Analysis: Citi's conundrum

Once the world’s biggest bank, Citigroup is moving closer and closer to nationalisation, which US Treasury officials are now refusing to rule out. Stephen Foley reports
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Another day, another plan. Still no solution. Citigroup’s windswept shareholders awoke yesterday to another bout of speculation about what exactly might happen to their company, once the most powerful financial corporation in the US and still one of the top three biggest lenders and retail banks.

The company is firmly in the camp of “too big to fail”, and the US taxpayer has already lent it $45bn (£31bn) to keep it afloat, yet its losses continue to balloon and investors increasingly fret about its solvency. There can be little progress on restoring order to the US banking system without an answer to the Citigroup conundrum. So are we any nearer?

“A strong, resilient financial system is necessary to facilitate a broad and sustainable economic recovery,” the US Treasury insisted yesterday, in what was meant to be a calming statement.“The US government stands firmly behind the banking system during this period of financial strain to ensure it will be able to perform its key function of providing credit to households and businesses … Moreover, we reiterate our determination to preserve the viability of systemically important financial institutions so that they are able to meet their commitments.”

Buffeted all last week by rumours that it would be nationalised, Citigroup has floated a complicated new plan that could see the US government emerge with a stake of 40 per cent. If the sums add up, it might be a blueprint for the rest of the banking system, when the Obama administration embarks this week on its much-trumpeted “stress tests” of the country’s largest banks.

But, as ever, the details we have heard so far raise as many questions as they purport to answer. It leaves untouched the longer-term issue about how much taxpayer money might end up having to be pumped into the banking system – and on what terms.

Its main characteristic, it seems, is to give the Obama administration more time to think, and to insist that it is not going to nationalise a giant bank. A 40 per cent stake falls short of the complete government takeover feared last week: instead of wiping out common shareholders, it turns the government into one. Citigroup shares jumped 9.7 per cent yesterday on the news.

Gary Townsend, a former bank analyst, now president of Hill-Townsend Capital in Maryland, said that nationalisation would be a disaster for the economy. “The government really doesn’t want to take Citigroup over because of all the complexities and the absence of knowledge about the possible subsidiary effects of doing so. I find it difficult to see the Treasury department successfully running Citigroup for a week. They would destroy the company, and have to put it into liquidation, and that would be destructive to anyone who owns anything similar to the assets on Citigroup’s books, which would all suddenly flood the market.”

Mr Townsend favours a suspension of the mark-to-market accounting rules which cover many of the mortgage assets on banks’ books and which have forced them into taking more than $500bn (£345bn) in writedowns since the credit crisis began, eroding their capital base and paralysing their lending activity.

But there is no signal that the administration will not be using mark-to-market assumptions during its stress test to judge how much of a capital cushion the bank might need to be given from the taxpayer.

So, is Citigroup well-capitalised, as the bank said again yesterday, or critically under-capitalised, as some analysts believe? The difference is vital. The more capital a bank has, the better able it is to absorb losses. The government (via the Federal Deposit Insurance Corporation, which protects depositors) traditionally takes over under-capitalised banks, but Citigroup is seen as too big for it to handle.

Trickily, the answer depends on how you measure capital. Since last October, when the government began putting money into banks – buying preferred shares, which pay the taxpayer a 5 per cent dividend and which must be paid back – the focus has shifted from one measure to another. Preferred shares count towards the so-called Tier 1 capital ratio, but not towards the much more conservative “tangible common equity” ratio. Tangible common equity is what shareholders would get back if the company were wound up.

Citigroup is indeed well-capitalised on a Tier 1 basis; it holds Tier 1 capital of 11.9 per cent or so, far above the regulatory minimum of 6 per cent. But the administration’s stress test looks likely to measure TCE ratios instead, and Citi’s 1.5 per cent is already below the 3 per cent seen as safe. The test is also going to include calculations on how much banks could lose on mortgages, commercial real estate, credit cards and business loans if the economy significantly worsens – all developments that would erode their capital further.

The plan under consideration for Citigroup yesterday is to convert the $45bn of preference shares into common equity, but analysts were mystified about how that added up to a 40 per cent stake, given that 100 per cent of Citigroup’s common equity is currently worth less than $12bn. The Obama administration is repeating its mantra that it believes in “a privately held banking system”, which is why it wants to avoid going over 50 per cent of Citigroup. For its part, Citigroup thinks it can talk the government down to a 25 per cent stake for the preference shares, something that would give US taxpayers much less control over board appointments, corporate governance and strategy.

Even converting the preferred into common is unlikely to be enough to get Citigroup to pass its stress test, according to Jamie Peters, an analyst at Morningstar, and it could well need more government money. This is why we are little further along today than we were last week, with regard to the Citigroup conundrum and the future shape of the entire banking industry.

For other banks – Bank of America widely being regarded as the next most exposed – the government said yesterday it would inject more money in the form of “mandatory convertible preferred shares”, a new kind of investment that could be turned into common equity if the TCE ratio goes into the danger zone. But how much and on what terms? No answer on that yet.

Ms Peters said: “A lot of banks have a very thin cushion. The question is, how bad can it get? How much more money might they need? If the Obama administration’s mortgage plan works and puts a floor on the housing market, and if the economic stimulus works and stops the jobs market getting worse, then this could work. The question is how long and deep the recession will be. Time will make or break these companies.”