Monday, November 24, 2008

The Government Bail-Out of Citibank

The article below gives a summary of the US Government bail-out of Citibank. This is important because it could be a model of how bail-outs of large financial institutions may occur. The key is the cash injection and the loss guarantee combined with some loss sharing provision. I am not saying there will be other large bank bail-outs, but we as a country have not even started the process of examining the insurance industry or other large financial institutions that manage investments such an annuties, retirement plans, etc. Text in bold is my emphasis. From Market

The government intends to invest $20 billion in and to guarantee as much as $306 billion of the company's troubled assets in a deal reached late Sunday evening. The agreement also gives the government control of executive bonuses, and it places limits on dividend payments.

The deal would likely make the government the largest Citi shareholder. The U.S. will end up with a 7.8% stake in Citigroup, Chief Financial Officer Gary Crittenden said on CNBC television Monday.

That would surpass the roughly 4.9% stake that the government of Abu Dhabi took in the company last year, and it also tops the 5% stake unveiled last week by Saudi Prince Alwaleed bin Talal.

"The U.S. government's creative ring fencing of Citi's $306 billion in troubled assets is a strong positive for the system and for Citi shareholders," Betsey Graseck, a Morgan Stanley analyst, wrote in an early morning research note.

The deal marks the latest of several government moves to support the financial sector and buoy investor confidence in it.

The Treasury's initial plan to buy up the industry's troubled assets gave way to direct investment in banks to bolster their balance sheets, and Citi has already received a previous $25 billion federal investment.

But, as Citi's shares fell more than 60% in the last week alone, the government decided to try yet another approach to avoid a collapse in Citi and a further loss of faith in the entire U.S. banking system.

It's unclear if the move will be successful, but "the U.S. government is lowering risk while not significantly diluting shareholders, keeping them engaged in the sector," Graseck told clients.

The rescue plan came together after a weekend of intensive negotiations involving the Treasury, the Federal Reserve and the Federal Deposit Insurance Corp., according to published reports.

Federal officials and company management desperately were seeking to avoid a replay of the disastrous failure, and subsequent bankruptcy, of Lehman Bros. earlier this year as stabilization efforts fizzled. Many observers have identified that event as the tipping point between dangerous market and economic conditions into a market crash with potential for a depression.

Citi "reached an agreement based on an innovative market solution to further strengthen our capital ratios, reduce risk, and increase liquidity," Chief Executive Vikram S. Pandit said in a statement. Citi's board approved the terms.

The lifeline being thrown to the bank represents the first time the government has absorbed bad assets rather than inject money directly into financials. Switzerland's government recently crafted a similar agreement with UBS.

"At some point the handouts have to stop and institutions have to start to take some accountability for what happened. Nobody wants to see Citi go into Chapter 11, but some type of sale or merger would likely have been the scenario preferred by the market," Aite Group analyst Christine Barry said.

The key provisions of the Citi bailout include:

The Treasury will inject $20 billion of capital, on top of a $25 billion federal infusion that was already dispatched.

The government will guarantee a roughly $306 billion pool of Citi's troubled assets, including mortgage-backed securities. Citigroup must absorb the first $29 billion in losses and 10% of anything beyond that.

Treasury will absorb the next $5 billion in losses, followed by the FDIC taking on the next $10 billion in losses.

Any losses on bad assets beyond that level would be taken by the Fed. The guarantees will be for 10 years for residential assets and five years for nonresidential assets.

Citi said it would issue $7 billion of preferred stock with an 8% dividend as payment for the guarantee.

Citi said it would issue warrants to the Treasury and the FDIC for some 254 million common shares at a strike price of $10.61.

The government must approve all executive compensation, including bonuses.

Effective with the payment of the next dividend on common stock, Citi agreed not to pay out more than 1 cent a share for three years.

Citigroup previously agreed to issue the government preferred shares in return for the $25 billion the bank received as one of the first nine companies to get capital infusions.

After the deal, Citi's Tier 1 capital ratio at Sept. 30, on a pro-forma basis assuming the October capital injection and the new capital announced on Sunday, is expected to be 14.8%, the banking giant said. Its tangible common equity would be about 9.3% of risk-weighted managed assets, Citi said.

In addition to $2 trillion in assets it has on its balance sheet, Citi has another $1.23 trillion in entities that aren't reflected there, according to reports. 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, The Wall Street Journal reported.

Up until last week, the financial markets had shown signs of recovering some confidence and stability as the shock of Lehman's September bankruptcy began to ease.

On Sept. 15, Lehman filed for Chapter 11 bankruptcy protection, ending the 158-year-old Wall Street firm's run and rattling the foundation of the global financial system.

Lehman's tentacles ran deep across global markets, and investors panicked as debt defaults sparked misery around the world, forcing selling by institutions and hedge funds and triggering the catastrophic "breaking of the buck" at one of the nation's most important money-market funds.

While Citi's difficulties are different from Lehman's, analysts said any disorderly breakdown at Citi would surely have sparked further chaos.

Citi's crisis came in spurts, as the bank has reported about $20 billion of losses over the last year amid huge writedowns for soured investments.

At this time a year ago, the stock market valued the company at about $180 billion. As of Friday morning, its market capitalization stood at $20 billion -- and its once-proud share price had shriveled to $3.75, a 16-year low.

Last week, short sellers focused on the perfect storm surrounding Citigroup. Its shares were sold in unprecedented volume as the concern about the scale of recently unveiled job cuts added to fresh fears about a quickly deteriorating commercial real estate market, as well as a surprise decision by the Treasury earlier this month to forgo purchasing troubled assets from firms like Citigroup.

That latter move by the Treasury likely prompted Citi's decision to bring about $17 billion of bad assets from a subsidiary onto its own balance sheet, sparking a probable charge of up to about $1 billion.

No one knows for sure how many assets like that Citi may have to haul onboard its balance sheet, and what kind of losses it could spark.

Should the company absorb many bad assets and take write-downs, that would eat into profits and, if it goes on long enough, eat away at core capital.

Even before the mortgage-fueled credit crunch, Citi and other banks faced calls to reorganize the company and even split it up.

Citi was created, under the guidance of Sandy Weill, by an acquisition binge in the 1990s that culminated in the merger between insurer Travelers and Citicorp. But the vision of a financial supermarket eventually came apart and Travelers was sold to MetLife

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