Citi Deal, Treasury's 'Stress Tests' Raise Lots of Questions

It’s done. It’s finished. It’s now time to put all of the speculation to rest. The government and Citi (C) have sealed a deal. How does it work?

The $25 billion dollars in preferred shares that the government initially invested will be converted into common equity shares assuming they get an equal number of private investors to do the same. Why?

1. Preferred shares normally receive dividends. Citi would have had to pay the government $2.5 billion in dividends next year. Very costly in an environment where conserving cash is essential. 

2. Preferred shares have no voting or controlling rights. A conversion to common equity at the current rate of $3.25 gives the government a 36% stake in the common equity shares of the company. Note the other $20 billion that the government invested will remain as convertible preferred shares with an 8% annual dividend. If conditions deteriorate, the government and Citi will look to convert the remaining investment. 

3. Usually if a company goes bankrupt the debt holders get paid back first, then the preferred shareholders and then the common equity shareholders. If you think Citi is going to fail you could argue that a shareholder would prefer to retain the preferred shares so that they’ll be in second position if the company fails. The government will not allow Citi to fail. 

4. The reason the government wants to make sure that private investors match the conversion of preferred shares that the government is willing to consider is because the government wants to protect their investment. If the bigger preferred investors like the Government of Singapore and Prince Alwaleed Bin Talal go along, as Citi has indicated they will, the taxpayer can take a little more comfort in noting that everyone is in it together. 

5. The current formula assumes other Trust preferred shareholders and preferred shareholders will consider the attractive conversion plan and move into common equity. 

So if you’re a preferred shareholder this morning and found out that Citi is suspending the dividend on your preferred stock, why stay in preferred shares other than to put yourself in second position if they fail? There’s absolutely no reason. The government has now essentially said that they will rescue this company at all costs. Current common equity shareholders now own 26% of the outstanding shares hence the dilution conversation over the past couple of weeks.

Long term, what does this say about the Treasury’s plan?

1. Preferred shares are gone. Common Equity is the new preferred. It does not require them to inject more capital. They get voting rights. Power to shake up boards as they’ll do in Citi’s case and by forcing the institution to match the conversion with private conversions, they protect their investment. 

2. The BIGGER issue is what happens to the tens of millions of Americans who rely on dividend income. The income funds that invest on behalf of retirees who live off of that income as though it were a social security check. They will be wiped out. 

3. The FDIC Chair said it herself yesterday when she announced the quarterly FDIC banking report when she said this is the worst climate in its 75 year history. She warned / suggested that financial institutions either suspend or reduce their dividends to conserve cash. This while the FDIC’s insurance fund has been depleted and odds are that they’ll have to double the rate by which they charge banks to inject funds into that insurance program. No mention just yet of tapping into the $30 billion dollar line from the Treasury Department. It is clear from the IndyMac failure, which cost them $10.7 billion dollars that they cannot afford to see a larger institution fail. So what happens….the smaller institutions that are holding up in the wake of this horrible credit environment will be forced to contribute funds when they really need it in order to make sure that the FDIC’s insurance fund remains solvent and prepared to protect deposits while financial institutions collapse. 

4. Finally, consider for a second this drastic turn to tangible common equity from tier one capital ratios. Two fairly wonky accounting terms but two different ways to look at the health and well being of a financial institution. Clearly the Treasury’s plan and the FDIC’s suggestions yesterday indicate that tier one capital ratios have not proved to be sound measurements of a banks health. Somehow in the past couple of months, the markets, certain investors and our government have determined that tangible common equity is the way to determine a banks health and well being. The problem with that is whose best interests are we considering? This plan ignores the millions upon millions of Americans who rely on dividends. This plan says to all of the financial analysts (so-called experts), the rating agencies and the accounting groups around the world that the benchmark by which we measure a banks health has changed because we forced them to write down assets to a market price when no market existed. So they have record deposits, they have record levels of cash but that’s not good enough because every single month we say to them give us your worst case scenario now. Every time we do that accounting rules force them to take another charge, another loan loss reserve. It’s a sinking hole. 

As you can see, I’m very frustrated about this. I don’t like seeing the rules change in the middle of the game. You have to ask yourself as a taxpayer now what you prefer to own, preferred shares or common equity shares. Frankly, I prefer to own common equity and participate on the upside. I do not qualify this as nationalization. I would like to think that once the deal with Citi is complete (by the end of April), we could hit rock bottom and begin to rebuild. If this conversion prevents the government from injecting more cash I say we take it. At the end of the day, we need these companies to win. We, the taxpayer, own them. It is in our best interest to see them get healthy. I still prefer removal of toxic assets into an aggregator bank without specific prices attached that hurt the taxpayer or the financial institution and rather a bill to the bank when the assets decline and a shared profit between the two parties on the upside. I want to see if Geithner’s public/private investment works. The details of that plan will determine the fate of these institutions over the next six months.

Citi’s Chief Financial Officer Gary Crittenden joined me in studio this morning and walked through many of these questions and a whole lot more. Look at what he says about profitability, about how we measure institutions from one country to another and if the Treasury’s proposed stress test is similar to the stress test Citi did internally.