Monday, November 24, 2008

Citigroup Bailout: Payback For Wachovia?

If you can't beat 'em...

I'm having some mixed feelings this morning. I've repeatedly expressed my frustration with the serial bailouts by the government and the Fed, and this morning we wake to learn that Citigroup will be added to our Bailout Wall of Shame. On the one hand, it pains me to see more taxpayer money being wasted.

On the other hand, I bought shares of Citigroup late last week for our more aggressive clients. This was my first foray into financials on the long side in quite a while, and I can't say that the purchase (a modest position) was made with an extreme amount of confidence. I viewed the purchase of the common more like a call option with (hopefully) no expiration.

It was clear to all that Citi was too big too fail. It was also clear later last week that the company was likely to need some government assistance, if for no other reason than to shore up confidence. The questions were how extensive the support would be and how much dilution would occur to the existing shareholders.

Now it's time for a little conspiracy theory. My sense was that Citigroup had a "get out of jail free" card to play. Recall, Citi had reached a deal to buy Wachovia with a government backstop not too dissimilar from what they are now receiving. That Wachovia deal was eventually scuttled when Wells Fargo came in with a counter offer. Citi then filed but soon dropped a $60 billion lawsuit to block the Wells deal. Why concede Wachovia so quickly, and why drop the suit? I can't help but think that Citi was assured of some preferential treatment in the future for quietly stepping aside in the Wachovia fight.

Whether or not there was any backroom agreement, Citi is certainly getting some good terms with this bailout.

  • Citi is getting another $20 billion in cash from the Treasury.
  • Citi will also get governement guarantees on a $306 billion pool of garbage assets. Citi will eat the first $29 billion of losses on this pool, and the government will cover 90% of additional losses. The guarantees are for 10 years on residential assets and five years for nonresidential assets.
  • The government receives $27 billion of preferred shares yielding 8%. This is a higher yield than the Treasury is receiving from its first round of preferred share issuance under the TARP plan, but it's less than Warren Buffet is receiving from his GE and Goldman deals (10%).
  • The government also receives warrants to buy 254 million common shares of Citigroup at $10.61.
  • Citi essentially has to eliminate its dividend, which is something it should have done anyway.
  • There will be some controls placed on executive compensation.
  • No management changes at Citi are required.
This strikes me as a great deal for Citigroup considering the market value of the company was only $20 billion heading into the weekend. This deal certainly doesn't guarantee that Citi will now prosper. They have a huge balance sheet beyond the $306 billion pool that will be covered by this agreement, and with the economy flailing, the company is sure to experience continued difficulties in the near-term.

This agreement does, however, buy Citi more time to address its balance sheet. The pressure will continue for the company to shed some of its assets. Buyers will be hard to come by, but just today we're hearing of potential interest from HSBC in some of Citi's foreign assets. Any asset sale would probably be greeted warmly by the market.

As for what to do now with this position given today's news, I plan to sit tight. I still view it as a call option - hopefully now a LEAP. It's nice that it's in-the-money (at least for the moment), and if it had an expiration (bankruptcy) date, that date has now been extended into the future. The government has explicitly signaled today that Citigroup is clearly too big too fail, and importantly, the government wasn't interested in wiping out the shareholders. Perhaps they feared that wiping out Citi's common shareholders would only make it harder for other banks to raise new equity capital.

Disclosure: The Rubbernecker is actually long a financial but still short the poor U.S. taxpayer.

The Market Rubbernecker is affiliated with Aspera Financial, LLC, a registered investment advisor. Please read the disclaimer on the home page of the Market Rubbernecker site.