The Real Reason Citi Is Selling Smith Barney

The frenzy over the Citibank (C) / Morgan Stanley (MS) joint venture has primarily focused on what to name the new baby. However, there is an underlying motivation for the tie-up, Citibank must do this deal or face losing $10b in tier 1 capital.

The FT published a story on January 9th that stated in Q3 08 Citibank had $96b in Tier 1 capital, of which $10.8b was made up of a deferred tax asset. The idea behind calling it an asset is a company can use deferred taxes to offset gains in the current year. The problem facing Citibank is the lack of taxable income this year. Deferred tax assets are only allowed in Tier 1 capital if the bank can show that it will earn pre-tax income in the next four quarters that will be equal to the tax asset held. Given that Citibank has lost money this year, it will be hard to convince its auditors that 2009 is going to be better. As a comparison, in 2007 Citibank reported earnings before taxes of $1.7b., while in 2006 earnings before taxes were $29b. At a 35% tax rate, Citibank would have to earn over $30b in the next four quarters to justify keeping the deferred tax assets as Tier 1 capital.

In the FT story, the tax consultant Robert Willens, suggested that if Citibank could convince auditors and regulators that it plans to sell an asset at a large profit in the next four quarters they may be able to keep the tax deferred asset as Tier 1 capital. I think you can see where I am headed. By selling Smith Barney at a premium, Citibank gets to hold onto $10b in deferred tax assets.

Felix Simon at Portfolio.com wrote an interesting piece on the mathematics behind the deal. In the article he attempted to calculate the present value of Smith Barney and came up with $0. I am not an accountant, nor do I play one on tv, so I am taking these calculations at face value. However, putting it all together, it makes sense. Citibank needs a $0 present value so that they can record a profit on the sale and keep the auditors and regulators at bay.

So while Bloomberg reports that Citibank may see a before tax gain of $10b, it seems to me it is just a wash sale with a kicker. If Citibank does not sell Smith Barney then they lose $10b. By selling Smith Barney, Citi keeps the $10b and any other additional consideration. Is this really a choice?

Disclosure: I am long SKF

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