Citigroup: Does a Breakup Make Sense? (Part II)

In addition to the valuation issues we discussed in our December 28, 2006 comment, we want to raise two other factors that, to us at least, mitigate against breaking up Citigroup (C) into three pieces -- domestic bank, international bank and investment bank. We are thankful for the comments we received on our earlier analysis and make reference to same below.

Business Issues

When approaching the issue of breaking up the C organization into three, stand alone businesses, the first thing to consider is whether these former business segments could, in fact, stand on their own. It was suggested by one commenter that the domestic business of C would be peered against Bank of America (BAC), the international unit against HSBC (HBC) and the investment bank against Lehman Brothers (LEH) and Goldman Sachs (GS).

We question whether the value enhancement arguments that, superficially at least, might be persuasive in suggesting that these three separate business lines would be more valuable alone than in combination take into account the degree to which the international and investment banking units depend upon the infrastructure and credit standing of Citibank NA.

For example, these proposed divisions do not follow the way in which C currently manages its five business silos -- global consumer, corporate and investment bank, global wealth management, investments and technology. Nor does the domestic bank, international bank and investment bank thesis, a perspective which seemingly arises from C's SEC disclosure, take notice of the legal entities upon which these activities depend. (This is just one reason why we like to look at the regulatory, legal entity financial disclosure that we use in our Basel II by the Numbers survey.)

Assume, for the sake of argument, that a break up were attempted that divided C into two consumer banks and the investment banking/wealth management operations. Would the proponents of the breakup of C really argue that the domestic money center give up all of its foreign branches? Likewise, would these same analysts really expect the international bank to be viable without the support of the domestic management, credit, clearing and back office infrastructure of Citibank NA and its affiliates?

In our view, the only way to make the international bank viable as a stand alone business would be to replace that infrastructure currently provided by Citibank NA with alternative personnel, facilities and services, an expensive proposition that might partly or even entirely eviscerate the economic and valuation benefit of the separation. An outright sale of the international assets to another organization would probably be more attractive, assuming that you accept the break-up, sum-of-the-parts, argument in the first instance. Indeed, we suspect that monetizing the foreign assets is the true agenda of the proponents of breaking up C.

Likewise, we are dubious of the value creation leverage for the domestic bank of giving up its foreign branches. Not only has Citibank NA done business in foreign venues for more than a century, but the US bank unit gains considerable earnings and growth potential from its offshore activities. Once you deprive the US bank of these historical connections in high growth foreign markets, what's left is large in terms of size, risk profile and capital needs, but not very exciting as a business or compelling as an investment opportunity.

In fact, if you accept the three-part scenario for breaking up C, the domestic bank may be the least attractive piece. Analysts often cite C regulatory and operational risk problems as a reason for the dearth of significant US acquisitions over the last several years, but we've heard many Citibankers privately thanking the Fed for taking pressure off to do expensive, dilutive M&A deals in the US. To us, the biggest bang for the buck in terms of C shareholder value comes from deploying capital outside the US. Let BAC and WB pay 3x book purchasing large domestic competitors at the top of the market for US banking assets. Meanwhile, C is expanding in China.

Finally, we have to question how any reasonable analyst could believe that C's investment banking arm could survive on its own. Much of the business flow that moves through the investment bank comes as a result of the affiliation with Citibank NA. The investment bank's brokerage and advisory businesses in fixed income, foreign exchange and OTC derivatives, for example, all depend upon the relationship with Citibank NA.

Sure, there are successful independent IBs such as LEH, GS and Bear Stearns (BSC), but none of these -- even mighty GS -- can play in Citibank's league in OTC derivatives. The bank's balance sheet is what makes the derivatives and corporate lending business possible and these segments could not be separated from it. When counterparties transact an OTC derivative trade with C the documentation specifies Citibank NA, not the holding company, and for good reason, as discussed below.

Regulatory Issues

The second issue, but one related to the business issues outline above, is the question of gaining regulatory approval for a breakup strategy. Several commenters speculate to us that the tax and structural implications of a C breakup strategy, while daunting, could be addressed by a swarm of properly incentivized investments bankers and tax lawyers. Perhaps. But such arguments assume that regulatory approval could be obtained to break the C organization into three completely independent pieces on terms that investors would accept.

Perhaps the most basic issued arguing against a breakup strategy is the question of how to carve up the assets of C into the three segments illustrated above. From the outset, analysts supporting the break up thesis must take notice of the fact that while economic efficiency arguments may be useful in persuading investors of the efficacy of their plan, regulators look upon such transactions based upon entirely different criteria, namely the statutory test regarding safety and soundness.

When regulators look at transactions proposed by a bank holding company like C, arguments regarding capital efficiency and investment returns are not relevant. As we have noted, the Basel II Economic Capital simulation in the IRA Bank Monitor, using portfolio level data from the FDIC, already suggests that, in a stressed scenario, C has too little capital to cover its existing credit, market and operational risks. Thus from the outset, the proponents of a break up strategy would face an uphill battle convincing the Federal Reserve Board and other regulators to let them divide C into three equally attractive pieces.

There are many issues involved in such a regulatory analysis, but we suggest that the 10,000 pound gorilla standing in that room is in which new business unit the C OTC derivatives book would reside. As a practical business or regulatory matter, you cannot separate the derivatives book from Citibank NA. Likewise, we suggest that regulators would object should the proponents of the break up strategy try to cherry pick attractive foreign and domestic assets from Citibank NA and other US bank affiliates, leaving less attractive domestic assets and the highly variable derivatives book.

We won't even comment on the idea of separating the non-derivatives investment bank into a separate business unit because, in our view, the investment bank by itself, sans derivatives and the lead bank's lending operations, would not be viable. Just ask any manager of a major broker dealer if they believe that the cash side of the business trading in stocks and fixed income instruments, and the investment management business, could survive without the double-digit margins generated by derivatives trading and advisory activities.

Bottom line: We don't think that the domestic bank, international bank and investment bank thesis makes sense from a business perspective, nor do we believe that C could obtain regulatory approval to carry out such a plan in a way that would be attractive to investors. And remember that as of 12/31/06, C was scheduled to have consolidated the 17 banking units which existed a year ago down to just four, making a break up strategy even more problematic. Next!

Disclosure: Author has no position in the above-mentioned stocks.