Is Citi's Gain Wachovia Shareholders' Loss?

This past week has been a monumental week, not just because the Dow dropped almost 800 points in one day, not because the bailout finally passed, but because of Wachovia (WB) and the greater implications for the banking system.

Since the failures began, the US government has been using the 3 megabanks (JP Morgan, Bank of America and Citibank) to clean up the major bankruptcies and bank failures. JP Morgan (JPM) bought WaMu and Bear Stearns. B of A (BAC) took on Countrywide Financial and Merrill (MER). On Monday it was announced that Citi (C) was going to buy Wachovia.

The thing about Wachovia is it could've become a fourth megabank, however this honor may pass on to Wells Fargo (WFC). As recently as last week, Wachovia was in talks with Morgan Stanley (MS) about a merger. The combined bank would've had around $1.8 trillion in assets, placing it along side the other 3.

Unlike all the other bank failures to date, Wachovia was a pretty diversified commercial bank. WaMu was just a savings and loan and had made a lot of wrong way bets on the housing market. Bear Stearns, Merrill Lynch and Lehman Brothers were all highly leveraged investment banks and did not have access to a stable deposit base for funds. Wachovia, by contrast had a strong deposit base, a diversified business, a huge balance sheet and was not all that leveraged.

On top of all that, Wachovia was not insolvent like, WaMu, Bear and Lehman when it was bought. Although they would've taken some hits, Wachovia had about $80 billion in equity at the end of 2Q 2008, granted about $37 billion of this was goodwill. In short, it might have been able to survive the crisis, and as Wells Fargo proved later this week, there was no need to sell it in a fire sale with FDIC backing. The main concern is that depositors were withdrawing money, which killed their balance sheet. Now this is huge. The fourth largest bank was just bought for 15% of what it was worth a year ago.

Now this is where things get scary. Out of the big 3, Citigroup is in the worst shape financially. Sure, they would have gotten a pretty good deal with Wachovia, $80 billion or so in equity for only $2 billion, but the company is leveraged up the wazoo. According to their 2Q earnings statement, the companies Assets-to-equity (the cheap and easy way) is about 15 to 1, but of their equity about 1/3 is goodwill and another sixth is intangible. As a result, their real leverage ratio is about 30 to 1, and this isn't even including the trillion dollars on in off-balance sheet SIVs, which they will probably eventually have to bring on their books. This means, that all it takes is for their portfolio to decrease by 3.3% and the company is done.

Now looking at Citi's financials, I notice that the company hasn't marked down many of their consumer loans from their commercial banking business. According to Nouriel Roubini, who has been pretty much right about everything in this crisis, calling it play by play from a year before it began, we are only about 1/2 to 1/3 of the way through the writedowns and loan losses, and Citi hasn’t marked down much of their consumer loan book.

So in effect, it's not difficult to imagine that Citigroup's $800 billion loan portfolio could get written down by 10%, thus wiping out the $69 billion in equity after goodwill and intangibles are subtracted. Then there is also the effect on their proprietary trading book, which is around $500 billion. The stock market has been tanking. Anyone want to take a guess how many losses they have incurred there? If Citi were to post a 13.8% loss on its trading portfolio, that $69 billion in equity would be gone. Mind you, the average hedge fund is down 10% this year. Also, don’t they still have quite a few CDOs on their books?

Another major concern is the deposit issue, as evidenced by Wachovia. Citibank had approximately $803 billion in deposits at the end of 2Q 2008, resulting in deposits 11.6x equity. In other words, if 8.6% of Citigroup's deposits were withdrawn suddenly, the bank would fold. While granted only about half of those deposits would be located in the US, it's troubling given where Citi's American operations are concentrated. Citigroup has its largest presence in the Northeast of the United States, the wealthiest region in the country. It is not too uncommon to find people in the Northeast with over $250,000, the maximum amount insured by the FDIC deposited in a given bank, under the new bailout plan. As a result, if Citi's future were to come into question, it would not be unreasonable to expect depositors with above the insured limit to run to the bank, seeking to move their excess funds.

If the Citi-Wachovia merger had gone through, it would have gone a long way to shoring up Citi’s balance sheet. For starters, Citi’s deposits would have grown to $1.3 trillion, significantly strengthening their financial position, especially in light of the tight credit markets and lack of interbank lending. Citibank has $114 billion in short-term debt on their books, and the added deposits would have given them some breathing room. However, given the fact that Wachovia was not yet insolvent, the question must be asked: why was the FDIC forcing this deal down our throats, especially in light of the fact that the government’s refusal to provide backing for Lehman and WaMu?

As you may remember, the government refused to provide any backing for potential acquirers of Lehman Brothers, resulting in not only the firms bankruptcy, but also the end of several hedge funds and chaos in the money markets. That seems to me to have caused quite a deal of systemic risk. Additionally, the FDIC refused to provide JPM any backing in their purchase of WaMu, despite the fact that it was insolvent, and the biggest bank failure in history to date. According to the terms of the Citi-Wachovia deal, Wachovia shareholders would be paid with shares of Citibank stock, with no cash changing hands, thus leaving Citibank's balance sheet in tact.

Additionally, the FDIC would assume any losses over $42 billion, possibly stemming from Wachovia's adjustable rate mortgage book. Citibank would have also gotten its hands on valuable deposits at a time when credit markets are frozen and banks are having trouble raising debt. The Citi-Wachovia also deal doesn’t make sense for a number of other reasons. As Vernon Hill points out, Wachovia and Citibank are a mismatch strategically, and Citibank has a history of poorly integrating mergers. Citibank has a poor retail model and has willfully ignored small and medium-sized business clients, the core of Wachovia’s business model. Finally, there are questions of Well Fargo’s role in the negotiations. Why did WFC wait until only after the bailout passage was imminent to make an offer? Also why didn’t the FDIC try to work with Wells Fargo, when WFC is clearly in a better position to absorb the company, and is willing to offer more?

A collapse of one of the 3 megabanks would have disastrous consequences for the US economy. Unlike Wachovia, there is no financial institution in the world that could swallow one of them, additionally, it is highly doubtful that any tie up between two of the three would be able to get through regulators, despite the critical market conditions. Of the 3, Citibank is by far in the worst position financially. A few months ago, the collapse of Citi seemed unfathomable, but after Fannie (FNM), Freddie (FRE), Lehman, AIG (AIG), Merill, WaMu and now Wachovia, and lingering questions about Morgan Stanley and Goldman Sach’s (GS) viability, it has suddenly entered the realm of possibility.

A failure of Citigroup, one of the three US Mega-banks, with $2 trillion in assets, would have posed a far greater systemic risk than Lehman Brothers' $600 billion failure or an $800 billion failure of Wachovia alone. Could the Citi-Wachovia deal not have been about saving Wachovia at all? Rather could the FDIC have been trying to save Citibank at the expense of Wachovia shareholders?

Disclosure: None