Federal regulators got a fresh inside look at Citigroup's (C) books over the weekend—and it wasn't pretty.
The result: a new $306 billion federal bailout for the bank. On the one hand, it provides more clarity as to the lengths the government will now go to shore up the U.S. financial system. On the other hand, investors continue to be wary about whether Citi was worth saving from oblivion. Worse, some of them worry that if a bank with one of the highest capital ratios nearly went under, who's next?
"You had a tremendous amount of people looking inside at Citi in the last few days to figure out how bad it was, and they came away thinking that the capital markets can't handle this," says David Ellison, manager of the $185 million FBR Small Cap Financial Fund (FBRSX). "So, Citigroup wasn't a going concern. What does it tell you about the industry and everybody else all around the world that has the same assets?"
On Monday, at least, the market chose to view the bright side of the Citi deal. Citi's shares jumped 2.18, or 58%, to close at 5.95 on Nov. 24. And the prospect of stability for financial stocks lifted the broader market, as the Dow Jones industrial average gained 397 points, or 4.9%, to 8,443.39. The Standard & Poor's 500-stock index gained 52 points, or 6.5%, to 851.78.Bailout Terms
Citigroup agreed to the unprecedented series of steps with the U.S. Treasury, the Federal Reserve Board, and the Federal Deposit Insurance Corp. to strengthen the bank's capital ratios, reduce risk, and increase its liquidity. Under the program, announced on Nov. 24, the Treasury will invest an additional $20 billion in Citi preferred stock under the Troubled Asset Relief Program (TARP), on top of $25 billion the bank received about a month ago.
Also, Citi will issue an incremental $7 billion in preferred stock to both the Treasury and the FDIC as payment for a government guarantee on $306 billion of securities, loans, and commitments backed by residential and commercial real estate and other assets. The bailout agreement also means that Citi must submit any executive compensation plans to the government for approval.
Under the guarantee, Citi will assume any losses on the $306 billion portfolio up to $29 billion on a pretax basis—meaning the government will assume 90% of any losses.
According to people familiar with the negotiations, the government struck a plan to "ring-fence" around about $300 billion in questionable assets, which will remain on Citigroup's books. That was the only group of assets for which the feds and Citi could agree on a potential value, sources say. That amounts to just 15% of Citi's total assets, which are a shade over $2 trillion.
The plan is not only good for the system, say those sources, but it provides cheap insurance for the government compared with the costs of a financial system in meltdown mode.
Sources also say that the calculations on the value of the portfolio were made on the "very unlikely event" that the U.S. economy has a downturn as severe as the Great Depression. The values of the assets in that $300 billion pool were based on projected cash flows for the life of the assets and not on their current and fluctuating distressed prices.