Nov 26, 2008

Business - Citi can sleep in peace

The US government’s bail-out of Citigroup, which was the most valuable bank in the world before it lost 83 per cent of its value over the past 11 months, would seem to be a smarter (and fairer) package than what the British government announced last month, in that it probably addresses Citi’s problems without getting into state control of a bank. More importantly, it salvages a bank whose sharply dropping share price had raised fears of panic withdrawal of cash by depositors, and the dread prospect of a major bank failure. It has clearly been another busy week-end for the Treasury, the Federal Reserve and the Federal Deposit Insurance Corporation, the three organisations that have cobbled together the bail-out package.

The package that has been announced recapitalises the bank quite substantially, and takes the heat off the bank by extending a guarantee on $306 billion of troubled loans (out of a total asset base of about $2 trillion). The guarantee lowers the risk weight on these assets, thus further bolstering the bank’s capital. Since the bank has already lost $20 billion in the last four quarters because of write-downs on derivatives and housing loans, and made provisions for another $24 billion, the guarantee (which is 100 per cent for a base slab and 90 per cent beyond that) should probably be enough to restore confidence in the bank’s future.

Shareholders who have already suffered a battering in the market will pay a further price, since their shares will have a dividend cap of 1 per cent for three years, while the bank pays the government an 8 per cent coupon rate on the $25 billion preferential capital that it is getting. The end-game could still be positive if one assumes that they will get an upside on the stock price. There will be no management change, so Vikram Pandit keeps his job, but the top management will have to accept some pay cuts that are an inescapable part of the government’s troubled assets relief programme.

At the end of the whole exercise, the government could end up owning nearly 8 per cent of Citigroup (some of it because of money given earlier), with no management control. If the bank does well from here on, that will give tax payers (who are funding the whole package) a chance to share the upside—but for that the stock has to more than double its present value. The deal is better than the UK government’s taking majority control of the Royal Bank of Scotland and 40 per cent ownership of the merged LloydsTSB and HBOS. Those banks lost in value on the market following the UK government move, whereas Citi shares gained yesterday in some European markets.

The Citi bail-out raises questions about the true extent of the US financial sector’s problems, especially since Mr Pandit assured stakeholders at every turn that the bank was safe and strong in every way—which clearly was not true. The problem seems to have arisen from sharply increased trading activity by the bank, without proper risk management—which points to internal management failures on a scale that raises troubling questions about the quality of management in any financial undertaking. The origin of the problem seems to have been new regulations that allowed banks to get into riskier activity, and the arrival on the executive floor of Robert Rubin, ex-Goldman Sachs (and treasury secretary under President Clinton). This episode adds to the weight of the arguments that run in favour of more comprehensive and tighter regulation of all financial sector activities.

No comments: