Citi's Underwhelming Bailout

| About: Citigroup Inc. (C)

If you want an idea of just how bad Citigroup's position was on Friday, just take a look at the term sheet of the deal announced on Sunday night. After the $309 billion of toxic assets have been ring-fenced, Citigroup will take the first $29 billion of losses. Citi will continue to take 10% of the losses after that, too, but the lion's share of the second $5 billion of losses will be taken by Treasury, using TARP funds. In return for taking on that $5 billion of contingent losses, Treasury will receive $4 billion of preferred stock, paying 8% interest per year, up front.

In other words, the deal is essentially pricing in the expectation that Citi's toxic assets are worth much less than Citi has valued them at -- so much less, indeed, that Treasury (a/k/a the taxpayer) is probably going to have to pay out the full $5 billion, even after Citi has lost a further $30 billion over and above the write-downs it's taken already.

Of course, it's not quite as simple as that. The FDIC (a/k/a the taxpayer) is taking a $10 billion third-loss tranche, and the Federal Reserve (a/k/a the taxpayer, even if it's nominally owned by the banks) is on the hook for hundreds of billions of dollars more, and isn't getting any preferred stock at all.

Sensibly, Citi's barred from paying dividends until it gets its act together and at least reaches the point at which the equity market window is open to it. Citi also gets to issue another $20 billion of preferred stock to the government, which will help shore up its capital ratios but which will come as little comfort to anybody holding Citi's common stock. Between the $25 billion TARP injection at 5% and the $27 billion announced today at 8%, Citi has to pay out $3.4 billion a year in interest payments to the government alone, before shareholders see any profit at all.

What's more, the capital being injected into Citi seems small beer, in relation to the size of the bank's balance sheet. Here's the WSJ:

In addition to $2 trillion in assets Citigroup has on its balance sheet, it has another $1.23 trillion in entities that aren't reflected there. Some of those assets are tied to mortgages, and investors have worried they could cause heavy losses if they are brought back on the company's books...

Despite the unprecedented scope of the rescue plan, it's not clear whether it will be enough to stabilize Citigroup. The roughly $300 billion pool of assets that are included in the rescue plan represent only a sliver of the company's more than $3 trillion in assets, including its holdings in off-balance-sheet entities...
Among the off-balance-sheet assets are $667 billion in mortgage-related securities.

It's going to be interesting to see just how much detail gets released about the make-up of both the $306 billion being ring-fenced and guaranteed by the government, and the rest of the $2.95 trillion for which Citi retains full responsibility. When the government guaranteed $30 billion in Bear Stearns assets as part of JP Morgan's takeover, no one really needed to know the details except for the government, on the one hand, and Bear's new shareholder, on the other.

In this case, however, Citi has shareholders across the globe, all of whom have every right to demand details of the transaction. Is a $27 billion cash injection, plus a $250 billion guarantee, really big enough to cause a change in trajectory of a $3 trillion institution? On the face of it, quite possibly not -- especially since existing management will remain in place, at least for the time being.

In the medium term, however, Vikram Pandit is surely toast. The board represents Citi's shareholders, who are now seeing the insult of the eradication of the dividend added to the injury of the past year's stock-price decline; his one big transformative deal -- the acquisition of Wachovia -- fell apart days after it was announced, with devastating consequences for Citi's stock price and viability. Of all the CEOs crunched by the present crisis, only Dick Fuld looks worse.

The fate of Citi as a whole is equally uncertain. No one knows who's going to lead it, over the medium term; hell, nobody knows who's going to own it, over the medium term. The US government might have guaranteed a chunk of Citi's assets, but it's done nothing about Citi's liabilities, including hundreds of billions of dollars in unguaranteed deposits, which are essentially unsecured senior debt yielding much less than Citi's unsecured senior bonds. Nothing in today's announcement makes Citi immune to a bank run, which means there's a very good chance the stock will remain under significant pressure. Given that it was the tumbling stock price which was responsible for this deal in the first place, one wonders if there was any point to this exercise at all.

In general, there's no sense of finality here, of the government stepping in and taking charge of the situation. Instead, Treasury seems to hope that with $20 billion and some loan guarantees it will be able to help Citi muddle through for the time being. I suspect that it might end up disappointed.

Disclosure: No positions in stocks mentioned