US government to hold up to 36% of Citi

Fears that the US government would take control of Citi were alleviated on Friday as the bank announced that the government will exchange only part of its preferred shares into common equity. At the same time, several other holders of Citi preferred shares will also convert into common shares, thus limiting the government's stake at 36%.

The deal will significantly increase Citi's tangible common equity level -- a measure that has recently caused a lot of concern in the market -- and will do so without any further investment by the government. While this may come as a relief to US taxpayers, who have already injected $45 billion worth of capital into Citi on two separate occasions in the fourth quarter of last year through the government's Troubled Asset Relief Programme (Tarp), a source close to Citi notes that despite owning more than one-third of the bank, the US government will not get any seats on the Citi board. Consequently it will not have the same level of formal control normally associated with an ownership of this size -- a shrewd move, perhaps, to leave the responsibility for getting the bank into shape to other parties.

But while the announcement stopped well short of a full nationalisation of the bank, it failed to halt the recent sell-off of Citi shares with commentators arguing that there is no guarantee that the government won't exchange its remaining preferred shares at a later date. To be sure, it doesn't take too vivid an imagination to believe that there could be more problems ahead for the world's major financial institutions -- in which case additional measures may be needed. Indeed, Citi on Friday announced a pre-tax goodwill impairment charge of $9.6 billion ($8.7 billion after tax) and a $374 million impairment charge ($242 million after tax) related to Nikko Asset Management in Japan for the fourth quarter last year, adding to an already announced quarterly net loss of $8.29 billion.

Investors also reacted negatively to the equity dilution for Citi's existing shareholders, which may be as much as 75% if all holders of preferred shares agree to accept the exchange offer. By the end of Friday's trading session, Citi's share price had slumped another 39% to $1.50 -- a 97% decline from its adjusted high of $51.01 in 2006.   

The selling pressure affected other banks too, as the deal added to concerns that other US banks may also opt to exchange their preferred shares for common equity.

Analysts at Goldman Sachs said the Citi announcement highlights the cost of government ownership through forced dilution; sale of core assets in order to generate more loss-absorbing capital; directed lending; dividend restrictions, etcetera.

"Government owned banks trade at a 50% discount in the UK, India and Brazil and we expect a similar theme in the US," the analysts, led by Richard Ramsden, said in a note published Friday. "We would avoid the shares as it is unclear whether this is the last round of capital restructuring, which means that existing equity may be further diluted in the future."

Citi said the government will exchange $25 billion of its $52 billion of preferred shares in the bank ($7 billion of which was received as a fee for guaranteeing up to $306 billion of real estate assets) to common equity at a price of $3.25 per share. The bank is also offering to exchange $27.5 billion of existing preferred securities and trust preferred securities held by other parties at the same price. The Government of Singapore Investment Corp (GIC), HRH Prince Alwaleed Bin Talal, Capital Research Global Investors, Capital World Investors and other investors have already said they will participate in the exchange.

While the $3.25 price at which the investors can exchange the preferred shares into common shares isn't exactly a bargain -- it represents a premium of 32% versus the close on Thursday and more than double the closing price on Friday after the exchange announcement -- the exchange offer is basically structured to make it even more unfavourable to keep the preferred shares. Other holders are therefore expected to follow suit.

Notably, Citi said it will suspend dividends on its preferred shares, removing one of the key attractions of holding these instruments. The bank will, however, make an exception for the government, which will continue to receive an 8% annual income on its remaining preferred shares by exchanging them into new trust preferred securities that will carry an annual coupon of 8%. Citi will also suspend dividends on its common shares, although this will have only a minor impact since the bank had already agreed to limit its quarterly dividends at no more than a penny per share for the next three years -- unless the government approves an increase.

If all non-government holders of preferred shares agree to exchange their holdings into common equity, they will end up with a combined 38% stake in the company. The government will hold 36%, while the existing shareholders will own 26%. (The earnings-per-share dilution will be less than the 74% implied by the new ownership structure because of the elimination of preferred dividend payments with analysts at Goldman Sachs estimating that normalised earnings power will fall by about 50%.)

A full conversion of the preferred shares will boost Citi's tangible common equity (TCE) to about $81 billion from $29.7 billion in the fourth quarter 2008, while analysts estimate that its tangible book value per share will decline by up to 30% to $3.75-$3.85 from $5.30-$5.40. The tier-1 capital ratio, which stood at 11.9% as of the end of December, will not be affected. 

Since the issuance of new shares to complete the exchange requires the approval of existing shareholders, the preferred shares will first be exchanged into interim securities with warrants, which will convert into common shares once such an approval has been obtained. If the share issue isn't approved, then the holders can use the warrants to buy common Citi shares at $0.01 apiece. In the meantime, the interim securities will pay a 9% dividend that will increase quarterly up to a maximum of 19%.