment vehicles), off-balance sheet investment funds that borrow in the short-term market and invest the proceeds in higher-yielding, longer-term investments such as mortgages and credit cards. SIVs are in trouble because the short-term markets, spooked by problems in the subprime market, seized up over the summer. That put pressure on sponsors such as Citi to act as a lender of last resort. Hendler said that Citi isn't under a legal requirement to bail out its SIVs, but that accounting pressures could force it to take writedowns anyway. Citi currently has SIV exposure of $66 billion, the largest in the banking industry.

Citi also has high exposure to collateralized debt obligations. CDOs are pools of debt that include some subprime mortgages. It's $46 billion exposure to CDOs is among the highest in the industry.

It could take Citi 2.7 to 5.2 years to recover from the losses, estimates Hendler. It would take Citi more than three years to recover, even if it cut its dividend, he said, and investors may not be willing to wait that long. The company's stock closed Monday at $34.77, up 46¢, or 1.34% for the day. It is down 40% from a 52-week high of $57.

Money-Saving Deal

Hendler said a deal with JPMorgan Chase would save billions of dollars and be immediately accretive to JPMorgan. "The primary driver of the merger math is the potential cost synergies of such a transaction," he said. Hendler estimates the internal rate of return on such a deal for JPMorgan would be 20%, if JPMorgan paid a 25% premium. The rate of return could move higher or lower, depending on the premium.

There's no guarantee that JPMorgan sees the same value in such a deal. CIBC's Whitney said weeks ago (BusinessWeek.com, 11/26/07) that Citi would need to cut its dividend, sell assets, or raise capital. But she doubts JPMorgan would be tempted to acquire Citi, because the regulatory and business hurdles are too high. "No way on the JPMorgan Chase deal," she says.

Citi may very well remain independent. But reassuring investors it can do so effectively is just one of the challenges facing the company's next CEO.

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