Wachovia Deal: A Home Run for Citi

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Includes: C, WFC
by: Tom Brown

People have been so transfixed by the implosion of Wachovia (NASDAQ:WB), they’re overlooking the fact that the buyer in the transaction, Citigroup (NYSE:C), is getting a spectacularly good deal.

The FDIC has basically gift-wrapped Wachovia’s national deposit base and handed it over for free. Citi gets Wachovia’s retail bank, its commercial and investment bank, and its private banking unit, including assumption of debt. In all, that adds up to $700 billion in assets and related liabilities, including $448 million in deposits.

For this, Citi hands over $2.2 billion in stock, and will issue $12 billion in warrants to the FDIC to backstop losses on $312 billion in troubled Wachovia assets. Citi’s loss on those assets will stop out at $42 billion.

Meanwhile, the company says it can generate $3 billion in costs saves after integration, to be offset by $1.5 billion or so of “dis-synergies.” The deal should be accretive to earnings starting in year one, net of a one-time restructuring charge. As a result of the deal, Citi becomes the largest depositary in the industry, and will have the third-largest branch network and completely reshapes the balance sheet and improves - overnight - the company's funding profile. All good.

Vik Pandit says—and I agree—there are really just two key risks: credit risk and integration risk. Neither should be especially tough to manage.

For its part, credit risk seems contained, given the FDIC backstop. If you exclude the commercial and industrial loans Citi is acquiring, the FDIC is actually reinsuring something like 85% of the total acquired loan portfolio. Even the lamest risk manager in the world (which Citi is not) can pick which 85% are most likely to be stinky. As for the other Wachovia assets Citi’s taking on (roughly $200 billion worth), the securities portfolio is relatively clean  (principally agency MBS) and 55% of that remaining amount. The rest is mostly PPE, goodwill, and sundry items . Oh, and via those FDIC warrants, the government now owns a 10% equity stake in the company  -- further incentive to protect the company's equity.

And integration risk?  Certainly present but, again, manageable. Citi is paying a conservative purchase price and is assuming some fairly high revenue "dis-synergies” following the close. Yes, there might be some difficulty here, given the upheaval in Citi's executive management the past few years. But if the company’s smart, it will turn the entire retail banking business, including its integration process, over to the Wachovia team, among the most capable set of retail bank managers in the business.

Citi’s capital position will improve as a result of the deal, as well. Pro forma Tier I will go to 8.8% (including all of the FDIC investment) and TRBC goes to 11.8%. This includes the impact of a $10 billion raise of common, a halving the dividend, and the $12 billion in preferred stock  (and warrants)  to the FDIC at a 6% yield. The company also says it will receive "regulatory capital relief" on the $312 billion risky portfolio it’s acquiring.

In all, the Citi’s earnings are set to rise, its capital position improve, while its competitive position is strengthened. As I say, a very good deal.