Citigroup Gets A “Conversion”

Earlier Friday Citigroup (C) announced it will offer to convert into common shares approximately  $27.5 billion of its preferred stock sold to public and private investors, and up to $25.0 billion in preferred stock bought by the U.S. government. The U.S. government would have approximately a 36% stake in Citigroup, while existing shareholders would be cut to a 26% stake, if fully executed.

The bank is suspending its payment of dividends on preferred stock. And though the common shareholders have to approve the deal, they do not have much choice, as Citigroup will issue securities to preferred shareholders who agree to the swap that let them buy common stock for a penny a share if shareholders don’t approve the deal.

The Treasury would only participate in the conversion once other preferred shareholders (predominately sovereign wealth funds) participated. So far, the Government of Singapore Investment Corp. and Saudi Prince Alwaleed Bin Talal have agreed to participate in the exchange.

While the conversion would not involve any additional government investment, under this maximum conversion scenario the primary result would be a significant increase in its tangible common equity and boost its tangible common equity ratio.

However, Citigroup will still have to endure a “stress test” (which examines a bank’s ability to withstand various economic scenarios). Once the test will have been completed, Citicorp would still be required to raise additional capital, which could create to potential for additional dilution.

This move makes the U.S. government the largest shareholder of the bank, and will probably play a much more active role in shaping the bank’s direction. It is a form of nationalization, whatever it may be termed by the Government. As a result of the deal, the stakes of existing common shareholders have been severely diluted. We expect the shares will remain under pressure.

We suspect Government will end up acquiring a substantial stake in the many other banks which will be required to rebuild their capital after the stress tests, as private capital will not be easy to come by. As such, we advise investors totally avoid those banks which are perfect candidates for capital infusion by the Government after the stress tests, like Bank of America (BAC), U.S. Bancorp (USB), PNC Financial Services Group (PNC) and Wells Fargo (WFC).

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