A Tale Of Two Cities - Citigroup And Detroit

The troubles with Citigroup (C) began in late September, when the government-assisted purchase of Wachovia (WB) fell through to a Wells Fargo bid that did not require government backing. A closer look at the deal reveals that the bid for WB was more than a push for a deeper pool of deposits. Citi and the government planned to divide the losses on $312 billion in assets, with Citi shouldering the first $30 billion and the gov’t covering the rest. Citigroup described the deal as a way of protecting it from Wachovia’s risky assets. However, the company would have been able to add a significant share of its riskiest assets in the plan, with the government on the hook. After the deal fell apart, Citi was unable to convince the government to help insulate it from further losses.

This past week Citi’s stock plunged 60%. On Monday, the company announced they were canceling plans to try to sell $80 billion of their riskiest assets. Later in the week, they purchased $17.4 billion in assets from their structured-investment vehicles (SIVs), with $1.1 billion in losses to be recognized immediately. Citigroup’s $2 trillion balance sheet is complimented by $1.23 trillion in off-balance sheet entities. This, in combination with the recent sell off, has spooked investors worried about the uncertainty of the content of these holdings, especially the amount linked to commercial and residential mortgage securities.

Bailout - The Details

The U.S. government agreed late Sunday evening to a bailout of Citigroup. The government will cover a $306 billion asset pool consisting of securities backed by residential and commercial real estate. Citi will absorb the first $29 billion in losses. Losses in excess of that amount will be shared by the government (90%) and Citi (10%). The U.S. Treasury (via TARP) will cover up to $5 billion, and the F.D.I.C. will take the next $10 billion. Should losses exceed this amount, the Federal Reserve will issue a non-recourse loan to Citi at OIS +300bps. Additionally, the Treasury is injecting $20 billion in capital (on top of the previous $25 billion Citi received).

In exchange for the capital injection and asset guarantee, the government was granted $20 billion in perpetual shares from Citi. The Preferreds will pay cumulative dividends at 8%. The Preferreds are non-voting, but put a restriction on paying of common stock dividends for three years without consent of the Treasury. Other stipulations include a mandatory reporting to the U.S. government, detailing revised executive compensation plans by Citigroup.

Reaction

Citi was up 57.82% and the S&P 500 (^GSPC) rallied 6.47% Monday on the news of the Citi bailout. After Bear, Lehman, Morgan Stanley (MS), Goldman Sachs (GS), and AIG (AIG), I can’t help but think the market is desensitized to such major displays of fundamental weakness. One of the largest and most recognizable financial institutions in the world acknowledged that it is unable to stand on its own two feet and the market saw a huge rally on the news. I would think this has to call the likes of JP Morgan (JPM) into question as the worst of the financial crisis seems far from over.

President-elect Barack Obama’s chief political adviser announced Sunday that passing a massive economic stimulus package would be his first priority upon entering office. The new package is likely to cost $500-700 billion, well above the original $175 billion discussed during his campaign. Monday, ten-year Treasury CDs hit its widest levels ever on fears of the government’s financial stability given the massive increase in supply. As discussed in a previous article entitled “Presiding Over Supply,” it seems the government has two options to pay for this huge increase. One, it can raise taxes. Two, it can inflate away the problem. A third option that has been suggested, which seems remote given our presidential selection, is to involve ourselves in a war that would stimulate the economy. I can’t emphasize enough the extent to which I think this massive increase in the federal deficit is going to be a huge problem for the gov’t (and taxpayers) and will limit the effectiveness of President Obama.

Detroit Motor City

One of the few bright spots in recent economic policy has been the Treasury’s reaction to the Big-Three automakers requests for funds from TARP. Paulson’s refusal centered on the notion that TARP was designed for financial institutions and the automakers were already granted a $25 billion stimulus (toward fuel-efficient design). However, I think the real reason for the refusal of funds was the realization that these companies are beyond simple capital infusions. The aged business models, pension problems and refusal for significant changes put them on the chopping block. The only viable option is to allow them to file for Chapter 11, restructure and slim capacity. The government, meanwhile, needs to offer some sort of “warranty guarantee” to keep demand for domestic autos while they complete their transformation.

The difficulty in this plan for President-elect Obama is explaining to middle-class America why we can bailout the financial services institutions but not the auto manufacturers, those companies that create a tangible product and have been considered the backbone of the American economy for years. Obama has done his best to explain this, stating “Taxpayers can’t be expected to pony up more money for an auto industry that has been resistant to change…And I was surprised that they did not have a better-thought-out proposal when they arrived in Congress….I think that the auto industry needs to present us with some clarity in terms of the dollar figures that they’re talking about.”

Disclosure: The mutual fund this author is associated with is long JPM and GS.

Posted in Categories: Auto, Contributor, External Research, Financial, Stocks, USA.

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