Feds Taking Up to 36% of Citi

Moves made by the U.S. government to shore up the struggling bank's capital structure don't come as a complete surprise

The federal government moved a step closer to taking outright control of struggling Citigroup (C) on Feb. 27, announcing a deal that could increase the government's ownership stake to 36% from 8% through a conversion of up to $25 billion in preferred shares issued last fall under the Troubled Assets Relief Program (TARP).

Other publicly held and privately placed preferred shareholders will convert up to $27.5 billion of shares to common shares under the deal. If the maximum share conversions take place, the U.S. government will own 36% of Citi's outstanding common shares, and existing shareholders will own approximately 26%. The conversion is occurring at a price of $3.25 a share.

The dilution of existing shareholders under the plan was greater than many expected and sparked a sell-off in Citi shares. The already-battered stock shed more than 40% of its remaining value.

The move doesn't involve additional funds to Citi from the Treasury, which has invested $45 billion in the bank under TARP. However, it will boost Citi by improving the bank's tangible common equity ratio, or TCE, a key measure of a bank's ability to withstand losses. In addition, Citi will suspend dividend payments on the preferred shares. The government's remaining preferred stock will be converted to a new security that will pay the same 8% cash dividend as the current preferred shares, the Treasury said.

In a statement, Citigroup CEO Vikram Pandit said: "This securities exchange has one goal—to increase our tangible common equity. While we believe Tier 1 capital remains the most important measure of the financial strength of banks, we recognize that the markets also view tangible common equity as an important measure."

Board Shakeup

In a related move, Citigroup Chairman Richard Parsons announced a board revamp, saying the 15-member board will be restructured "to have a majority of new independent directors as soon as feasible."

Investors including the Government of Singapore Investment Corp., Prince Alwaleed bin Talal bin Abdulaziz Alsaud, Capital Research Global Investors, and Capital World Investors will participate in the exchange, Citi said.

Citi also announced it is taking a goodwill impairment charge of $9.6 billion for the fourth quarter, resulting in an additional net loss of $9 billion for 2008, and a $374 million charge related to its Japanese Nikko Asset Management unit. The two charges bring the bank's net loss in 2008 to $27.7 billion.

In an interview, Citigroup CFO Gary Crittenden, said the company had conducted internal examinations—or "stress tests"—to determine whether it had enough capital to withstand extreme financial shocks. "We went through the process of doing stress tests to get an understanding whether, in a stressed environment, we would still end up with capital ratios that were strong, and we can conclusively say the answer is yes."

Crittenden was quick to provide a caveat, however: The feds will soon conduct a stress test of their own in the coming days, which may produce a very different perspective on Citi's capital standing. "The government has its own stress test, and it would be difficult with any absolute assurance to say there will be no additional capital required," he said.

Citigroup investors are also concerned about potential losses and toxic assets at the bank. Crittenden pointed out that at the end of 2007 the bank had some $226 billion of assets that were at risk, including collateralized debt obligations, commercial real estate, leveraged loans, private equity business, and risky mortgages. That portfolio has been marked down on the company's books to $36 billion.

"It's a big positive and obviously we've had a very difficult year in terms of reducing our risk concentrations," he said. "We do believe we understand what our risk positions are, and we have worked hard to work them down."

Crittenden said further capital structure moves that would increase the government stake to more than 50% were "not likely."

The day's news drove Citi shares down by 43%, to 1.41. "While we anticipated the government's stake increasing to at least 35%, the privately and publicly held conversion will dilute shareholders more than anticipated," says Morningstar (MORN) analyst Jaime Peters.

Daiwa Securities (8601.T) analyst Nicholas Smallwood says: "We are not surprised by the government's action. Indeed, creeping nationalization of the large, damaged U.S. banks has been in the cards for a while. We believe this will be an ongoing theme. However, the additional goodwill impairment was a surprise."

Before it's here, it's on the Bloomberg Terminal.